Higher Rock Education - Economics Blog

What's In a Bitcoin?
Wednesday, February 07, 2018
Bitcoin is a cryptocurrency that can be used to buy and sell goods and services anonymously, without the involvement of a bank or government. Transactions are tracked by a network of independent computers using blockchain technology. Recently, bitcoin has received much press, not because of its use as a currency, but because its value appreciated over 20,000% in 2017. What is the underlying reason for the appreciation of bitcoin?  

In our blog, Is Bitcoin Money, I concluded that bitcoin is not money, yet. The IRS agrees. In 2014, the IRS ruled that bitcoin is property. (IRS 2014-21) So if bitcoin is of little value as a currency, what is its value?

In 2017 the value of one bitcoin fluctuated between $740 and $19,870, for a return of over 22,000%! Bitcoin is like stocks, with one huge exception. There is really nothing backing the asset. A stockowner owns a small interest in the company. Bitcoin is not a company, nor is it a product produced by a company. Bitcoin has been compared to gold… but gold can be converted into jewelry or many other commercial uses. Not bitcoin. Property value is driven by the law of supply and demand. So what creates the value if bitcoin is not backed by an asset? What is driving the increase in demand? Speculation. 

Irrational investing is not uncommon when far-reaching technologies are developed. Many new companies enter the market to take advantage of the opportunities. Investors in the late 1990s experienced the dotcom bubble. Many companies reached a market capitalization of several hundred million dollars when they had little more than an idea and a name with dot.com. When the bubble burst, some values dropped to under a dollar. For example, Pets.com went from an IPO to bust in 268 days. Experts were advising that the assets behind the dotcoms were insufficient to justify the high valuations. Many financial experts believe bitcoin is the next investment bubble. 

So is bitcoin’s value in the blockchain technology? I confess, I do not understand the technology, but I understand blockchain has potential for valuable applications in more than cryptocurrency. In theory it can be used in securing transactions by decentralizing trust. It can be used in record keeping and tracking shipments. Blockchain is a network of linked computers that has a record of every transaction on the network. No single computer has control, which makes it impossible to change or erase a transaction, thereby adding security because nobody can manipulate the data. However, I do not see the link between investing in bitcoin and investing in blockchain – especially since the bitcoin software is open source and bitcoin is not a company or a product manufactured by a company.

Some argue that the forces of supply and demand will push bitcoin to higher values, because the supply is limited, and the demand is growing. Bitcoin is created by miners. Miners have several jobs. First, they record bitcoin transactions in the open ledgers by adding the transactions to the blockchain. They are paid a fee for this service, but they can earn even more if they solve a mathematical puzzle and are rewarded bitcoin. Other miners verify that the winner’s answer is correct. Presently, the supply of bitcoin is limited to 21 million “coins”. To date 16.8 million have been created. (Visit Blockchain for a current figure.) Most currencies are managed by a central bank that controls the money supply. During certain periods these central banks have financed their government’s needs by increasing the money supply, which devalues the currency. In theory, limiting the amount of bitcoin makes bitcoin immune from devaluation by increasing the money supply. Speculators believe the combination of the limited supply and the increase in acceptance will continue to propel bitcoin’s value higher. 

Proponents of bitcoin also believe the demand for the currency will grow. Eventually processing transactions will take less time. The price will stabilize, with widespread acceptance and increased liquidity. Meanwhile the public’s growing distrust of authorities, whether it is a government, central bank, or large businesses, will make bitcoin more appealing because transactions are anonymous and cannot be altered. Bitcoin’s medium of exchange should improve as more vendors accept the currency. A more stable price will enhance its store of value, and its measure of value. (It should be noted that while identifying information is not provided in transactions, transactions can be traced if the user’s bitcoin address is identified. In fact, some agencies embrace blockchain technology because there is a record of every transaction on every computer.)

Presently, I see very little value in bitcoin as a currency. I agree with the IRS, those who buy bitcoin are purchasing property. However, I see little substance backing the price. Bitcoin’s value is in the role it has played in the development of blockchain technology, but I do not understand how the technology could translate into a higher value of bitcoin. Bitcoin is not a company. A company could leverage the technology. Its value depends too much on future expectations that I believe are a bit far-fetched. I will not invest in bitcoin. Anyone who is interested in investing should take extreme caution. Consult with an expert, and do not invest any money you could not afford to lose. 



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