- Be aware that every investment is gray. There is no black and white out there. The same applies to cryptocurrencies.
- I’ll analyze whether Bitcoins can be valued, if are they a currency, how to price them, what influences the price, and what the fundamentals are.
- From one perspective, it even looks like a positive risk reward situation.
I get lots of questions about bitcoins and other cryptocurrencies.
The questions usually come from younger people who blindly invested based on some interesting narrative heard somewhere that convinced them to renounce a few beers. However, those who invested have done very well and now it isn’t just a few beers anymore but a significant amount in the form of a few codes on an account and things are getting serious.
All the questions and excitement surrounding Bitcoin led me to really analyze the environment out of curiosity, and provide my opinion on what can happen and what kind of an investment Bitcoin actually is.
I’ll do my best to keep this a discussion analyzing both sides because it’s normal for human behavior to be exclusive, i.e. you either like bitcoin or you don’t. That isn’t a good way to approach investing as every investment has its pros and cons, as do cryptocurrencies. This analysis will allow you to make better decisions about cryptocurrencies and your personal financial situation.
This article will be a bottom up article where we’ll start by analyzing whether bitcoin is a currency, if can it be valued, if can it be priced, we’ll analyze the risks and potential rewards, and I’ll describe scenarios for those who own cryptocurrencies or might be thinking about buying in.
Is Bitcoin A Currency?
For something to be a currency, it has to be accepted in transactions. As you can sell your bitcoins for actual dollars, bitcoin can be considered a currency.
But the same applies to cowry shells which were used as currency until the 20th century. As long as people accept it as payment and have trust in it, it’s a currency.
Figure 1: Cowry Shells used in transactions until the 20th century. Source: National Bank of Belgium Museum.
The fact that Bitcoin is a currency leads us to the daunting task of determining the value of it. It isn’t possible to determine the value of a currency as it’s not a cash producing asset. The only thing that can be done is to price a currency by comparing it to other currencies where the value, i.e. the price, will be totally dependent on supply and demand for the currency, in this case, bitcoin.
For example, what’s the value of gold? It’s a metal that you can’t eat. If you are thirsty, a glass of water is much more valuable than a bar of gold. The first conclusion is therefore, bitcoin can’t be valued and you shouldn’t listen to any explanations of what the value of a bitcoin is.
What can be done, then? A bitcoin can be priced. So, let’s start with that.
Trust in the issuing authority.
In order to price a non-cash producing asset that is in fixed supply, we could argue that a bitcoin should increase in value alongside inflation, especially since global Central Banks are on a printing spree. Bitcoin prices should then move similarly to gold prices.
Figure 2: Bitcoin prices are totally uncorrelated with inflation. Source: XE.
As bitcoin prices have surged and there has been practically no inflation, there is something else influencing the surge. Therefore, bitcoin can’t really be compared to gold, even if it has some similar characteristics.
In a crisis, given its fixed supply, gold prices usually surge as gold is considered a safe haven. This is thanks to the fact that gold, just as bitcoin is supposed to be, has no governing authority and is limited in supply. However, you can open your vault and touch your gold. That’s something you can’t do with bitcoins. Therefore, bitcoin pricing will depend on the trust in the issuing authority.
The bitcoin revolution lies in the fact that there is no issuing authority, unless we call the computer algorithm the issuing authority.
The algorithm is generates 25 bitcoins every 10 minutes to reach a maximum number of bitcoins in circulation of 21 million by the year 2140. A bitcoin is created by mining for it, i.e. letting a computer do some computing that leads to the creation of a bitcoin.
So it all boils down to trust in the bitcoin algorithm and the price surge shown in the chart above tells me that bitcoin price movements are totally dependent on supply and demand. As there is huge demand for bitcoins, the 16.5 million in circulation at the moment have a relatively high price in comparison to the past.
Figure 3: The number of bitcoins in circulation. Source: Blockchain.
So if Bitcoin is a currency, and there is huge demand for it, it has to be accepted in transactions.
Acceptance in transactions.
Below is a list of bitcoin-accepting vendors. What’s clear is that you can’t really buy everything, so the practical usage of it is rather limited for now.
Figure 4: Some of the bitcoin accepting vendors. Source: 99Bitcoins.
Now, the transactional value is still limited and what I see is that the daily number of transactions isn’t really taking off. On the contrary, it has been declining for the last few months.
Figure 5: The number of transactions in the last year are flat while the price has increased five-fold. Source: Blockchain.
In fact, the actual number of transactions has declined as the prices of bitcoin have surged. This would lead to the conclusion that the current price of bitcoin is based on pure speculation and should therefore be treated as such.
Security, conversion, storage, rate of return.
In order to be a respected currency in the future, bitcoin has to be secure, allow conversion, offer storage of value, and possibly provide a rate of return.
Bitcoin is as secure as it’s operating software. Some say it’s unbreakable. Some say that it isn’t. This I find very similar to a central bank. Some say it’s impossible for them to go bust, while others see them as the primary source of global financial risk. Therefore, we could say that bitcoin offers the same security as other currencies.
Just as with currencies, there are now many bitcoin-esque cryptocurrencies. In fact, there are more than a thousand of them.
Figure 6: Top 20 cryptocurrencies. Source: Coin Market Cap.
Which of the above will be the currency that will prevail and become a regular payment method in the future? That’s impossible to know. Given that there are more than a thousand of them, it’s highly likely that the one that will prevail will be something we don’t have yet. Nevertheless, bitcoin’s market capitalization of $55 billion makes it a significant player in financial markets.
What’s also significant is that the daily traded volume is over $1 billion. However, a big part of that comes from day trading and as you can buy bitcoins in fractions, it’s also clear that many retail speculators are jumping on the bitcoin bandwagon in fear of missing out. Research shows that especially the young buy bitcoins as they prefer bitcoin to stocks.
As for the storage of value and rate of return, it’s still too early to discuss. It’ll take a while for cryptocurrencies to become established and therefore be considered a storage of value. The high volatility and speculation surrounding bitcoin certainly doesn’t help its cause as stability is what makes a currency attractive.
As for a rate of return, perhaps in the future you will be able to borrow and lend bitcoins or another cryptocurrency, but that would require a complex infrastructure which leads me to believe that the blockchain technology is definitely here to stay. The question is, which cryptocurrency will survive?
Blockchain technology is something very interesting and it’s definitely here to stay. However, the fuzz around bitcoins and other cryptocurrencies reminds me of the excitement surrounding internet stocks in the 1990s, especially among the young, tech savvy population.
If you own bitcoins, you must consider yourself a currency trader and not an investor.
Right now, owning a bitcoin is the same as owning a volatile currency where the price of it depends on sentiment and demand created by a specific population that pushes the price higher in fear of missing out. After such huge spikes, there are many who shout that bitcoin will reach $100,000 which attracts more speculators to the game.
I’m not saying it isn’t possible for bitcoin to reach $100,000, just that it’s speculation and should be treated as such. The number of actual transactions isn’t increasing which shows no traction in the real world, which would make it an actual possible investment.
So to conclude, if you own bitcoins or you are considering owning them, just know that you are speculating on the fact that there will be someone who will pay more for them in the future which doesn’t have to be a bad thing.
On the risk reward side, if bitcoin has the possibility to reach $100,000, then what you could make is 33 times your money while you could only lose what you’ve invested in it. So therefore, it’s a positive asymmetric risk reward situation.
Keep reading Investiv Daily as we’re always discussing interesting investment opportunities and in the future, you might want to diversify all the dollar gains you’ve made with bitcoins.