Finding Market Fit for Bitcoin
On why bitcoin needs real demand and where it’s going to come from
“In the short run the market is a voting machine, but in the long run it is a weighing machine” — Benjamin Graham
“It’s a mirage. The idea that it has some huge intrinsic value is just a joke” — Warren Buffet on bitcoin
“Bitcoin is worthless, artificial gold” — Charlie Munger
“Bitcoin is a remarkable cryptographic achievement and the ability to create something that is not duplicable in the digital world has enormous value” — Eric Schmidt
As we explained in a recent post, whether Bitcoin will turn out to be a reliable store of value for investors in the long run or not boils down to one question — How much global demand can we expect for bitcoin in the future?
For something to store value, it supplies should be limited and the demand for it should be robust. The supply side of the equation is rock solid for Bitcoin — Only 21 million bitcoins will ever be mined. It is not duplicable despite being a digital asset. You cannot give the same bitcoin to two people just like you can’t give the same currency note or gold coin to two different people.
But the demand side of the equation is a huge unknown. Yes, there is a demand for bitcoin today. But how confident are you that there will be robust demand for bitcoin 10 or 50 years from now?
Before we attempt to forecast the demand for bitcoin 50 years from now, let’s think about why there is the demand for bitcoin today. Why did you buy your bitcoin?
Because you are confident you’ll be able to sell it for a higher price next year? Well, that’s not good enough and you know it — Every single person who bought shares of internet companies with non-existent business models during the dotcom bubble or bought overpriced homes just before the subprime mortgage crisis were also confident that they would be able to sell it for a higher price the next year (even the vast majority who acknowledged that the investment was speculative in nature and disconnected from fundamentals).
It is okay to buy something with the sole aim of flipping it as long as you have a fundamental thesis for why it will appreciate in value that is not tied to someone else’s irrational exuberance. That’s what we are after in this post.
The Value of Gold
Bitcoin is frequently compared to gold. Why do people buy gold? And how much are they willing to pay for it? Every year approximately 2500-3000 tons of gold are mined.
While the supply inflation of gold is not steady and precisely predictable like that of Bitcoin, it is too small to matter and fluctuations in supply have almost no influence on the price of gold.
The price of gold is dictated almost entirely by, yes the demand for it. The demand for gold depends on income levels, interest rates, inflation levels, and several other macroeconomic and geopolitical factors.
A good rule of thumb is — When people get burned in the stock market, they seek refuge in safe havens like gold. Jewelry accounts for approximately 50% of the global demand for gold, most of it coming from India and China.
Gold bars and coins account for roughly 25% of the demand. Electronics, other industrial uses and dentistry account for another 15% of the demand. Central bank net purchases account for about 5%.
Increasingly, there is a surge in demand for gold from Exchange Traded Funds, Gold-backed stablecoins and other financial instruments that let you invest in gold without the hassle of owning and safeguarding it.
At first glance, the fact that roughly half of the demand for gold comes from jewelry might indicate that it’s primarily valued for its intrinsic utility as an object of beauty. But careful examination of the price sensitivity of demand for jewelry indicates otherwise — A 1% increase in the price of gold results in only a 0.5% drop in the demand for jewelry.
Simply put, if most people buying jewelry considered it as an item of consumption akin to a new pair of jeans, they’d be a lot more sensitive to its price.
Surveys also indicate that as much as 80% of the people who buy gold choose to do so because it is a safe investment. In other words, gold is primarily used as a store of value and a hedge against inflation.
When hyperinflation runs wild, people are willing to pay more for gold. When markets crash, they are willing to pay more for gold. When people temporarily lose faith in securities (including the fiat currency notes in their wallets that are no longer secured by gold or silver like they used to be in the past), they turn to gold for shelter despite the fact that gold itself is not secured by anything. And that point is worth reiterating — The price of gold is not secured or backed by anything.
What gold has going for it is robust demand that is more than capable of absorbing temporary gluts in supply (should they occur) or outflows to other asset classes, making it inflation proof and to certain extent volatility resistant.
Demand for Gold
The demand for gold exists despite the fact that the vast majority of people who invest in gold generally do not expect large returns from it. This might be hard to believe given the price of gold in U.S. dollars has appreciated by more than 400% in the last 20 years (an average annualized return of approximately 8.4%).
But it is important to remember that the abysmal returns of stocks over the first decade of the century which made investors flock to gold is responsible for almost all of those gains.
In the last ten years, the price of gold in U.S. dollars has appreciated at an average annualized rate of approximately 3.5% — In other words, investments in gold are nothing more than a hedge against inflation under normal circumstances.
