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Aug 27, 2013

Bitcoin and its Value

Posted by in categories: bitcoin, business, economics, finance

Originally posted as Part I of a four-part introductory series on Bitcoin on May 1, 2013 in the American Daily Herald. See the Bitcoin blog for all four articles.

The last couple of months proved a very exciting time for Bitcoin and its new owners, with values increasing from $30 to $260 within a month only to come crashing down in days. It went from virtual anonymity to virtual ubiquity and back again — the only constant being that it’s virtual. The dust has now settled and the talking heads have changed topic, and Bitcoin is slowly regaining strength. But does this mean we can finally, in a quiet and rational way, contemplate what this Bitcoin really is and where it has room to fit into our lives? The answer to that is no, because the concept of Bitcoin is so strange, unintuitive and foreign, no matter when you discuss it and with whom, it will lead to very divisive arguments. So I say now is as good a time as any to dive in and discuss it.

So what is Bitcoin, anyway?

Bitcoin is a virtual currency. It is a string of 1s and 0s, much like a lot of what we interact with in this day and age. It’s something new. It’s unique. It’s controversial. The detractors say it’s only useful for terrorists or drug lords who want to move money around undetected, which no doubt they do. But much like the Internet is so much more than pornography, so is Bitcoin so much more than drug money. E-mail liberated the letter from the postage stamp, Skype liberated telephone calls from crippling AT&T long-distance rates, Facebook liberated photos from the dusty photo album sitting on your shelf unopened. You can think of Bitcoin as what will liberate financial transactions from the grip of the financial institutions and the state.

Technical/dictionary definitions can be found in many places. This short article cannot give a full account. But it will present analogies to make the concept of Bitcoin easier to grasp. Given that Bitcoin is virtual, the analogies can only go so far, but the first step is to think about bitcoins as though they were actual coins forged out of the shiniest and prettiest gold. This is the cornerstone to understanding that bitcoins are in fact a commodity, like a gold nugget turned into a coin and made to become money. The analogy is that the element from which the gold coin is forged requires to be mined. Sure enough, it exists in nature, but it is hidden from plain view. It has to be explored to be brought into useful existence, and this gets exceedingly hard as time goes by and as the easy pickings have all been found. Much the same is with Bitcoin. It is decisively unlike any other piece of software or any other electronic file to which we are accustomed. You cannot just copy and paste it and you cannot just reinstall it ad infinitum. The sense we should be getting is that Bitcoin is a scarce good.

Don’t let go of that mental image as I endeavor to explain a bit about the technical aspect. Bitcoin belongs to a new kind of asset class, one that is called a crypto-currency. Its very existence is predicated upon a network of computers that resides within the internet. This Bitcoin network consists of thousands of individuals who are online and connected to one another at every given second of the day, constantly communicating with one another through pieces of software designed with this one networking purpose in mind. Through complex cryptographic means, each coin and all of its transaction history is known to the network while keeping the identity of the owner of this coin completely private. Due to the fact that transmission from one owner to another (the financial transaction) is broadcast to the entire network, it is made virtually impossible to then use the coin again since everyone knows you’ve already given it away – thus it overcomes the problem of double-spending (think “copy & paste”) the same coin. The analogy to a gold coin (or any physical good) is that only one person can ever hold and own the coin, thus it is scarce (in the economic sense) and one person owning the coin prevents another person from owning it.

As to the technical aspect of ‘mining’ bitcoins, these again are computers running specialized software on this network. Miners solve complex algorithms to discover which string of characters would be the next Bitcoin to be produced. The computations are so complex, and increasingly so, that the computers required are expensive, state of the art computers using up time, space and energy. Inherent in the Bitcoin network design, there is a capacity to the network (21 million bitcoins) and inherent to the mining process, it becomes exponentially more difficult to solve these algorithms. Therefore, by nature, the rate of creation of new coins is decreasing and an upper limit is in place. Today over half are in existence, within 25 years over 99 percent will have been mined and by the year 2140 no more coins will be added to the supply. The analogy to gold mining is that gold is finite and it takes effort to discover it; ‘real world’ resources, time and money, are expended in the process. While, of itself, this doesn’t give Bitcoins their value, it does make it either profitable or not and it incentivizes entrepreneurs where the profit exists. Bitcoins cannot be created out of thin air by a Federal Reserve-like entity. It is a commodity that will attract miners should it be profitable, and likewise detract miners when loss-making conditions arise. It is a product of the free-market.

