Bitcoin Price - Scam or Real?

Is Bitcoin just another Tulip mania of the 21st century or is the first digitally scarce decentralized currency a marvel of technology that truly is worthy of its price appreciation?

🚨Big Disclaimer: Let me start this article with the standard disclaimer. This is not investment advice. I am not an investment advisor. This information is meant to be for educational purposes. Please do your own research before you decide to invest your hard-earned money. If you are unsure seek help from a professional financial advisor who can understand the full breadth of your financial needs & commitments to advise you on what you should do.

🧗Start of the Journey - Part 1 of many articles

I was inspired to write this post by the heated intellectual discussions I have had with friends on this topic. Let me forewarn you. A single post or article is not enough to cover all pros, cons & nuances on this topic. See this as the start of a journey where over the course of a few weeks we will dwell into different aspects of the asset. So sit back with your cup of coffee or glass of wine and let’s dive into the question of “What should be the price of Bitcoin? or Is there real value in Bitcoin?” This is not the easiest questions to answers. I have tried not to hide behind a lot of technical jargon and keep it to stuff I can explain to my son.

💰$450M for Leonardo da Vinci’s Painting - is it worth it?

I am sure that was the question on people’s minds in Nov 2017 when Dmitry Rybolovlev paid $450M¹ for “Salvator Mundi” a painting by Leonardo da Vinci in an auction at Christie's, New York. Have you ever stopped to wonder what factors may cause this painting to be so expensive - it is rare (only 1 of its kind), by a very renowned artist, in demand by a community of individuals who value these paintings. Dmitry is one of those who value this painting, expects it to go up in price, and has the financial means to purchase it. I don’t have anywhere near that much money so even if I wanted it, I would be priced out of the market. I might even be happy seeing an image of that on my computer and derive value from it. But the price of my copy is $0. It is free because there is an unlimited supply of pictures of the painting online.

💸 But then Price & Value are not necessarily connected?

Price (what you pay): Price is the amount of money paid by the buyer to the seller in exchange for any product and service. Value (what you get): implies the utility of worth of the commodity of service for an individual.

Basic economics dictates that Price is determined at the intersection of Demand (people want the item) & Supply ( how much of it is available). ²

Not all high-value items are expensive and vice-versa not all low-value items are cheap. This can be explained easily with the popular example given by Profesor Adam Smith about water and diamond. Water is much important for us to survive still its price is low, while the diamond is just used for ornamentation and nobody dies if they do not get it, still it is priced very high. The reason behind this is that while the value of water is high for us, it is available in abundance (more of the ocean’s water is being made drinkable). While the value of diamonds is low, it is seen as a status symbol and has a limited supply, thus driving up its price.

🏆 So is Bitcoin the Diamond or Gold of the new digital Age - Low Value but High price?

Although it’s not tangible, Bitcoin’s code gives it features of traditional fiat currency, including scarcity, divisibility, portability, fungibility, and recognizability. Besides, Bitcoin is decentralized and can be used without middlemen, provides some level of transparency, can be accessed and used by anyone with an internet connection, is impossible to counterfeit and confiscate, and has other features such as programmability. Most importantly, it can be used as a store of value like gold or other commodities, yet unlike its physical counterparts, it can be transported from one end of the world to the other via communication channels in a matter of minutes.

A few things to know about bitcoin

• Bitcoin network is a complete financial system that facilitates the transfer and custody of bitcoin, a new digital monetary asset.

• Bitcoin is free and open-source software (FOSS), code that lives on the Internet. Individuals can run the code or copy it and create their own variant.

• Scarcity. Limited supply of 21 million bitcoins, hardwired into the technology code

• Divisibility. A single Bitcoin can be divided into 100000000 Satoshis. One Satoshi equals 0.00000001 BTC. This can go up to 16 decimal places.

• Deflationary. To date, ~18M Bitcoins have been mined. Miners who maintain the network and record the transactions are reward 6.25 Bitcoin ~every 10 minutes for successfully writing a new block. This reward halves every 4 years (bitcoin halving). Thus the system has a defined deflationary policy hardwired into its software code.

