Why #Bitcoin has Value?
In this article, I will attempt the difficult task of explaining how to value, or price, Bitcoin. However, I will discuss the topic at a fundamental level. This is not a technical analysis.
Money is language
We must first understand that money is a language. Money helps rank the relative wealth and value of individuals, goods, and services. Neither language nor money need intrinsic value. They need no alternative use.
Think about the game Monopoly. The players agree to the rules of the game and compete. The winner of the game has the most property, which is bought with Monopoly Money. Monopoly Money has no intrinsic value, but it is used to measure who is winning. Real money cannot be substituted for Monopoly Money — that is cheating. Monopoly Money becomes more valuable than real money, in terms of winning the game.
In the game of real life, humans agree on how to measure value using the language of money (with the money of their choice), and they agree to acquire and trade things that have intrinsic value.
Gold Failed us
For many reasons, gold has been our BEST money, but it is not perfect. It does have intrinsic value, and it is argued by most that this is an important feature. However, its intrinsic value is also one of its imperfections. Great Austrian economists from the past have argued that money must be a commodity. This is partly true, only because all types of money have always been commodities, though that does not mean this is a requirement. But, what good is the intrinsic value of gold now? Is it any consolation, if gold were to no longer function as money, that you could sell your hoard to industry, for 1% of your original purchase price? Of course not.
Early on, humans used some commodities that later evolved into money. The world converged on the best money, which was gold. In a free market, it’s assumed that independent, self-interested decisions by individuals, who seek to store wealth in the best and most liquid money available, will push the world to converge on only one form of money. But this hasn’t happened. Because gold was not easily divisible for small payments, silver emerged as money as well. And because gold was not easily stored, it was trusted in banks and gradually became centralized in fewer and fewer banks, until it was possible to confiscate and mandate the use of government-issued fiat currencies backed by gold. Then the Gold (Control) Act, 1968 is a repealed Act of the Parliament of India which was enacted to control sale and holding of gold in personal possession. And because of this, all other fiat currencies, which were once assigned different weight claims in relation to gold (through the INR ), no longer held claims to gold. Governments were then able to freely inflate the money supply, and they did, silently robbing civilization of stored wealth. Gold failed us.
All money used in the world is government-issued and controlled. Free market money was wiped out. When free market money was “reinvented” by trading electronic claims to real gold (e-gold), it was shut down.
WHY BITCOIN WAS BORN
The pubic insures banks and earns no premium
Banks gave out enormous amounts of credit, under a fractional reserve system, effectively creating money. Their reserves were too low and when the banks failed, central banks created money to bail them out. Banks were able to take risks and gain the rewards, but not face the consequences. The rich became richer.
In response to the 2008 financial crisis, Bitcoin was released by someone operating under the pseudonym Satoshi Nakamoto. The timing was perfect. Embedded in the very first Bitcoin block were the words “Chancellor on the brink of second bailout for banks” — the front page headline in the Times on January 3, 2009. Incidentally, original copies of this newspaper are very rare and incredibly expensive.
Bitcoin, a free market, non-government-issued money, is growing and has all the important properties of gold, but it is also:
Easily verifiable as genuine,
Unable to be shut down by any government,
Cheap to transfer,
Peer-to-peer with no third party,
With Bitcoin, billions of dollars’ worth of value can be transferred across the world with incredible security, in 10 minutes (though it’s best to wait one hour for the best security), typically for $1 or less. This is not a trusted Visa or PayPal third party payment. It is final settlement, akin to a bank moving gold or cash in an armored truck with high security. This is not how you transfer funds to pay for coffee. Payment rails like the Lightning Network, or at worst Visa or PayPal Bitcoin payments, can take care of coffee. This is bigger. The world yearned for a permissionless, scarce, uninflatable money, and now it has it — it doesn’t need a new payments system.
Clearly, Bitcoin is incredibly good money and valuable. The fact that it is highly volatile, a property of any evolving money, should not incorrectly and negatively bias our assessment of its potential.