The value of money and Bitcoin

A brief mention was made that this is a new type of asset class. Also mentioned repeatedly is that this is a commodity. These definitions cause great discomfort to many who view assets and commodities as necessarily objects in the physical realm. Accountants have long held the view that a balance sheet can also be comprised of intangible assets. Value, it was argued, does not come from an object’s tangibility, but rather from its subjective utility by its owner and from its scarcity. Businesses, after all, pay great premiums to acquire others’ brands or to employ people for their talents or ideas. To be sure, a Bitcoin is a string of 1s and 0s and interacts only with software, but when this string of 1s and 0s is useful and its ownership boundaries are clearly delineated (meaning what I own, you cannot own at the same time), then it can be thought of as an asset and it can acquire value based on the subjective view of market participants.

Most discussions on forms of money invariably include references to ‘stores of value’ and to the money commodity as having ‘intrinsic value’. It is important to realize that any good arising from the free market will appreciate in value as more people want it and will act as a store of value as long as its popularity remains so. But with popularity dwindling or with marginal utility dropping any good is subject to its store of value diminishing, gold notwithstanding. Intrinsic value is itself a misnomer. Goods do not have intrinsic value. Goods may have intrinsic properties or characteristics that are valued by society or enable them to be well utilized for a specific purpose. Money’s properties, for instance, would include being fungible, divisible, recognizable, durable, portable, rare/scarce, etc. If a good or a commodity intrinsically has all of these properties, then it is likely, over time, to evolve to become a medium of exchange (money). This good will then acquire value with its increased recognition as a popular and well accepted form of money. But calling this ‘intrinsic value’ is fallacious, albeit somewhat common.

Historically, precious metals, especially gold and silver, have retained their values due to their intrinsic properties mentioned above. This has given rise to people’s perception of them as being a ‘store of value’ and of having ‘intrinsic value’. Another red herring introduced to the argument is that gold has other uses, say in dentistry, aerospace, or jewelry. True enough, this would imply that should the metals lose all perception as being money (a highly unlikely scenario, but theoretically possible), then at least the owner is able to sell off their existing holdings to goldsmiths and other industry participants. The resultant oversupply relative to demand would probably mean gold owners would salvage a few percent of the value at best. Therefore, for all practical purposes, the fact that gold has value other than money (a characteristic Bitcoin doesn’t share) is of little relevance when discussing it as a medium of exchange.

With Nixon’s closure of the ‘gold window’ in 1971, gold has ceased its official role as money. However it is quite evident that as an asset class, precious metals are still highly regarded and form a part of many prudent investors’ portfolios. Payment for goods and services with a Krugerrand or a Silver Eagle would constitute ‘barter’ if one were to go by today’s strictly legal definitions of money payments. But if (or when) the US Dollar system collapses, there is no doubt to an ever increasing proportion of the population that ‘payment’ with gold and silver would arise as legitimate forms of money. The creation of bitcoins has introduced another alternative, one which would be unwise to ignore.

Bitcoin adoption and its rise in value

As long as its acceptance as money is only to a narrow audience, its value will remain low and the possibility of a price collapse is a real risk. But one shouldn’t make the error in deducing, therefore, that it cannot acquire value as people learn about it and accept it. Every commodity starts its life as having no value until someone finds a use for it and starts exchanging it with others who also see the value in its use or its properties. If a commodity acquires value as a medium of exchange through voluntary free-market interactions, and is not forced upon the populace through legal tender laws (as fiat money is), then it no longer matters that it doesn’t have other uses. It will be acquired and exchanged for the sole purpose of acquisition and exchange. In a free market, after all, if people lose confidence or interest in the product – any product (money or otherwise), its value would decrease and potentially reduce to zero.

So why has its value gone up so greatly? Is it all attributed to an irrational bubble-induced craze? Perhaps. But perhaps ever more people are starting to realize that this invention fits the bill. It is fungible, divisible, recognizable, durable, portable, rare/scarce (an in-depth look at each will have to be the topic of another article). When one considers the design of this ‘product’ in light of these attributes, one begins to realize that the properties that led gold and silver to the fore as ‘natural money’ can exist in other goods. People gawk at miraculous inventions that enable us to perform heretofore unthinkable tasks. Transacting in money is no different. Money is simply the most marketable commodity. It shouldn’t surprise us, in this day and age, that someone was able to invent an alternative form of it – and let the free market decide what is more marketable. What we have witnessed over the last few weeks are volatile price fluctuations, as people rush into this craze wanting to make a quick buck. But with more people owning bitcoins and more businesses willing to accept payment in them, Bitcoin is gaining currency. This is exactly the process that took gold from ornament to payment, only instead of taking centuries, it is happening before our very eyes. For those seeking a return to free market currencies, consider Bitcoin as a successful alternative.

