Bitcoin is nowhere near done…

Bitcoin is going to be big — real big.

If you’ve at all been online in the past few years you’ve heard the terms Bitcoin and Blockchain. Blockchain is (in my experience) a technology that the more you learn about, the more you start to realize just how revolutionary it is. Bitcoin is just one use case of Blockchain but it’s a quite compelling one. There are risks of course (read more below), but the potential is rather staggering.

Oversimply, Bitcoin is a virtual currency that has now pretty immutably established that it has value. This value will perpetually fluxuate but it will continue to be worth “something” and I believe that something will continue to grow. When you hold a piece of paper currency in your hand, the world pretty much agrees who owns it although only the people around you see that you’re the one actually holding it.

Extend that concept and assume that somehow everyone in the world knew that you were holding that dollar. That’s closer to how Bitcoin works. Every person (every single one) in the Bitcoin ecosystem agrees on how many bitcoins every other person owns. The database of “who owns what” is on thousands of different computers — and they all agree.

Functionally Bitcoin is a currency (i.e. a mode of transacting value) and a store of value (i.e. or even an investment). I can of course say the same about the dollars I’ve stuffed under my mattress. The exciting/scary thing about Bitcoin is that it’s wildly volatile. It’s value fluxates by double digit percentages quite often. In general it’s value has risen ~3500% in the past few years and far more if you got back to it’s inception.

The other fantastic feature I find about Bitcoin is that it represents a peer-to-peer digital value transfer. Again with paper currency, if I wish to give you 10 dollars — I can hand you the money. If we are alone, no one in the world knows that transaction happened. Now if I instead wish to send you $10 digitally then it won’t be a private transaction. We need Paypal or Venmo or our banks to be involved. Partially because we lack the ability to store digital money except inside one of those services, but also because we need some sort of verification that the money actually moved.

Bitcoin changes all that. It allows you to send someone $10 digitally without an intermediary. Oddly, instead of the transaction being fully private, it’s now fully public. Every person in the Bitcoin ecosystem knows that transaction happened. They don’t necessarily know who the giver or receiver are (they might be able to figure it out), but they do know the transaction happened. The transaction also happened without a single intermediary, instead the whole darn Bitcoin world verified the transaction by consensus.

On the other side of the discussion is Bitcoin as a store of value — and that value has been rising significantly for the past few years. It’s my opinion that it’s also nowhere near done. (Disclaimer: this is not investment advice, if you make or lose money, don’t blame or credit me).

To explain why first let’s start with the most important point: Unlike US Dollars or shares of stock in a company, the supply of Bitcoin is forever limited. There will be at most, 21 million bitcoins ever. Roughly 16 million of those Bitcoin currently exist and the rest will appear into existence over time. They are being mined as we speak and in a few decades, we’ll be done. 21 Million, that’s it. Possibly the second most popular cryptocurrency called Ethereum does not have a limited supply however the amount of Ethereum that enters the ecosystem arrives in a fixed number on a fixed cadence. That dilution is forever decreasing in it’s impact on the amount of total Ethereum. Hence, this same argument will apply to Ethereum too — at least eventually.

Limited supply is a nice foundation for increasing the value of something but by itself, it’s not sufficient — there needs to be demand. You might say gold or uranium is of limited supply (which is not particularly true as compared to the discrete mathematical limit of bitcoin, but let’s say), but you cannot easily transact with gold or uranium. I cannot transfer value across the Internet. Bitcoin has a value and an immediate use.

A common argument against Bitcoin is that it “has no value”. Unlike say a US dollar as compared to other currencies or even better, a share of stock in a company. This is true and this is a major factor in Bitcoin’s extreme volatility. the Bitcoin community is quite used to the idea of losing 30% of their value in a day. But, the opposite is true too. There’s no anchor to which to attach Bitcoins price. There’s no price Bitcoin is “supposed to be”. It’s not likely to go to zero so long as anyone attributes value to it, but it could easily drop in half. It could also double.

The price of Bitcoin follows the pricing of human irrationality better than any stock. Stocks do have some anchor point where the price starts to appear over priced. Usually this is some calculations of price to earnings or revenue or future potential. But even in the latter case, potential is governed by reality. When Bitcoin goes up people get excited and the next day now believe that’s the new price. And it is.

But apart from irrationality, value still requires some demand. There’s two obvious sources of demand on the horizon.

Firstly, there’s you. You’re reading this article ostensibly because you have Bitcoin, heard about it, and/or are thinking of buying some. There’s only 21 million of them, that’s less than the population of California (although most Bitcoin transactions include fractions, so you can indeed own 1/1000th of a Bitcoin).

Cryptocurrency for better or worse is now considered by many as a new type of asset class and portfolio diversification has induced many people to consider it. Simply put, there’s an army of potential Bitcoin buyers entering and will enter the market over the next few years that will “throw a few thousand dollars” into it. They know it’s volatile. They know it’s risky. They’re not out to buy it all up, but simply have a foot in the door. They’re also not panic sellers. It’s just part of their portfolio. As an aside, Bitcoin might be the simplest way for the unsophisticated investors to divest out of their country’s Fiat currency. There’s evidence that some Venezualan’s have invested in Bitcoin to combat the recent inflation in their economy.

