Why do Bitcoins have value?

Divjyot Singh
Sep 3, 2017 · 8 min read

Preface

After a brief hiatus, this is the third chapter in a series of 6 chapters written to explain Bitcoins and Blockchain. By the end of these chapters one should be able to understand, invest, and trade in cryptocurrencies.

Link to Chapter 1: https://medium.com/@divjyot.cse/what-is-a-bitcoin-5bac98b41423

Link to Chapter 2: https://medium.com/@divjyot.cse/what-is-blockchain-9126b45d8f0


Chapter 3: Why do Bitcoins have value?

Perhaps the most divisive and perplexing question for the investor community in the 21st Century.

Let’s understand this.

How do most of us know about Bitcoin?

From its ever increasing price. The price that continues to make headlines in every news item month after month after month.

From under $1 in 2010, the price of Bitcoin has increased more than 5,000 times to current price of about $4,800.

Such a staggering price rise over such a sustained period of time has created a feeling of FOMO (Fear Of Missing Out) amongst investors — small and large alike.

And that is how people, who don’t know about Bitcoin, hear and imagine Bitcoin to be — 21st Century’s biggest FOMO.

Some call it a bubble, some a pyramid scheme, some the future, and some digital gold.

What is it really? In fact what gives this hard to understand, non-tangible commodity such high prices. I mean it’s cheaper to buy an ounce of gold than to buy 1 Bitcoins. Why? How?

Let’s understand this.

Imagine:

Imagine; rather remember, your nostalgic childhood. Amongst a lot of activities and memories, one small memory of childhood is that of cartoons (particularly for ones who grew up in the 90s).

Remember the cartoon — The Flintstones?

For those who don’t know, Flintstones was a cartoon show that depicted the life of a regular family — The Flintstones — in the stone-age.


Their cars were made of rocks and used to move by using the driver’s feet to peddle them.

Their paper was a piece of rock, and their typewriter had a bird’s beak.

And, their money was pieces of rock.

The last one is not just fiction, but a fact as well. The earliest human settlements used sea-shells or stones as the currency. In fact, as recent as the 19th century, the Bornu Empire in Africa required its citizens to pay taxes in cowry seashells.

Wait, but why?

Imagine the stone-age human settlements. They had no Government to issue paper currency. No banks to distribute that currency. They even did not know how to mine gold or silver and make coins from them.

Naturally, the worthless rocks that had little productive use (maybe ornamental) became valuable. Because people started using them for transactions. Because people on a whole agreed and believed in their value.

The stone-age was a time of perfect decentralization.

And now you would have understood one of the two general principles of value -

Something has value if there is a demand for it at a given price point.

Bitcoin’s value:

In addition to the demand rationale for Bitcoin’s value, there are some other interesting supporting arguments as well:

Utility argument:

Things have value because they have some utility. Copper is used as an industrial metal (in wires, utensils, refining equipment, etc.) and it has a certain inherent demand because of that utility. This demand leads to a certain price that Copper commands.

Similarly, Bitcoin has a utility. It is the world’s #1 way to transfer money from a given geography to the other without involving banks or Governments. Every day close to 250,000 Bitcoin transactions are processed (confirmed), which implies that 250,000 Bitcoin transfers from one party to the other are taking place. Bitcoin is facilitating commerce and hence, has a value.

Manufacturing Cost argument:

As we saw in the previous chapters, Bitcoins are created by a process called mining. This process requires a lot of computer’s processing time and consumes a fair amount of electricity.

Another way to assign value to Bitcoins is to consider the Cost Price + Profit Margin number. The electricity, the processing hardware, and the people cost required to run mining operations and create Bitcoins adds up to give the Cost Price of the Bitcoin. This gives it a certain inherent value.

One of the things to remember is that as more and more Bitcoins are created, the Blockchain gets bigger and bigger, and it becomes harder and harder to ‘mine’ more Bitcoins. Hence, the cost of production and the selling price of Bitcoins keeps on increasing.

Scarcity:

The lifetime supply of Bitcoins is limited to 21 million. Sure, each individual Bitcoin can be divided into many Satoshis (1 Bitcoin = 100,000,000 Satoshis), but the overall supply is fixed. Central Banks or Governments of the world can’t create and pour in more money (also known as ‘Helicopter Money’).

This gives comfort to Bitcoin traders. In a scenario when the price of the Bitcoins is rising, the owner/parent can’t create more Coins and dump them in the market (thereby sending the prices crashing down).