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Comments — comments are now closed.

  • Manuel Perez on August 27, 2013 7:35 am

    This is a very good and explicit explanation of the current Bitcoin situation, though I must point out that crypto-currency is a human invention, and what one human mind can invent another can duplicate and improve.

    The Bitcoin chain in a P2P environment is pretty good protection against fraud and forgery, and should also serve as a quick detection system for the day that someone “breaks the code”, thanks to the duplicate files that are in “the cloud”. All crypto-currencies, and fiat currencies share the weakness inherent in their software: that whomever breaks the “code” used by banks, governments, servers or P2P systems will be able to abuse the system until detection/correction takes place. In the fiat currency/banking world, the LIBOR and WHALE scandals (not to mention Wall Street software “glitches”) should serve as warning signals, and I suggest we remember that this weakness extends to Bitcoins, too.

    The value of Bitcoins and other currencies lies in their usefulness and reliability. Once Bitcoin Exchanges comply with worldwide anti-money laundering requirements then “tech-savvy” individuals and small businesses can freely use the Bitcoin as a financial instrument and currency for investment and commercial purposes. Bitcoin will be attractive because of its pseudo-anonymity/privacy as well as the intrinsic fraud protection the “chain” represents.

  • Daniel Shafrir on August 27, 2013 3:42 pm

    Thanks for the comment, Manuel. You mention that:
    “All crypto-currencies, and fiat currencies share the weakness inherent in their software: that whomever breaks the “code” used by banks, governments, servers or P2P systems will be able to abuse the system until detection/correction takes place.”

    All software has inherent weakness. As it so happens, crypto-currencies such as Bitcoin are open source and the code has been examined by countless coders, cryptographers and hackers and it is considered extremely secure. Moreover, the code is run by a distributed network with unimaginable computing power, so there is no one party controlling it. The main vulnerabilities of Bitcoin code is in upgrades to the system (which could cause a fork), or a very unlikely 51% attack. Both of these are rare and/or extremely unlikely and would be spotted almost instantaneously (hence the abuser will have very little time to abuse the system and wouldn’t be able to do too much harm anyway).

    Now to make one thing very clear – fiat currency is not governed by ‘code’ (unless you’re talking in the most abstract sense). The Federal Reserve creates one-sided accounting entries in its books (thus ‘creating’ money out of thin air) but that is not abusing a bug in the code. That is the very intention of the system itself! Governments rely on inflation for their very existence (see parts III and IV of this series in the Bitcoin blog). You mention the LIBOR and the ‘London Whale’ scandals as the fiat currency scandals. Those are only inconsequentially related to the fiat currency system. A century of money printing (including current Quantitative Easing measures) and the fact that money is created out of nowhere at the whim of a small group of individuals is the true scandal nobody seems to care about. Bitcoin is in no way, shape or form equivalent to what characterizes fiat currency (again, see part IV of this series).

    I will concede that there are ways to manipulate the value of Bitcoin, much like there is a way to manipulate the rate of LIBOR or the unintended consequences of Wall Street glitches which caused the flash crash (assuming that’s what you’re referring to) which manipulated the value of certain stocks. If there is an agency (say an exchange like Mt. Gox) which has a substantial impact on the volume of exchanges between Bitcoin (BTC) and fiat currencies (say, USD) and say that exchange was subject to bullying by the financial regulator/government or even to denial-of-service attacks, that could have an impact on transactions between BTC and USD and therefore would have an impact on the value of BTC in USD. But this has no impact on Bitcoin as a currency, namely that the currency is still fundamentally sound. Any commodity’s value can be manipulated. That is a weakness one can extend to Bitcoin. The difference is that a fiat currency’s value is determined by legal decree and forced upon everyone whether they want it or not, whereas a free market currency’s value is determined by what people are willing to offer for it in a voluntary market. This is where Bitcoin, gold and silver differ from all national currencies in the starkest of ways.

  • Rich Brumpton on August 28, 2013 3:22 pm

    I was reading Manuel’s comment in that broadest sense you mention. ‘Code” can mean almost the same thing that ‘Machine’ meant to our grandparents when used in as an analogy.

    I have found that technological structures give a very good handle on understanding a much more messy reality. One of my favorite uses of this is to help geeks understand politics and the legal system. Laying out a world of Lawyers = Hackers, Politicians = Programmers, Judges = Debuggers, etc can be an interesting exercise that leads to some insights for those that have a very heavy technical understanding, but have avoided politics.

    I have not tried yet, but I suspect a similar analysis and analogy to the financial system would be enlightening.

    Great article, I look forward to seeing more!