Bitcoin – Price Drivers

As mentioned previously, it is important to distinguish the value and merits of Bitcoin in (at least) two categories, 1) as a currency, and 2) as a commodity.  Other merits such as it’s function as a transaction settlement protocol will not be addressed here.  The ‘value’ of Bitcoin implies much more than it’s price alone, so it is also necessary to separate ‘price valuation’ as measured in other currencies from the more broadly theorized intrinsic ‘value’.  The most important thing to remember about any fiat currency is that its valuation is a function of FAITH, first and foremost.  Despite the fact that Bitcoin is truly unique, I must place it in the category of ‘hybrid fiat currency’ until there is a better way to define its status.  The analysis of the price valuation of a ‘faith-based’ currency requires a traversal through many layers of derivatives that ultimately drive the level of faith in the currency.  The following are some thoughts in terms of the ‘commodity price valuation’ of Bitcoin and do not necessarily reflect the ‘value’ of Bitcoin as viewed in a broader scope.

Supply and Demand:
Assuming a relatively stable underlying faith in a currency, one of the strongest influences on price valuation is the supply vs. demand.  With Bitcoin, the supply is completely knowable and predictable.  The Bitcoin protocol describes exactly how much is produced over time, therefore it easy to determine the precise amount of supply that is available at any given moment.  See Bitcoin Supply Statistics here.  With all other factors remaining constant, only a change in demand for Bitcoin would drive the price up or down.  The price of course is a valuation in terms of some other currency, so these valuations fluctuate based on the region and associated currency that is being used to purchase / sell Bitcoin.  For simplicity, lets consider a single currency, US Dollars (USD), in any examples to follow.  A simple example of demand-driven price is the time-frame of January – April 2013 when a combination of natural demand met with media-hyped-demand, driving the price from around $15 to over $250 for a short period of time.  Further analysis of this time-frame may indicate that issues originating within some of the Bitcoin exchanges may have added fuel to the volatility, but I think it is fairly safe to use this as an example of increased demand resulting in increased price.

Geopolitical Events:
Changes in economic policies, regional regulations, shifts in political leadership, and many other geopolitical factors certainly have an influence on the valuation of Bitcoin.  Some of these factors are small and others are VERY large.  For simplicity, let’s narrow down the impact to two primary factors for any given ‘event’: 1) The economic impact of the geopolitical region in terms of potential investment in-flows or out-flows.  In other words how much currency ($) may be converted to Bitcoin (BTC), or vice versa.  And 2), a determination of whether the event will have a positive or negative impact on the Bitcoin ecosystem.  The first factor will determine the magnitude of the change in price, and the second will determine the direction of the price.  There is a great example of this type of valuation-driver in Bitcoin’s brief history as well.  Back in the September / October 2013 time-frame, there was a tremendous amount of media coverage regarding China’s increasing demand for Bitcoin.  While BTC China (a Bitcoin trading exchange located in China) was founded back in 2011, it was the increasing demand within China paired with significant external investments into the BTC China exchange that played a large role in Bitcon’s skyrocketing price from around $150 to a brief peak over $1200.  This all took place between September – December 2013.  Technically, this price increase was both a supply / demand function based on Chinese demand, availability (via BTC China Exchange), and media coverage fueling the fire, as wells as a geopolitical event due to the localized nature of the event (primarily in China), and the regulatory state of the region (there essentially were NO regulations or otherwise limiting factors in place).  A more significant geopolitical event resulted in the rapid decrease in Bitcoin’s price in mid-December 2013.  The Chinese central bank barred all financial institutions from directly dealing in any Bitcoin transactions and prohibited these institutions and payment companies from clearing transactions for Bitcoin exchanges.  The immediate impact of this event was a drop of over 50% in Bitcoin’s price in a single day (this was reflected on many exchanges simultaneously).  The price fairly quickly bounced back to some degree, but has not reached the prior highs to this date.

Technological / Coding Flaws & Exploits:
Bitcoin is a protocol developed as software code.  As with any software program, there is a potential for ‘bugs’ or flaws in the coding logic.  Bitcoin has overcome several of these issues in the past.  In each previous encounter with software bugs, there were fixes put in place without compromising the integrity of the block chain (Bitcoin’s ledger of historical activity).  While this factor clearly has the potential to do the most damage to Bitcoin’s price on the down-side, it is also primarily responsible for it’s success thus far on the up-side.  The longer Bitcoin survives attacks and attempts to exploit the protocol’s weaknesses (if and when they are found), the greater the likelihood that it will endure future attacks.  The Bitcoin network actually gets stronger through the process of surviving attacks.  I think it is safe to say that the ultimate success or demise of Bitcoin will depend on the mitigation of technological flaws.

There are other factors that are more difficult to quantify because they contain too many unknowns.  One such wildcard would be the advent of a new technology such as the recently-developed, and now operational, ‘quantum computer‘.  It is theoretically possible that this type of computing power could overrun the entire existing Bitcoin network.  This threat seems unlikely, but is ‘real’.  It is definitely something that the Bitcoin community will need to keep an eye on.  It is also perfectly plausible that the Bitcoin protocol could be enhanced to adapt to quantum computing being in the picture.  Another technology-related threat would be a competitor to Bitcoin that is developed completely independently.  If something truly better comes along, then financial interests will migrate toward the competitor thus driving down the price valuation of Bitcoin in favor of the ‘better’ product.  This threat is difficult to imagine or gauge right now because there really does not seem to be anything on the horizon.  There are certainly many derivatives of Bitcoin out there, but most of the viable players actually depend on the existence of the Bitcoin network itself for their own viability.  In most cases, their value is tied directly to the Bitcoin block chain itself.  These entities are more like ‘plug-ins’ for Bitcoin that may or may not add value to the overall ecosystem.  I don’t really see them as threats since anything that does not add value will simply be ‘voted down’ by lack of adoption within the ecosystem, and anything that does add value will make the ecosystem stronger.  The remaining list of factors are decreasingly likely to have a large impact on price in the short-term.  However, the landscape is changing daily.  This post will likely be obsolete within a few months, if not sooner!

