Why is Bitcoin worth anything?
September 27, 2018
In conversations about Bitcoin I often get the question of why Bitcoin is really worth anything. Why would anyone pay 6000 dollars for a "digital coin" that you can't even touch and that barely any store accept as payment? Let's go through the basics.
First of all, the price of anything in a free market is always fundamentally about supply and demand. The demand side is especially interesting for Bitcoin since it is the first digital asset that is actually strictly limited. Mathematics combined with the consensus of people using the system guarantees that there will never be more than 21 million bitcoins. The supply increases according to a predetermined formula until finally no more bitcoins are created around the year 2140.
This is not only unique in the digital world, but also in the physical one. Gold, that has often been used as money throughout history has a total supply that increases by 1 to 2 percent per year right now and this rate has been fairly steady for quite some time. This is of course not written in stone - if a large, easily accessible gold deposit were discovered the supply would increase at more than the usual rate. Bitcoin is different in that the supply is governed by math and rules that can't be changed by any authority.
To put the value of 1 bitcoin in relation to something, let's compare it to the equivalent amount of gold, i.e. the same fraction of the total supply. There is roughly 190 million kilograms of gold in the world so owning 1 bitcoin is like owning roughly 9 kilograms of gold. The price of 9 kilograms of gold is right now at around 350,000 dollars.
So, the supply of bitcoins is strictly limited and this is one factor of Bitcoin being worth something, since if anyone could produce more bitcoins at a whim the price would crash. But a limited supply is not enough for something to be have value. For example I could create a completely unique painting, but I'm pretty sure that noone will buy it, even for 10 dollars. The other side of the equation, the demand, is necessary and a bit more complicated. Why is there a demand for something like Bitcoin?
If there is to be demand for something, that something must have some kind of quality that people want. During a speculation bubble such as the one in late 2017 (or in 2013, or in 2011) that quality has basically become "something that increases quickly in value". People see something that increases a lot in value, and boy do people like stuff that increase in value! So now demand increases because Bitcoin seems to have this almost magical quality. This is typical of all speculation bubbles and at some point there is a crash, when people no longer believe that this quality is actually there.
Analyzing demand in a bubble phase is therefore not very interesting. What is it that makes Bitcoin worth 6000 dollars, right now, when it obviously doesn't have the magic quality of constantly increasing in value? Now it's more about what Bitcoin can actually be used for, but also what people believe is a possible future for Bitcoin. Also valuations of companies focus a lot on what prospects the company has for the future rather than what it accomplishes right now, especially for new companies.
Here are some of the areas where Bitcoin might play a role in the future.
Digital gold ("store of value")
Comparing Bitcoin to gold is relevant. Gold is shiny and pretty but the most important property is actually that the supply is limited. The new gold that is added to the supply each year is small in comparison to the current total supply, i.e. what is known as the stock-to-flow ratio is high. This is why people have chosen to use gold as a store of value over time and as mentioned earlier Bitcoin also has this stability, but in a more refined form. What Bitcoin lacks compared to gold is the historical record, Bitcoin has only been around for 10 years while gold has functioned as a store of value for thousands of years.
But, Bitcoin has other qualities that gold lacks, for example that it is fast and simple to transfer globally.
Digital cash ("medium of exchange")
The fact that Bitcoin can be transferred directly between people and companies all over the world means that Bitcoin can fulfill another of the functions of money, to be a medium of exchange. It is actually very unusual that something is suitable both to be a medium of exchange and a store of value so this makes Bitcoin unique in a historical context. Of course gold, in the shape of gold coins, can be used for payments but to a larger and larger extent it is instead locked up in vaults and replaced with paper and digital bits that are simpler to transfer.
On the other hand, the money that we use for payments (such as bills or bank accounts) are not suitable as a store of value because of high inflation and the fact that they are controlled by some authority. Authorities come and go so seen over a long period of time it is a lot safer to keep your wealth in something that is not controlled by a single entity.
A global currency ("unit of account")
The global Forex market, i.e. where trading of all the world's currencies take place, is the single largest market in the world by far, based on trading volume. There is something a bit absurd about this, that we use this much resources for trading currencies back and forth. This is really the same problem as the fact that we use different languages in a world where we try to cooperate, do business and get along on a global scale. Only the European Union employs thousands of translators full time and these direct costs are still probably small compared to the indirect costs of efficiency loss and collaboration that never happens.
If the whole world would use the same infrastructure for money we could get rid of the world's largest market and use those resources for more productive things. It is impossible to imagine that this would happen by some agreement of all the world leaders to use a common currency. It instead has to happen through a decentralized, neutral currency that anyone, anywhere can use and be a part of. That's how it happened with the internet and that's how it needs to happen this time. Bitcoin has for the first time in history made this a practical possibility.
Not only does Bitcoin have the properties that makes it good money in a traditional sense, it also has features that makes it possible to build new services and products on top of it. Services and products that we can't even imagine yet. If you want to understand more about how Bitcoin is programmable money, please check out this presentation by Andreas Antonopoulos.
Today's valuation of Bitcoin is based mostly on what people expect Bitcoin to be in the future. If Bitcoin can actually live up to some of the promises outlined above today's valuation is no doubt pretty low. On the other hand, if you believe that Bitcoin's impact on the economy will be no greater than the fax machine’s, then today's valuation is probably too high.