Despite all the hype, speculation and FOMO, nobody got close to a credible valuation model for Bitcoin. Those who, like Tom Lee, claim that “Bitcoin is worth X dollars”, usually simply run a regression of Bitcoin’s price against a few variables, and pretend that correlation equals causation.

To come up with a valuation model for Bitcoin, one first has to understand where its value comes from. I’ll go through the usual suspects - means of transaction (check out the part on speculation cycles !), store of value, network effect, and try to explore new sources of value.

Bitcoin’s source of demand has changed over the years

Value comes from demand, conditional to the marginal supply at a given price. It’s microeconomics 101 - the price of everything is determined by an equilibrium between marginal demand and marginal supply. To have value, Bitcoin must experience some kind of demand.

If you know all about Bitcoin’s history, you can jump to conclusions here.

2009: Let’s have fun!

At the very beginning, Bitcoin was only known to a small group of cryptography forums’ habitués, where “Satoshi Nakamoto” communicated about his efforts to create a peer-to-peer currency. These people wanted to have some Bitcoin for the sake of playing with it, because they saw it as an “intellectual experiment“, as Robert Shiller put it much later, in January 2018. They very much wanted to mine it themselves, because it was part of the fun. So there was demand, but the price people wanted to pay for Bitcoin was basically their time, and a few cents on their utility bill - they didn’t think of it in money terms, not yet.

As the small group of fans grew, along with mining difficulty, mining gradually lost its status as a sure way to get some Bitcoins. Up until November 2012, miners would get 50 Bitcoins whenever they managed to mine a block, with one block awarded approximately every ten minutes. But with hundreds of people mining concurrently, it could take you weeks to get your reward. Moreover, you had to install the mining software, a not-so-straightforward task. At some point, as the probability of claiming a block reward dropped, along with the average technological proficiency of people who wanted to play with Bitcoin, the idea of buying it, instead of investing a lot of your time in mining, started to make sense.

2010: Pizza and first bout of speculation

It took Laszlo Hanyecz almost a week to buy two pizzas for 10,000 Bitcoins in May 2010, but he did it (full thread here).

The person who paid the $25 or so to the pizza place, and got Laszlo’s reward, did it for the fun of it. The market for BTC/USD was anecdotal at best, and that deal probably doubled the monthly trading volume of Bitcoin at the time. Nonetheless, Laszlo posted that he would again and again offer 10,000 Bitcoins for a couple of pizzas, he created a floor, and a real bid, in the Bitcoin/pizza market. Apparently, it was all it took for people to start buying Bitcoin.

2011: Drugs, speculation, and the first crash

As Bitcoin’s popularity (and liquidity) rose, Ross William Ulbricht decided to take advantage of its pseudo-anonimity to create Silk Road, a place where anyone could buy anything with Bitcoin. Human nature being what it is, “anything” basically meant drugs.

For the first time, Bitcoin had a real use case: circumventing the law. However, this use case didn’t confer it any fundamental value, as Bitcoins purchased in order to buy drugs, were in theory sold immediately afterwards by the dealers, because they needed real hard cash in order to pay their suppliers.

However, as Bitcoin’s price kept rising at an outstanding pace, very naturally, people who came into owning them, were inclined to keep them and watch their price go up. Until it didn’t, any more, and then they all tried to sell. The first Bitcoin bubble burst in late 2011. That-s the problem of zero-sum games: for every winner, must be a loser.

2012: Drugs, speculation, manipulation

I won’t go into much length about what happened at MtGox - you can read on other sources all about how bots manipulated Bitcoin’s price on the exchange, right up until its bankruptcy in 2013. The second Bitcoin bubble had the support of a new kind of player, with very deep pockets (especially when it decided to double-dip in its clients’ wallets): an online exchange. For the first time, Bitcoin’s value became artificial, as the demand for Bitcoin was inflated by FOMO, created by price manipulation.

2013-onward: ICOs and speculation

The main use case for Bitcoin, to this day, seems to be the financing of various projects through initial coin offerings. However, this use case doesn’t confer to Bitcoin any value, because an ICO is, one again, a zero sum game: investors buy Bitcoins pre-ICO, send them to the smart entrepreneur (or con artist), who then sells them back for real hard cash, because he/she needs to pay for everything in, you guessed it, real hard cash.

However, it seems that most ICO teams elected not to sell their crypto fortunes post-ICO (at least for Ethereum, see here). The price is going up, so why sell? Much like with Silk Road, an appearance of demand created an appearance of value, until reality kicked in and someone tried to sell the magical virtual coins to get some real money - and the price crashed.

Is Bitcoin valuable because it’s used for transactions?

From it’s history, it appears that Bitcoin is mostly used to transfer value. Someone buys Bitcoins, sends them to someone else, and that person then sells these Bitcoins for real hard cash. It’s obviously a zero-sum game (less the miner rewards and fees), so it shouldn’t create any value. However, the three events where Bitcoin was used as a currency (pizza, drugs, and ICOs), Bitcoin’s price surged. This means that Bitcoin transactions weren’t a zero-sum game. What could be the reasons for that?