  

• Portability. Bitcoins can be transferred through a communication channel like the internet, satellites or even radio waves, which makes it the most transferable currency that ever existed.

• Fungibility. Every Bitcoin has the same value as its counterpart, regardless of who owns it and what history it has. Just like one ounce of pure gold is always equal to another ounce of pure gold. No matter what happens, one Bitcoin remains a symbol of value interchangeable with another Bitcoin.

• Durability. Any Bitcoin or Satoshi can be reused countless times without degrading.

• Recognizability. A growing number of merchants and users recognize and accept Bitcoins. Although it’s still far from the level of acceptance of fiat currencies, many people distinguish Bitcoin from non-currencies or other counterfeit money and are willing to accept it as a means of payment.

• Decentralization. No single entity oversees Bitcoin. Unlike traditional money, no one can censor, control, or change the network or its transactions, so that no one can confiscate your money.

• Accessibility. You don’t need to have a verified bank account to own or accept Bitcoins. All you need is some basic computer knowledge and an internet connection. Bitcoin's accessibility makes it extremely convenient for underbanked areas of the world

• Uncounterfeitability. Every Bitcoin transaction is recorded on a distributed ledger and is secured by the computation work of nodes. The system was designed to prevent the double-spend problem which hindered preceding digital currencies from taking off. As a result, all transactions on the Bitcoin network are uncounterfeitable and irrevocable.

• Programmability. Unlike regular money, Bitcoin also introduces a dimension of programmability. It means that in the future, Bitcoin can receive updates and have even more handy features like smart contracts, multi-sig transactions, and others.

  

🔥So Where does the Demand for Bitcoin Originate

Predicting the short-term price of Bitcoin is extremely hard and is influenced by various factors around the market sentiment, FUD, News, Hashrate etc. I am more focused on looking at the demand side drivers for its long-term price & value.

📱1. Network Effects (Metcalfe’s Law)

The more people that are on a network, the more valuable the network becomes. This was identified in the Telco sector but has been the bedrock of understanding the exponential growth in Internet Platform companies.

Metcalfe's Law” says that a network's value is proportional to the square of the number of nodes (devices or users) in the network. So if there are only 2 phones they can only call each other, but 12 phones can make 66 connections and this increases exponentially. We have seen this with the platforms we engage with every day Whatsapp, Linkedin, Facebook. Each of these are examples of growth through network effects, building barriers to entry for new entrants. It is very hard for someone to start a new LinkedIn - when users sign on to the new platform none of their contacts are would be there, so who will they follow and message?

As the first Cryptocurrency on the block Bitcoins network is continuing to grow - retail investors, small & large institutions, governments (El Salvador) etc.

💰2. Store of Value

A store of value is an asset, commodity, or currency that maintains its worth and therefore can be exchanged in the future without deteriorating in value. Cash is useful to transact with in present-day and valuable to keep for short-term liquidity. However, as a store of value over a longer period of time, its track record is terrible

According to The Fed’s Consumer Price Index, $1 in 1913 (the year The Federal Reserve was established) would buy you roughly what would require $26.15 in 2020. That is a cumulative loss of a little over 96% in purchasing power from the most dependable fiat currency in the world during that time span. Ironically, an original stack of Monopoly game money from 1935 is worth roughly $40-$60 on eBay today as a collectible item, meaning “Monopoly Money” has held its value better than real money over the last 85 years.³

So the 100,000-foot view is that this Bitcoin is an excellent store of value in the sense that it stores value over time. Diminishing quantity juxtaposed with the propensity of currencies to debase over time and the substantial amount of money being pumped into the system is a solid foundation for Bitcoin’s price appreciation. If you look at the current monetary system, there aren't very many good places to store value over time. The current ideology of those in power is to make sure that the money is flowing through the economy and to make sure that the velocity of money is fast enough so things don’t stall.

https://howmuch.net/articles/rise-and-fall-dollar

💵3. Payment Network

Bitcoin also happens to be pretty good at transferring value across physical boundaries. While we have got used to making small payments instantly in a shop but it still takes days to transfer money across borders. A final settlement in 10 minutes halfway around the world with the potential to bank a large portion of the unbanked & underbanked in the world is amazing.

