It is hard to conceptually separate the meaning of the 3 key terms that should govern any rational decision about the purchase of a good, service, asset or an investment. We often mix them up, which results in a narrower assessment of the asset and our situation vis-à-vis that asset. When it comes to cryptocurrencies, this confusion can be compounded by the rapid change in market sentiment, expressed in rapidly shifting prices of these digital assets. Many times, we wrongly confuse this price with the actual value of the asset, and at a subjective level, we can even get the utility of that asset wrong. Therefore, it is necessary to understand these 3 key terms — price, value and utility — to improve our decision-making ability when it comes to the kind of digital assets we are looking to purchase or liquidate, and the timing of our actions in the market.
we wrongly confuse this price with the actual value of the asset, and at a subjective level, we can even get the utility of that asset wrong
Forget Adam Smith!
The first economic theorist who defined these concepts and wrote those definitions down, was Adam Smith. Nevertheless, he defined them in such a way that blurred the line between the objective and the subjective. Therefore, economic theorists after him, have come up with a variety of definitions for these concepts. To avoid delving in economic theory too long, for the sake of moving onto decision-making in the dynamic world of cryptocurrency markets, we will define these 3 concepts in their simplest form, without getting into their derivatives:
- Price — The sum of money that gives us a common denominator about how much an asset is worth. Price is a form of assessment of an asset’s value.
- Value — The objective merits or benefit derived from the ownership of an asset.
- Utility — The subjective benefit that an individual in a particular situation derives from an asset.
Why is Bitcoin So Expensive?
Knowing these definitions, allows us to approach cryptocurrency markets differently. This is especially evident when we come across someone who asks us a question such as “why is Bitcoin so expensive?” Answering this question can give us an incredible insight about how subjectively we think about cryptocurrency markets. Many of us are likely to reply that Bitcoin is not expensive; for us the opposite is true. We regard Bitcoin or other altcoins to be selling at a discount, especially when we denominate them in fiat.
This has to do more with our perceived utility of Bitcoin or other altcoins, than with their more objective value and how the markets move to assess this value, through the use of a price that a critical mass of buyers and sellers agree upon. In a way, the utility of Bitcoin or other altcoins to a person who believes in the traditional financial system and in centralized inflationary currency, is 0. Therefore, that person will not buy Bitcoin at any price. Others see the value in it, but disagree on how to quantify it, or how to price that value in. Those people are more likely to buy Bitcoin or other altcoins at certain prices only. We tend to see cryptocurrency in terms of a hedge against a financial system that has crumbled many times before, or as an asset that will allow us to be free from centralization. Many of us are willing to buy Bitcoin or our favorite cryptocurrency at any price if given the opportunity.
Many of us are willing to buy Bitcoin or our favorite cryptocurrency at any price if given the opportunity.
So, what is the real value of Bitcoin and other leading cryptocurrencies, that has lead so many to pour in their money into these markets? The answer is objectively unquantifiable, unless we test it in the markets, where buyers and sellers will try to assign a price to that value, based on the utility they and others derive from it. From this exercise in logic, we can more or less point towards a few rational and objective criteria that may help us determine how to assess the value of cryptocurrencies, without looking at the price and without allowing utility to cloud our judgement:
- Value is correlated with demand, but demand is hard to gauge before looking at the market.
- Serving the purpose it was designed for, should be the first indicator of value.
- Usage levels.
- Generating a ‘network effect’ — which adds value — can also be an objective criterion.
- Practicality, in some ways a corollary to that network effect, should also be an objective indicator of value.
The Value of Bitcoin
The list of criteria above is not conclusive. Nevertheless, it allows us to assess the value of Bitcoin and other altcoins without recurring to the price and without allowing its utility to cloud our judgement:
- Bitcoin was designed to be a form of P2P electronic cash. While many would argue that it no longer fulfills its original purpose, at some point it did.
- The fact that Bitcoin might not act as a form of P2P electronic cash anymore, is also a function of other of its characteristics, which allowed demand for Bitcoin to develop.
- Its nature as a decentralized, deflationary asset, created a market for people who derived utility from it as a hedge or as a store of value.
- On the network effect side, these characteristics also created a critical mass of users, proselytizing agents and developers that continued to enhance the initial asset.
- Bitcoin has increasingly become a more practical asset to store and exchange thanks to this network effect.
- Its usage also rose. In fact, Bitcoin’s usage is now arguably beyond its network’s processing capacity, which prompts us to question how much usage may increase value before it starts to destroy it, unless conditions change.
The Price of Bitcoin
Assessing Bitcoin’s value is an extremely challenging exercise. If it is difficult to assess how these criteria affect value, it is even more challenging to price them in properly. Although we know that the addition of another 200 Bitcoin ATMs in Japan for example, will make Bitcoin more accessible, therefore more valuable, it is difficult to price that into the market. This is part of the reason why Bitcoin prices are so volatile. Markets are assessing its value constantly, and those assessments fluctuate radically over time.
This is part of the reason why Bitcoin prices are so volatile. Markets are assessing its value constantly, and those assessments fluctuate radically over time.
Utility in a Shifting Market
Therefore, we should always take the price with a grain of salt. Bitcoin value assessment without looking at the markets, is something that we can somehow appeal to, primarily because we understand how much Bitcoin is worth to us. The utility we derive from Bitcoin depends on an assessment of our personal situation in relationship to the market. If we need to buy groceries, and do not have enough money to do so, we will deem that the utility of those groceries at this point in time is higher than that of our Bitcoin holdings. Therefore, we will proceed to liquidate a fraction of our holdings, without thinking too much about the value of Bitcoin or its price. This is the crux of the issue, because the aggregated will of the market, i.e. the utility individuals derive from Bitcoin, might affect its price beyond our ability to assess its value objectively.
Once again, it would be extremely challenging to understand at which point utility — both at an individual and collective level — will start affecting the asset’s value. It is virtually impossible to price that into the markets. Nevertheless, after understanding the basic tenets of value, we can see how it can exist independently from utility and even price. The problem is that it would need the latter to validate it in the market and enable trading, and the former to generate interest. That could be the focus of a whole doctoral thesis, especially when it comes to an asset such as a cryptocurrency, but at least now it should be clear to every reader what price, value and utility are, how to approach them when they make decisions about the purchase or sale of cryptocurrencies and how they interact at a very basic level.