Speculation enabled by long transaction cycles

It takes time to perform a transaction using Bitcoin. At best, you can buy the coins, send them, and sell them back for real cash, over a few hours. More realistically, the person who receives Bitcoins won’t sell them straight away; this lengthens the transaction cycle to a few days, maybe even weeks. For ICOs, the transaction could take months, as the subscription periods extended over multiple rounds. This means that initial bouts of buying Bitcoins aren’t immediately offset by equal bouts of selling, triggering a rise in price because demand outstrips supply.

Moreover, the demand for Bitcoin for its transactional use case is completely inelastic, meaning that it doesn’t depend upon its price. This means that a rising price for Bitcoin doesn’t negatively impact its demand - a very unique property in the real world.

These two phenomena put together - a very long transaction period, and inelasticity of demand - are a perfect combination to bootstrap a rise in price. People seeing Bitcoin’s price go up, not only elect not to sell the Bitcoins they have, but also try to get some more. Directly, by purchasing them, or indirectly, by selling something for Bitcoins - may it be pizza, drugs, or worthless ICO tokens. This self-reinforcing demand cycle leads to explosive bubbles, until the source of demand disappears - Laszlo not being able to mine enough Bitcoins to pay for $2000 pizzas, Silk Road being shut down by the Feds, or the marketing costs of an ICO blowing out of proportion, and ICO investors running out of real money.

Lost coins

Bitcoin is notoriously difficult to use. There are a hundred ways to lose your coins, from forgotten passwords, crashed computers, or lost hardware wallets. Every time someone loses their coins, a little bit of demand isn’t met by supply, making transactions a little bit better than a zero-sum game (less miner rewards and transaction costs).

Is Bitcoin valuable because it’s a store of value?

The “digital gold” meme had its best moments back in 2017, when Bitcoin’s price was riding high on ICO demand and HODL speculation.

Bitcoin fanboys tend to mystify its value, because they don’t have any good explanation of where it comes from. Their arguments range from “Bitcoin has value because we all agree that it has value” to “nothing has intrinsic value anyways”. However, in the real world, value comes in two forms.

Financial arbitrage value

Would you rather hold dollars that pay zero interest, or a government risk-free bonds that pay you 2% in coupons every year, for the next 3 years?

If you don’t expect to need your money over the next three years, you’d much rather buy a three-year bond. Or, if you expect you’ll need your money, but don’t expect government bond interest rates to go up over the next year, you might want to buy the three year bond, hold it for one year, collect 2%, and sell it back on the market.

You can’t do much with government bonds - you can’t use them for anything, not even to pay for food. However, you can sell them for dollars. That’s why financial securities have value - they have expected future cash flows, in the form of coupons, regular dividends, special dividends, share buybacks, company takeovers, company buyouts, you name it.

The price of a financial security if the current expected value of its future cash flows, adjusted for its risk.

Bitcoin has no future cash flows. Worse, the Bitcoin network costs a lot of money to run (currently around $5 million per day in electricity and ASIC hardware), so you could say that it has negative future cash flows, and you would be right. From a cash flow perspective, it has zero value.

But maybe its price stems from…

Utility value

Let’s take gold as an example. Real gold, not the fake digital one you peddled to your Grandma last Xmas, and she won’t talk to you ever since.

As the chart above indicates, the demand for gold comes mainly from jewellery and industry (source: Most of the gold being bought today will end up in the form of wedding rings and bracelets. It won’t hit back the market any time soon, probably never. I bought an engagement ring for my wife, then a couple of wedding rings for our wedding. Yes, intrinsic value maximalists, I did it because of tradition, because of some made up belief that we have to do it, not because I actually needed the rings in order to survive. Nonetheless, this tradition is so deeply anchored in the human psyche, that you can project constant demand for gold wedding rings for centuries to come, with almost absolute certainty.

Commodities have value because we need them to exist in our modern and complex civilised world. Most of gold is bought with the expectation of use it somewhere, not with the expectation of selling it to a greater fool like with Bitcoin. 100% of Bitcoin coins are bought with the intention of selling them. That’s Bitcoin’s true and only use case: to be sold.

That’s no store of value. That’s a zero-sum game.

Global currency value

There’s one kind of financial asset that doesn’t have future cash flows, doesn’t have utility, yet has value - cash itself. What if Bitcoin has value because there’s a chance that it will one day be used as a widespread currency?

That’s the theory that was used to value ICO projects like Tezos. Arthur Breitman himself admitted that his cryptocurrency should be viewed as a bet, an option on becoming a global currency.

That’s very convenient, of course. Global money supply, or M1, currently stands at $7.6 trillion. Throw in checking deposits, government short-term bonds, money market funds, time deposits, and you’re staring at a whopping $90 trillion. Anything that stands a chance at replacing all this pile of money surely should be worth a few trillion right now, don’t you think?

The key word here is “chance”. If Bitcoin has a 1% chance - a really small percentage - to become the global currency, its current market cap should be, according to that theory, $900 billion, with one Bitcoin being worth somewhere around $50,000.