In summary so far, Bitcoin has the properties to become the world’s best available money, and it is gaining ground on other currencies, but it is still in its infant stages. Its market cap is tiny and its price swings wildly. As it grows to a significant size, the price will stabilize (and be much higher).
Factors affecting Bitcoin’s current price
Mining bitcoin and inflation
It is important to understand how bitcoin is created, at least on a superficial level. Bitcoin is mined by computers. Every 10 minutes on average, a new block of transactions is added to the total ledger, also called the blockchain. It contains the history of every transaction since inception. Every block requires a puzzle to be solved that can only be done by brute force trial and error, and that puzzle must be solved to make the block valid and accepted by the network as the next link in the blockchain.
This is a competition. Miners all over the world use computers and take the available requested transactions from the pool (“mempool”) and put them in a block that they fashion themselves. They also include a reward of 12.5 bitcoin that are linked to their own address — created out of nothing (“mined”) but respecting the rules. The winning miner, the one who finds the solution first, gets to put their version of the next block (which pays them new bitcoin) onto the blockchain. Then the race starts again for the next block of transactions. This computing power costs energy, which costs money. Miners with cheap electricity make the most profits. They spend money on capital (e.g., computers, land, air conditioning, staff, interest on loans, etc.) and electricity and sell their bitcoin rewards on the market to make a profit. To put it simply, they are performing electricity-price vs. bitcoin-price arbitrage.
Miners with high costs become unprofitable as the price of bitcoin drops, and acting rationally, they switch off their machines. When the price of bitcoin goes up, more miners invest in equipment and compete, and new blocks are created faster and faster because of more worldwide computing power (“hash rate”).
But every 2,016 blocks (about two weeks), the Bitcoin software adjusts how difficult it is for miners to find blocks (“difficulty adjustment”) so that block times stay close to 10 minutes, and the newly created bitcoin rate stays constant. This raises the cost of mining. When price goes up, initial profits go up, more miners join, Bitcoin adjusts, profits come back down, and as a final result, hash rate goes up while all else stays the same. The opposite is also true: The difficulty, and cost to mine, goes down as miners switch off as the price drops. The mining participation follows the price, but the block production rate and bitcoin production rate remain consistent.
Why i have explained this? Its about Inflation, and that is crucial to understanding the value of money. Money with a growing supply is less valuable than one with a stable or shrinking supply, all else being equal. Every 10 minutes, 12.5 bitcoins are rewarded to a miner, who then sells them on the open market. A proportion may be held, particularly in the early days, but now, mining is big business. That is, arbitrage business, not speculation. Every 210,000 blocks, the reward to miners halves (roughly every four years). This supply started at 50 per block, then halved to 25 at block 210,000 four years later. Then to 12.5 per block in 2016. In May 2020, at block 630,000, the supply will fall to 6.25.
18.375 million bitcoin in total will have been released at that future date. And from then on, the inflation rate will be 1.79% of stock, lower than gold’s inflation. The total supply of bitcoin can never be greater than 21 million. That is written in the code and can’t be changed. Not even gold’s supply is capped. Nothing but our time is as scare as bitcoin. Since money puts a value on our time, this is quite powerful.
“But the code can be changed,” I hear many say. This is true, but what matters is the community’s consensus. The community of holders will act in self-interest and not allow the 21 million cap to be breached. How the users can enforce their will is outside the scope of this article, but analyzing the Bitcoin vs Bitcoin Cash history is very informative.
Price: Demand vs Supply
Knowing the inflation rate precisely, and estimating that miners mostly sell new bitcoin, allows us to closely estimate the average supply flow side of the equation to figure out bitcoin price. Is there any other asset where the total stock, and supply to the open market, is so accurately known? I don’t know of any.
Because we know supply flow and price, we can calculate demand flow precisely. 1800 bitcoins per day sold to the market at a price of 10,000 USD means that 18 million dollars is invested with new money, into bitcoin, per day. (We must exclude the supply/demand fluctuations caused by traders as they enter and exit the market and have no net effect on supply, demand, or average price.)