Would you invest in Bitcoin today if you expect similar returns from it in the next 10 years? If you are not someone who lives in a part of the world where hyperinflation is a fact of life, you probably answered no.
If you live in a part of the world where monetary, as well as trade policies, are carefully designed to maintain inflation levels within strict bounds and generally manage to successfully do so, you almost certainly answered no.
Bitcoin — A Digital Gold?
And that is something you need to bear in mind — While people constantly refer to bitcoin as digital gold, the average investor has a very different set of expectations from bitcoin relative to gold. This fact is seldom acknowledged explicitly — The vast majority of people who invest in bitcoin today are speculators who expect large returns on their capital either in the short run or the long run. They are most certainly not looking for something that simply stores value.
The total value of all the gold that has ever been mined at today’s valuation is roughly $9 trillion. At the time of writing this article, The market capitalization of bitcoin is about $185 billion.
However, it is unreasonable to expect that a certain percentage of the wealth currently stored in gold will inevitably be transferred to bitcoin, making your bitcoin significantly more valuable.
Touting this huge market opportunity as the sole basis for investing in bitcoin is therefore misguided in my opinion. The digital gold metaphor is fundamentally unconvincing. Bitcoin is not a digital alternative to gold today and it is unlikely to be one in the immediate future.
As of today, the best digital alternatives to gold (assets that store value and offer protection against inflation without excessive volatility) are gold-backed exchange-traded funds (ETFs) and gold-backed stable coins.
Yes, they are centralized. Yes, you are forced to rely on middlemen. Yes, independent audits (more middlemen) are necessary to verify the authenticity of the underlying gold reserves. But they offer what people all over the world have always wanted from gold — A safe investment. They also offer the divisibility (you can easily buy or sell fractional shares of gold ETFs and tiny fractions of gold-backed stablecoins), liquidity and ease of ownership of bitcoin.
Gold is still 1st Choice
If you’re still not convinced, look no further than what happened in the last five days. The S&P 500 index dropped by 8% amid heightened coronavirus fears. Investors rushed to safe havens like gold and treasury bills. What happened to the price of bitcoin? It fell by 9%! No, bitcoin is not digital gold. Yes, the metaphor is useful to drive home the point that scarcity is valuable even within the context of digital assets. But a literal interpretation of the digital gold metaphor is misleading and dangerous.
The Fiat Currency World
Where else can robust, sustainable, long-term demand for bitcoin come from? There is more than $80 trillion of broad money in the world held in fiat currencies, about $5 trillion of it in circulation in the form of notes and coins and the rest of it in checking accounts, current accounts, savings accounts, money-market accounts et cetera.
The U.S. dollar is by far the most popular fiat currency. Close to two-thirds of all central bank foreign exchange reserves are held in U.S. dollar. It is the de facto global currency of the world. Around 90% of forex trading involves the U.S. dollar on one side of the trade.
So far, monetary and trade policies have been remarkably successful in keeping U.S. dollar inflation under control. However the ever-increasing U.S. federal budget deficit (currently at $1.1 trillion) has raised serious concerns regarding the possibility of a looming U.S. dollar inflation.
China currently holds about $3.1 trillion in foreign exchange reserves, most of it in the U.S. dollar. A U.S. dollar inflation in the immediate future will, therefore, have serious consequences for the Chinese economy.
For this reason, China has been putting pressure on the International Monetary Fund for a separate global currency reserve, while simultaneously diversifying its foreign exchange reserves.
Bitcoin — The Global Reserve Currency?
There have been suggestions in the past that bitcoin has the potential to be a global currency reserve. However, at present bitcoin does not meet one of the fundamental requirements for being a global currency reserve — It is not an effective medium of exchange because of its intense volatility.
At the very minimum, a global currency reserve needs to be a medium of exchange, a store of value and a unit of account. At present, bitcoin is none of the above. Therefore the often touted $7 trillion global currency reserve market opportunity is indefensible today.
Global Remittance
What about the market opportunity presented by international wire transfer? The overall global remittance volume stands at approximately $715 billion today.
India and China are the top remittance recipient countries in the world, each accounting for roughly 10% of the total volume. The competition for these markets is intense, resulting in relatively low transaction costs.
If you are sending a relatively large amount to somewhere in India or China, the transaction cost for a fast, cheap service is about 0.6%-0.7% of the amount sent. However, the average transaction costs for sending a relatively small amount of money to low and middle-income countries across the world are as high as 7% of the amount sent.