Fat chance. The world’s vastly different economies could never live under a single currency - just have a look at the extreme difficulties of using a single currency in the Eurozone, a rather homogeneous set of countries. While Lithuania’s economy is overheating, Greece is still mired in a depression.

Ok, let’s assume then that only one country elects to use Bitcoin as a currency. Let’s be optimistic, and assume that it’s the United States. The US M3 (broad money supply) currently stands at $14.2 trillion, so if Bitcoin has a 1% chance of replacing the US dollar, that still gives Bitcoin a valuation of $8,000. That’s not bad, right?

But then, please tell me, if the United States government elects to use a digital decentralised currency, why would it choose Bitcoin? Why not create something new that it controls, and that scales? Why on Earth would the US government use a currency that’s controlled by Chinese miners?

To be continued…

In the next piece, I’ll explore Bitcoin’s network effect (which is to me the most promising source of intrinsic value), and throw around some speculations as to what might (or might not) happen to it in the future.

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  1. Great article. My grandma died and left all gold jewelery to my mother and she will give it to my sister and she will give it to here doughter. Hardly will hit the market in this first half of the century. 😂

  2. I think Bitcoin also needs to be understood in its social and historical contexts. Since the GFC we have seen a marked increase in purely speculative investments in all markets and this has led to a great deal of corruption in markets. I studied companies on the LSE AIM market and was shocked to see the routine level of fraud and corruption with which small management teams misled investors with promises of Jam tomorrow inducing them into backing worthless companies which were simple money sink pits. What was equally shocking was the extent and lengths that investors on forums would also go to in order to deceive themselves and others about the companies they were invested in. I saw pump and dump crews in operation in generally corrupted markets. I also saw how licensed brokers were equally corrupted and complicit in misleading investors and with the shale oil industry in the US you could also throw corrupted investment bankers into the mix. Devon Energy is a good case study of all of this but there are many many others.

    Then when I looked at Bitcoin and ICOs I saw all those same things repeated in that world. I have to ask myself why has this urge or need to speculate so wildly come from?

    I think it’s source is the failure of Neoliberalism to deliver the economic improvements that it promised and now we can clearly see that wealth is in decline globally and ‘growth’ now only notionally takes place by the speculative ‘investments’ of ever increasing debt. This has to led to an increasing sense of hopelessness.

    The article below describes the situation in South Korea but it also applies across the developed world as it shows Bitcoin as a predictable and desperate response of a younger generation who do not see that they have a viable future.

    Bitcoin’s value is very much a symptom of these wider political and economic issues just as was Brexit, Trump and the yellow vest protests in France. Bitcoin is a reactionary phenomenon but unfortunately it is one that merely places the forlorn hopes of its victims in the hands of the same unscrupulous market manipulators and Bitcoin Oligarchs in the crypto casinos.

    As the least regulated of all the markets, crypto shows how utterly corrupt completely free market capitalism actually is. Unfortunately the other increasingly deregulated and ineffectively regulated markets are not far behind as moral and ethical standards carry on falling and regulators don’t seem to want to do anything about it as we saw recently with Elon Musk blatantly lying in order to manipulate Tesla’s share price or when a chief officer at the SEC suggested that they could turn a blind eye to crypto markets because it was suggested that they got their kids interested in finance.

    1. New markets are born all the time. Think of the swaps market 30 years ago. And as for all new things, people who understand what’s going on are going to screw those who don’t, but who think that they do. The Procter & Gamble (the name is fitting here) story, for instance, is amazing -
      Over time, the new market gets regulated, gains in transparency, and scam opportunities fade away.
      What’s new with crypto, is the amount of accessible material on the new market. First, because the Internet makes it easier to access said material; second, because everyone used the Internet to disseminate that material among as many people as possible.
      So we have the privilege of being able to watch the slow-mo train crash in real time. And yes, the SEC should have moved in much, much faster. It’s not so much about the amount of money transferred to crooks, as it is about the general feeling of fairness and trust in the system that’s been shattered. Or is about to be shattered, as the millions of retail “investors” slowly realise that no, they didn’t invest in something that just happened to “not work out”, but that they’ve actually been duped.

      1. A lot of the problems are systematic as as you say new markets are born all the time. What is happening on a grand scale is that outsourcing of government to the private sector or outsourcing the solution to the financial crisis to the very people who caused it is that no-one in government or even at central banks is technically accountable or responsible.

        Bitcoin itself is the most irresponsible system in the world as no-one manages it and consequently no-one is responsible for its energy budget for example and so BTC’s energy use was systemically unrestricted as no-one even had to monitor it and no management entity of company had to pay the bills.

        In the GFC bankers effectively outsourced responsibility for loans to third parties using new systemic financial instruments such as MBS and CDOs. This meant they could make irresponsible bad loans. Basically when we choose to develop systems that allow people to behave irresponsibly then it is no surprise that they become morally and ethically degenerated and act irresponsibly.

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