Non-sovereign argument:

Bitcoin supply is not dependent on any sovereign actions. They were being created before there were regulations and they’ll continue to be created in the future, because of the anonymity and power of the Internet.

This Governmental lack of control over Bitcoin makes it the preferred transaction currency in places of conflict or places with unbearable regulatory restrictions. For eg: in the troubled Venezuelan economy Bitcoin (and other Altcoins) have become the preferred currency over the unstable sovereign Venezuelan Bolivars (the local currency).

Bitcoin is as prevalent the US Dollar, but it works without the need for a bank account.

Digital Gold:

The combination of the last 2 arguments — Scarcity and Lack of Governmental controls, give Bitcoin the reputation of Digital Gold.

One of the emerging trends in the Bitcoin trading universe is that the Bitcoin price rises whenever there is a global threat on the horizon.

North Korea threatening a missile launch — Bitcoin price rises

Donald Trump elected — Bitcoin price rises

Brexit decision — Bitcoin price rises

This is a similar price behavior as that of Gold — the go to “Risk-Off” commodity. This gives a perceived value to Bitcoins as a Safe Haven.

Arguments Against:

There are many worthy arguments which say that Bitcoins should not have any value at all. Many go ahead and call it as a Bubble or a Ponzi Scheme. Let’s hear them out:

No Intrinsic Value: A traditional economics or a finance professional would loudly proclaim that Bitcoins have no intrinsic value. This means that stripped of all the market euphoria, perceived prices, and any external factors, Bitcoins have no inherent value.

In fact, the world renowned economist Paul Krugman said — “Bitcoin is Evil”.

It’ll be interesting to think here then, how does paper money have value.

Not a currency: A lot of enthusiasts are quick to call Bitcoin a currency. It has all the features that any currency is supposed to have, which are — Durability, Divisibility, Fungibility, Portability, Scarcity, and Recognizability.

However, as scholars point out, Bitcoins lack one practical feature that every currency should have — Stability.

The price of Bitcoin is very volatile. Even on a daily basis. This makes it difficult for people to use it for everyday transactions, as there is no sense of price direction.

Imagine, you get an export contract worth 100 BTC. The goods are to be delivered after 15 days. However, within those 15 days, the price of Bitcoin changes from $3,000 to $2,000 (as it happened in June of this year). This will obviously create a problem for you as you now are getting less value for the goods you supply.

Fad/Ponzi Scheme/Scam: The most common and a blanket criticism of Bitcoin is that it is a Scam. The smart investors point out to the fact that there is no trustworthy authority (like a Government or a Central Bank) that backs the value or operations of Bitcoins.

In fact, billionaire investor Howard Marks (who successfully predicted the dot-com bubble and Great Recession of 2007) has called it an unfounded fad or even a pyramid scheme.

Comparison:

Bitcoin is what Peter Thiel would call a Zero to One invention. Something that was created out of no previous inspiration and is not a logical/foreseeable improvement over an existing invention. Essentially, something that was created out of blue.

However, as we saw above, the closest comparables of Bitcoins are Precious Metals (like Gold) and Sovereign Currencies (also called as Fiat Currencies). To understand and appreciate the value argument for Bitcoins let’s run a quick comparison of these 3 entities:

Source: nakamotoinstitute.org

So what’s the point here?

Well, just like every new thought and invention faces criticism and has to prove its worth, Bitcoin will also have to go through the test of time.

It will either be an idea whose time has come and all the persecution would be helpless to stop it (like Copernicus v. the Church), or it will turn out to be a fraud, a fad that will eventually die down (like the Tulip Mania).

However, one thing that I have learnt in my 11 years of trading is:

“Respect the markets. Respect the markets. Respect the markets.”

And the markets are telling us something. For the past 7 years, they are.

Source: Knoema.com

As a blanket advice, I say this to every current or prospective Bitcoin (or any cryptocurrency) investor — Invest only the money you can afford to lose.


Now that we have understood what Bitcoins are all about, we can move on to the juicy bits. In the next chapter (your next Sunday afternoon read), we will start learning how to buy, store, and start trading in Bitcoins. This is from where it gets exciting.

Stay Hooked…

(The contents of this article are the personal work of the writer and written in his personal capacity. The opinions expressed in the article are author’s own and in no way reflect the views or objectives of the organization(s) the author may be associated/working with. For any comments, queries, criticisms please reach out to the author at “divjyot_singh2016@pgp.isb.edu” or write in comments below)

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