However, this promise of everyday transactions is not around the corner - due to the size & timing of each block there are limitations to the Bitcoins use to make micropayments. These are being addressed by an upgrade that has been in the works for some years - The Lightning Network. It is a "layer 2" payment protocol that sits on top of Bitcoins’ main ledger. It is intended to enable fast transactions among participants addressing the scalability problem in the base layer. Just like 2 housemates keep a running tab of who paid what and only settle at the end of the month, this upgrade would allow people to have a running IOU with various people without each transaction being written to the ledger (this is a high-level explanation, a more detailed response can be found here )

A topic to cover in subsequent newsletters would be on the layering of money and Bitcoins place in a world with CBDCs.

🏢4. Global Settlement network

Bitcoin has the potential to become a settlement system for banks and businesses. Unlike traditional settlement systems, the Bitcoin network is global, it cannot censor transactions, and its money cannot be inflated by institutions like central banks. Instead of facilitating a large volume of low-value transactions at the point of sale, Bitcoin could evolve to handle large transactions between and among financial intermediaries. Today, most dollar-based international payments must settle through the Federal Reserve’s Real Time Gross Settlement (RTGS), or Fedwire.

⏳5. Portfolio Diversification

Institutions are big fans of statistics - rightly so, they are trying to squeeze out higher returns at every level of risk. At its heart, modern portfolio theory is just the old eggs-in-one-basket adage dressed up in mathematical terms. The reason to diversify is that you can get the same return as on a less diversified portfolio but with less volatility, or, equivalently, keep the volatility constant while getting magnified returns via some leverage.

If you haven’t read it, my article on learnings from investing has some interesting thoughts on diversification - 10 Investing Lessons I Learned (Part 2)

Bitcoin is fearsomely volatile, but it has more than made up for that with appreciation. The Coin Metrics Bletchley Index clocks bitcoin’s Sharpe ratio over the past five years at 1.6. That compares (per Morningstar) with 1.1 for the Vanguard Balanced Index Fund, which is about as diversified as you can get using stocks and bonds.

If you could invest with hindsight, you’d go back in time, put 100% of your money in crypto and hold tight to the roller coaster. Over five years you would have multiplied your cash 105-fold 

🥷6. Protection Against The Seizure Of Assets

Bitcoin enables personal sovereignty, a useful - if not crucial - characteristic in jurisdictions where property rights are not recognized or enforced. With good public and private key management, we believe bitcoin cannot be seized.

And many more use cases.

So in Conclusion…

With a Limited Supply, Growing Demand (network effects & increasing uses cases) Bitcoin appears on track to becoming a globally accepted decentralized reserve and store-of-value asset that’s easy to transport & transact.

It has 24/7 price discovery, relative scarcity and is nobody’s liability or project.

Some interesting questions for the next weekly newsletters…

• Does Bitcoin need to be accepted by everyone to have value?

• Governments are already bringing out CBDC’s (central bank digital currencies)

• What if all governments ban bitcoin

• Are there any financial models to value Bitcoin ie. Stock to flow

• What are the difficulties of Valuing Bitcoin

• What can cause the value of bitcoin to crash or drop

• Criticism to Store of Value - Volatile, Not backed by anything, not accepted everywhere, regulatory restrictions

If you liked this article - Do subscribe to my free weekly newsletter, share it with your friends, and give me feedback & comments. You can find me on Social Media Twitter - @sauravbhats or Linked in.

1. https://en.wikipedia.org/wiki/List_of_most_expensive_paintings

2. https://keydifferences.com/difference-between-price-cost-and-value.html

3. https://howmuch.net/articles/rise-and-fall-dollar