In particular, the transaction costs for sending money to some parts of Africa can be above 10% of the amount sent. While the current situation screams for disruption, expecting the participants to convert a significant portion of their $715 billion in savings from fiat currencies to bitcoin every year to achieve the goal of low transaction costs is a stretch.
I personally believe that stable coins with easy (and cheap) onramps and offramps for fiat currencies will serve as the backend for a cheaper global wire transfer service.
The underlying programmable asset (cryptocurrency), programmable distributed database (blockchain) and decentralized consensus protocol that enable the service will essentially be invisible from the consumer-facing frontend.
In other words, it is unlikely the customer will care if it’s an asset-backed stablecoin with reliable, independent audits like TrueUSD or a collateral-backed stablecoin like Dai which relies on collateralized debt positions and economic incentives to minimize volatility that enables the service as long as it achieves the scale required to support the necessary transaction volumes.
There is no reason customers will automatically favor a trustless system with carefully designed incentives for taming volatility if it does not lead to reductions in transaction costs. Even Ripple XRP can serve as the basis of such a service if the processing company manages to keep transaction costs low by leveraging on demand liquidity despite the intense volatility of the underlying asset.
But I remain deeply skeptical of the premise that financial institutions (which provide liquidity) will carry XRP on their balance sheets for a small fee. Whether a Ripple partnership actually gives a money transfer business any real competitive advantage also remains to be seen.
What about E-Commerce?
What about the legitimate e-commerce opportunity? There has been a lot of excitement around more and more e-commerce merchants accepting bitcoin payments every day. However, is the excitement justified? What fundamental problem does bitcoin solve for a merchant?
Yes, an e-commerce merchant can find companies that process bitcoin payments (transfer bitcoin from a customer’s wallet to the merchant’s wallet) for lower merchant discount fees relative to those for credit card payments (somewhere between 1.5% to 3% usually) — As little as 0% for low sales volume and typically less than 1% even for high volume sites.
However, given the intense volatility of bitcoin today, no sane merchant wants bitcoin on their balance sheet. And that’s where the hidden costs show up. To convert bitcoin received as payment into cash, the merchant typically needs to withdraw the bitcoin to a cryptocurrency exchange first (for a fee) and convert it to cash on the exchange (more fees) before withdrawing it to a bank account from the exchange.
Besides, even setting this limitation aside the bitcoin blockchain is far from being production-ready for commerce at scale. The bitcoin blockchain currently processes about 4 transactions per second on average. For context, Visa processes about 1700 transactions every second on average and is capable of handling more than 24000 transactions per second based on internal stress tests conducted by the company.
Alipay processes more than 250000 transactions per second during peak traffic on Single’s day in China while keeping the merchant discount fees between 0.6% and 1.2% of the payment.
It is also worth pointing out that the real cost of bitcoin transactions paid out to miners in newly generated bitcoins (which dilutes your bitcoin making it less valuable similar to how newly issued shares in a company make your share less valuable), is about 1.5% of the transaction volume on average today or about $40 per transaction! For context, Visa’s operating revenue is about 0.25% of the total payments that flow through its network and it makes about $0.17 per transaction on average.
To summarize, bitcoin is yet to have a meaningful impact on legitimate commerce that complies with the law of the land.
Wrapping Up…
In my opinion, the most promising reason to expect real demand for bitcoin, in the long run, is the money currently being held in bad fiat currencies that suffer from high inflation — I estimate this number to be around $6.5 trillion.
While bitcoin is significantly more volatile than most fiat currencies today, the gap has certainly been narrowing. Bitcoin’s precisely defined supply inflation makes it an attractive asset for those who fundamentally distrust their government’s ability to maintain the value of its currencies.
There has recently been an explosion in the demand for bitcoin in countries like Venezuela. However, it is far from established whether bitcoin is the asset of choice for protecting hard-earned savings currently being held in bad fiat currencies from high inflation. Stablecoins that achieve scale and widespread adoption as a store of value and a medium of exchange will give bitcoin a run for its money here too.
To summarize, bitcoin has a long way to go before any fundamental investor sees value in it. Today, it is predominantly an instrument for speculators to place bets on the future of money, most of whom have no intention of actually using it as a medium of exchange.
It is an absolutely remarkable cryptographic achievement and the bitcoin community has every right to be extremely proud of themselves. But a great technology creates lasting economic value only when it serves as the basis of a great product or service — Bitcoin is yet to have its killer app. Temporary surges in demand for bitcoin that followed the Cyprus banking crisis or the Brexit vote will ultimately prove meaningless for bitcoin’s future if the increased awareness does not eventually lead to robust demand for it. Bitcoin needs real demand that supersedes speculative inflows and outflows and keeps volatility in check.
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