That was working backwards. Now that we have teased out new demand, try thinking forwards: 18 million dollars is invested per day; 1800 coins are made available as brand new bitcoin per day; price should therefore be $10,000 per bitcoin. Note how this has nothing to do with the business activities and profits of miners. Many news articles and commentators get distracted by the politics and soap opera of the mining business world, but it makes no difference to Bitcoin. The level of mining only influences the security of the network. The more money spent on electricity by miners, the more an attacker needs to spend, the more secure Bitcoin becomes. But the security is way more than enough at the moment and does not change how much bitcoin is supplied to the market per day. It only affects the perception of security to market participants and therefore indirectly influences supply and demand (price) to a small extent.
As I mentioned before, the supply flow of bitcoin will soon halve. What will happen then? If demand stays constant and supply halves, the price will double. As the price doubles, people pay more attention, and more people look at and learn about Bitcoin. The price shoots up. Everyone that wanted to invest does, runs out of money they are willing to invest, and then suddenly, the wave of money coming in stops, as FOMO demand is satisfied.
But miners keep producing bitcoin and keep selling constantly. As the demand wave drops, and supply remains constant, the price will crash. Many will get burned, again. But some will have learned what Bitcoin is and will regularly buy some quantity regardless of price. These are the Dollar-Cost-Average (DCA) folks — the “Bitcoin Angels”. These people put the floor on the bitcoin price, not the hodlers of last resort, although they are important too, as they stop the price from falling further, though they do not hold it up. The ones buying in the face of constant supply hold up the price. The last floor was around 3500 USD ( INR 2,62,500 )in 2018, equating to 6.3 million USD of buying per day on average. The next floor will be higher. Unless a critical flaw in Bitcoin is discovered that can’t be fixed, people who DCA won’t stop. Their numbers only grow. Once Bitcoin is understood, one does not forget what they know. Many become consumed by it, and like me, teach others about it. You’re most welcome.
The Halving of supply is “ IMPOSSIBLE “ to price-in.
The halving of supply, incidentally, cannot be priced in. It is impossible. Whether you believe in the efficient market hypothesis or not, bitcoin supply changes cannot be priced in. That is because news of a future event can influence supply and demand and therefore price, and potentially price in the event. But the halving event is not news — it is supply. Even if price were to increase and look like it has been “priced in”, when the day comes, supply will be halved regardless, and with steady demand, price will still go up.
In summary so far, the price of bitcoin is based on two factors that affect the price of any asset (supply and demand). Except, in the case of bitcoin, supply and demand can be calculated with near certainty. This is unique and a great opportunity.
The future of Bitcoin and final stable value
What about the future price? Well, supply in the future is known, but demand is not. Estimating demand involves predicting what will happen to Bitcoin.
Will it die? Can it be killed?
Debunking all the risks to Bitcoin’s survival is for another article, but my overall position is this, and I’ve said it before: Only two improbable things can kill Bitcoin:
- Extinction of the human race.
- Loss of freedom and communication due to worldwide, coordinated totalitarianism.
If Bitcoin doesn’t die, through the Lindy effect, it will gain popularity as more and more people will believe it won’t die. Through a worldwide open-source computer programming effort, it will improve as well. I won’t discuss privacy improvements or layer two developments with the Lightning Network, or redundancy communication developments through MESH networks — there is too much for me to keep abreast of and write about. Suffice to say, I am confident demand will grow.
And continued growth makes it more likely that Bitcoin will eventually become the world reserve currency, and ultimate near-perfect store of value. In that case, one could take all the world’s store of value and divide it by the maximum supply of bitcoin to arrive at a maximum bitcoin value of around 50 million to 100 million USD per bitcoin.
One day, when mining companies pay for electricity with bitcoin instead of USD, the circular economy will explode. At the exchanges, the order books on the sell side will be empty. USD and all other fiat currencies are likely to become worthless and no one will sell any quantity of bitcoin for them. 1 bitcoin will be worth 1 bitcoin, not 100 million USD.