For the moment, this is a tantalizing source of demand. Extremely few investors own Bitcoin and more and more will. This will help fuel Bitcoin’s rise over the next few years as a constant upward pressure.

But that’s not the interesting part of the story. That’s not where I see the true demand being created. The overwhelming source of demand will come from transactions and that’s a place we’ve only just begun.

You see, you can indeed buy things on the internet with Bitcoin. I can go to Overstock.com, put something in my cart, and electronically send them the required number of (probably fractional) bitcoins to pay for the items. Overstock is plenty happy to take the Bitcoin and send me my new rug. People rarely do use Bitcoin to buy goods today, but they use Bitcoin to send money. If you have any belief these activities will increase over time, then you’re buying into the increasing value of Bitcoin.

You might think it’s risky to send money via Bitcoin, but it’s not. Not at all. Because what happens in this transaction is a function of the fluidity of Bitcoin in electronic transactions. If I buy a rug a $100 rug from Overstock using Bitcoins what really happens is a 3 step automatic process. One is that I convert $100 USD to the associated number of fractional Bitcoins. I send those Bitcoins to Overstock’s Bitcoin wallet. Overstock then immediately converts those Bitcoins back into USD. Neither I nor Overstock needs to own the Bitcoin very long at all. We really just needed to own them for the exact amount of time for them to get transferred over the Internet (which varies but can take minutes to hours).

Bitcoin’s volatility is a concern, but as long as it’s relatively stable during the transaction itself (i.e. not a long time) it really isn’t a factor.

That’s a rather fascinating point. When I converted that $100 into Bitcoin (getting ready to send to Overstock), I absolutely did not care what the price of Bitcoin was. I really don’t care if my $100 converts to 10, 52zillion or .1 Bitcoins. I’m sending it to Overstock anyway. Overstock doesn’t care either because as long as the price stays relatively same during the transaction, they’ll get $100 USD to pop out the other end when they convert it back to USD and that’s all they care about.

What’s more is that while my Bitcoin transaction is in flight — those Bitcoins (or fractions) are removed from the supply pool. They are not available to be purchased by anyone else. If transactions increase, the number of Bitcoins temporarily removed from the supply pool grows. What happens when the number of Bitcoin involved in transactions triples, or goes up by a factor of 100?

As the supply dwindles, the price goes up. As the price goes up, Bitcoin investors will get shy about buying. But Overstock buyers don’t care about it’s price. Regardless of how high the price of Bitcoin rises, those wishing to transact in Bitcoin will keep buying for the purpose of transactions, the price doesn’t matter. The more transactions that are simultaneously occurring, the more the supply is stressed.

Bitcoin investors on the other hand, who vowed never to sell will eventually be shaken loose. As the price rises, they’ll be more and more convinced to put their Bitcoin back into the supply pool for a profit.

This is unlike any other currency or investment vehicle. The dollars under my mattress do not make other dollars worth more (and most dollars are now electronic and we can always make more). Gold might have some semblance of limited supply and industrial use, but it’s terrible for buying rugs. Shares of stock in a company may be solid stores of value but aren’t appropriate for transactions at all.

The bet I’m making on Bitcoin is that the number of transactions will continue to increase. So far, the trends think that’s right.

Sounds too good to be true — and it might be. There’s some important downsides you should know that change this whole discussion.

For the 10th time, the volatility is also unlike anything you’ve ever seen. It’s not that Bitcoin might lose half it’s value within the next 3 years, it’s that it most definitely will lose half it’s value in the next 3 years. It has no price basis so any price is correct and will shortly thereafter be considered the new normal. Some investing is gambling and this is most assuredly that.

Secondly, governments don’t yet know what to make of it. The United States IRS has figured out how to tax it (and if you buy/sell Bitcoin, keep copious records and pay the right taxes, the future likely holds more scrutiny for Bitcoin and it’ll be smart to have your ducks in a row). That being said, it’s not impossible that Bitcoin might simply be outlawed in certain countries. It’s almost happened a few times. If that happens it could be killed (or at least dented) overnight and all your wealth with it.

Thirdly, it’s unregulated. Mt. Gox was a famous Bitcoin exchange that largely disappeared overnight with everyone’s money. Turns out that banking industry regulations really do help protect consumers. This is the wild west. If you transact, find the most reputable firms you can.

Fourth, Bitcoin is popular well within the underbelly of the Internet. Bitcoin itself has not been hacked, but sites and individuals who hold it have. Security is largely up to you.

Fifth (let me emphasize, there’s no shortage of risks) — Bitcoin might not win. There’s hundreds of crypto-currencies now with different features. Coins like Ethereum and Litecoin might have just the right mix to overtake Bitcoin as the coin where the world’s transactions happen. In other words, all my thoughts here might come true — but for some other coin besides Bitcoin.

To me, Bitcoin represents a new place to store value with a unique set of features that set it quite apart. I don’t see it’s longterm upward price trend changing. That being said, I never look at the day charts — I simply don’t have the stomach for it.