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Source: wonderfulengineering.com

Bitcoin analysis part 4: can it be a useful store of value?

An attractive store of value is scarce, durable, and maintains a stable price over time. Bitcoin is currently lacking in all these aspects.

This is the fourth article in a series analysing Bitcoin. The other posts are linked at the bottom of this piece.

A store of value is something whose price remains stable over time. Bitcoin doesn’t fit the bill at the moment, as its price swings wildly from day to day. Yet the cryptocurrency’s promoters believe that as time goes by it will settle down and shine as a kind of “digital gold”.

In this post, I’ll explain how Bitcoin measures up against two of the world’s most widely-used stores of value: the US dollar and gold. I’ll focus on three attributes that are desirable in a store of value:

  • Price stability
  • Scarcity
  • Durability

Price stability

To see how bad Bitcoin is as a store of value, let’s compare it to the US dollar. In the chart below, the green line shows the price of a typical basket of goods in the US (the Consumer Price Index) in terms of the dollar. The line is almost flat from 2014 to 2017, meaning that the dollar held its value consistently over the period. Someone holding dollars could be confident that the money would buy roughly the same amount of goods and services whenever he decided to spend them in the years ahead.

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Source: Interfluidity

Contrast that with the red line, which shows the price of the same basket of goods in terms of Bitcoin. From month to month, the price of things in terms of Bitcoin veers all over the place. Holding Bitcoin exposes someone to the possibility of windfall gains, or big losses. This may be a desirable quality for a speculative asset or a casino, but not in a store of value.

Bitcoin faces a massive chicken-and-egg problem here. For its price to be stable relative to other goods and services, it would need to become deeply embedded in an economy as a medium of exchange and a unit of account. But as I’ve explained in the last two posts, this is extraordinarily unlikely to happen because fiat currencies already do these jobs more effectively than Bitcoin.

Scarcity

Bitcoin aficionados are increasingly comparing the cryptocurrency to gold. The idea is that both assets are obtained through “mining” and have limited supply. Gold is an interesting example because its price is volatile over the short and medium term, but it holds its value well over very long periods of time. Back in Roman times, a one-ounce gold coin would buy you a toga and some sandals. These days the same amount can buy you a suit and a pair of shoes.

Gold miners add about 1–2% to total above-ground holdings every year. A similar amount of gold is used up each year in electronics and other industrial applications, so the total worldwide pool of gold held as jewelry, coins or bars doesn’t vary much from year to year. Bitcoins are also scarce, the thinking goes, because their supply is increasing slowly and is capped at 21m. These limits on Bitcoin supply are written into the source code on which the Bitcoin network operates.

The important thing to realise, however, is that scarcity in and of itself isn’t enough. An asset must have intrinsic value for its scarcity to matter. In gold’s case, its intrinsic value relates to the fact that it’s a rare physical element that has applications as an industrial commodity and for the display of wealth in jewelry. It also has several millennia of history of being effective as a store of value.

Bitcoin, by contrast, hasn’t yet demonstrated that it has any inherent value. As I’ve explained in previous articles in this series, it’s far from certain that Bitcoin will offer any sustainable advantages as a medium of exchange, and it also faces competition from hundreds of other cryptocurrencies. The scarcity of bitcoins is only relevant if the Bitcoin network proves to be useful for something.

Durability

A good store of value must be durable. Gold fits the bill because it is virtually indestructible. It doesn’t corrode and its durability is well understood thanks to mankind’s knowledge of the natural laws of physics. Even in an apocalypse, all the world’s gold would continue to exist.

No-one can be so sure about Bitcoin. The cryptocurrency is less than a decade old, is based on abstract mathematical concepts, requires a constant source of electricity to power transactions, and will only exist as long as people choose to run the computer code on which the Bitcoin network relies.

Holding a large amount of wealth in Bitcoin comes with a variety of security risks that do not exist with established stores of value such as gold or income-generating assets such as bonds, equities and real estate. Here are three of the known vulnerabilities:

  1. If your bitcoins are stolen, you can’t get them back. Bitcoin transactions are irreversible. That makes it attractive for thieves to hack into people’s Bitcoin wallets or Bitcoin exchanges to steal their funds. Such thefts are a common occurrence. While fiat currencies can be stolen too, victims can do something about it because banks are able to reverse erroneous or fraudulent transactions.
  2. If you lose the private key to your Bitcoin address, you’ve lost your bitcoins. A British man once unwittingly threw away a computer hard-drive that contained a digital wallet holding 7,500 bitcoins — an amount that would now be worth about $135m. If you lose or forget your private key, there’s nothing you can do about it — those bitcoins are gone forever.
  3. The blockchain could be hacked or suffer a catastrophic failure. All software contains bugs and vulnerabilities. The Bitcoin protocol it no exception. One known vulnerability is that if any one Bitcoin miner, or group of miners, gains 51% of the Bitcoin network’s computing power, it would essentially give them control of the system. The Bitcoin blockchain depends on how miners solve “hash problems”, mathematical puzzles that require a lot of trial and error. Any advance in technology that allows one miner to solve hash problems more rapidly than others would undermine the entire system. Other security risks in Bitcoin’s underlying technology will inevitably come to light.

It’s important to recognise that most of these security risks cannot be fixed. They are baked into the technology that allows Bitcoin to operate. It seems unlikely to me that someone looking for a long-term store of value would choose an asset that is vulnerable to losing all of its value in a hacking attack or security malfunction.

Summary

  • A good store of value is scarce, durable, and its price is stable over time.
  • Since it was released in 2009, Bitcoin’s price has been extremely volatile. It has been much less effective than fiat currency cash at maintaining a stable value relative to goods and services.
  • Bitcoins, the units of currency within the Bitcoin network, are scarce. But the Bitcoin network, as one of hundreds of competing cryptocurrencies, is not.
  • The scarcity of bitcoins is only relevant if the Bitcoin network proves to be useful for something. Bitcoin doesn’t currently offer much inherent value for payments or anything else.
  • Bitcoin is less durable than gold. Someone holding bitcoins is particularly vulnerable to total loss of value, because of the inherent security risks of the cryptocurrency. Unfixable risks include: the inability to recover stolen bitcoins; total loss of bitcoins if a private key is lost; and the ever-present threat that the Bitcoin network will fail because of a known or unknown security flaw.

Thanks for reading! If this has sparked some thoughts or if you think I’ve got something wrong, please let me know in the comments below.

Here are the previous parts in the series:

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