Please chime-in below with comments on other factors that are not listed here!

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Bitcoin: Currency or Commodity?

As promised in my last post, here is the next installment on the topic of Bitcoin.  As a reminder, Bitcoin is the first (known) and widely used cryptocurrency, but it is not the only cryptocurrency.  I will use Bitcoin as a focal point for my topics because I have the more knowledge and experience with it than any others.

Is Bitcoin a currency or a commodity?  While studying Bitcoin, I learned more about it’s purpose and how it works as a currency, but found myself acting as if it were a commodity.  I was lucky enough to buy a few Bitcoins (BTC) in late 2012 at a price around $15.  I actually spent most of my balance at that time, but because I still had a small balance and was interested in the concept, I was compelled to learn more about it and follow it’s evolution.  The dramatic increase in it’s price (measured in US Dollars) in early to mid 2013 made it clear that BTC had more value as an ‘asset’ (commodity) than as a ‘medium of exchange’ (currency) at that time.  In fact much has been written on this topic, so feel free to explore other opinions on this topic, but here is my take.  I have decided that when discussing Bitcoin with others, it is important to start the conversation with a clarification on whether the discussion is focused on its merrits and/or dangers as a currency or a commodity.

Bitcoin as a Commodity:

When the first Bitcoins were mined, they had little or no value at all (based on valuation in other currencies).  It was just a network network-based computer program that was ‘born’ by spawning the underlying algorithms on a few client PCs that began mining the virtual coins.  In fact, there is a story out there about the guy who mined 7500 Bitcoins during the currencies infancy, then basically forgot about them. As the story goes, he later trashed his old computer which ended up in a landfill.  The Bitcoins that were held in the digital wallet on that hard drive will never be reclaimed. So based on current BTC prices, there is roughly $7 million sitting in a landfill somewhere.  When the guy mined the coins, they probably had a value of a few bucks. The rise of any ‘investment’ from a few bucks to $7 million sounds more like a valuable ‘asset’ rather than a currency.  Why would anybody in their right mind use BTC to buy groceries when the same BTC could buy a house a few months later?  I think that BTC will be horded and regarded in large part as a commodity until such time that a price equilibrium is established between BTC and other world currencies.  The world basically has to collectively determin what percentage of other native currencies are to be converted into the form of BTC for the eventual use as a currency in the future.

Bitcoin as a Currency:

The properties of Bitcoin as a currency are nothing short of genius.  It actually is a currency on steroids in many ways.  It is not only a medium of exchange, but also provides the transaction network for settlements as well.  Contrast this with our current system, where a purchase may be made using a credit card (the transaction network), then later paid for by cash or electronic transfer from a bank account.  True settlement of the transaction may take days.  With Bitcoin it usually takes about 10 minutes.  For more information on the technical architecture of Bitcoin, see the links at the bottom of this post.  The limited supply of the currency (and eventual cap on total BTC in existence) is a welcome change from the inflationary policies that our current central banking systems have maintained over the last century.  There are some concerns by critics that Bitcoin will ultimately have a deflationary effect on economies.  While it is true that some level of deflationary pressure is almost certain based on the Bitcoin supply model, it remains debatable as to the overall positive or negative impact in the long-run.  The currency is COMPLETELY in the control of the holder of the currency.  However, one MUST TAKE GREAT CARE TO PROTECT their asset.  One area that will require much more development is a way to ensure that novice and non-technical users of the currency are able to conduct business without fear of theft or fraudulent actions resulting in the loss of their wealth.

There is a delecate balance in play here.  While I expect BTC to be largely treated as a commodity in the near-term, it’s value as a commodity is tied to its value and viability as a currency.  If ALL BTC currency transactions in the form of purchasing goods and services were to cease, then it would have relatively little value as an asset.  I don’t really see it crashing for this reason however.  Afterall, if we approach this end of the spectrum, then people will be looking to unload their BTC.  And what better way to spend this fortune than on a new Ferrari!  Then we have the news headline, “Ferrari purchase for 100 BTC”.  This type of news is like gasoline on a fire, causing people to once again see value as a currency, thus demanding more BTC for themselves.  Since BTC is limited in supply by design (which cannot be altered), the value as an asset again rises.

The maturity of BTC to a widely accepted currency will likely be much like the rollercoast ride of a child going through the awkward teenage years.  For those who like excitement, get on board!  It will be fun!  But for those who are risk-averse, you may want to just keep yourself informed and maintain a very small exposure to the currency (if any at all).  I personally think it can’t hurt to have little bit at stake in the currency.  If nothing else, having a stake in it will force you to stay informed (it worked for me).  And, it also acts as a potential hedge against the ever-decreasing buying power prevalent in ALL other currencies.

LINKS:

How Bitcoin Works

Bitcoin Security Architecture