Other applications that might drive Bitcoin's inherent value

http://reason.com/archives/2013/11/19/bitcoin-more-than-money

As pointed out earlier, Bitcoin as a store-of-value only makes sense if there are multiple applications driving its use.

Is 1 Bitcoin worth more than 2 dollars?

In the previous post, we had covered why we believed Bitcoin was vastly over priced. We had concluded, assuming that Bitcoin was a money transfer instrument, that 1 BTC = $2 was a more realistic conversion.

One of the objections to the analysis above is that Bitcoin's worth as a store-of-value was completely disregarded. Does Bitcoin's decentralization and limited supply give it enough credibility if it did not have any application other than as store-of-value? Obviously not. If it did, then what is to stop anyone from floating LayCoin with exactly the same properties as Bitcoin. The only reason any coin would have store-of-value is if it had a genuine application driving an inherent value.

As covered in the previous post, the genuine application for Bitcoin that the Bitcoin community was hoping for is its acceptance as an alternate currency. However, that requires an economy that is completely denominated in bitcoins. We had also covered why Bitcoin based economy was not feasible. We had concluded that the only genuine application possible for Bitcoin was as a money transfer instrument.

Then, why are people investing in Bitcoin?

The answer is, it's the same reason as why people invest in companies that have a promise of making future revenues. People are hoping Bitcoin would be widely accepted and it's inherent value will reach what people are paying for it now.

But, how do we compute the inherent value?

A good way to gauge that would be to see what would happen if people holding on to bitcoins as store-of-value suddenly lose confidence and dump them all. The only people in the market buying bitcoins at that time would be the ones using them for its only application as a money transfer instrument and that would mean 1 BTC would settle at $2.00.

If we, indeed, have to take its application as store-of-value into account, then we can assume that a certain percentage of bitcoins would just be held as savings and not put into circulation. If we want to assume a stable value for bitcoins and not the one where the bottom would just fall out, then let's arbitrarily assume a maximum variability of 50% if there is panic in the bitcoin marketplace. That would mean that only 50% of the bitcoins would have to be held as savings and the rest would have to be in active circulation. Therefore, considering that people value 1 BTC at $1000, Bitcoin would have to enable nearly $6B worth of money transfer transaction every 8 minutes. Please see the previous post to understand the reasoning behind this conclusion. That is indeed a very tall order!

Why Bitcoin is a separate currency and why it is vastly overpriced

In the previous post, we saw the layconomist interpretation of why Bitcoin had to be created as a separate currency and briefly touched upon its real value. We understood that Bitcoin's real value stemmed from it being used as a cheaper alternative to VISAs/MASTERCARDs/WESTERN UNIONs and PAYPALs of the world. We determined that one main reason behind the attractiveness of Bitcoin as an e-commerce vehicle was that the decentralized infrastructure network pays itself with newly created bitcoins rather than with transaction fees for enabling money transfers.

In this post, we will

1. examine the claims by Bitcoin supporters regarding creation of Bitcoin as an alternative currency to the US dollar,
2. examine the viability of Bitcoin as a pure money transfer service,
3. dig deeper to calculate what a bitcoin (BTC) should actually be valued in terms of dollars (at last check, the going rate for 1 BTC was more than $1000!) and
4. and try to understand the long term viability and sustainability of Bitcoin.

Bitcoin vs US dollar (Is  viable?)

According to Bitcoin supporters, Bitcoin was actually created as an alternative to the US dollar because "the Fed is eroding the value of dollars by printing more of them." The Bitcoin community believes that currency itself is a commodity to be traded, rather than treating it as an instrument for simplifying complicated barter exchanges. That leads to the belief, using the argument of supply and demand, that if more dollars are printed then the value of each dollar is greatly eroded. Thus, Bitcoin was created which was inherently designed to be limited in supply thus preserving its value. Bitcoin is striving to gain acceptance by first acting as the conduit for electronic transfers and eventually hoping to have an economy denominated solely in bitcoins.

However, primers on Bitcoin describe how an economy based on limited supply of money is inherently deflationary and non-sustainable. Money supply needs to keep pace with a growing economy. A layconomist explanation of why that is so will be given in a forthcoming post shortly.

Let's also study the dollar and bitcoin's roles as investment destinations. The claim made is that the US dollar is a fiat currency and is not backed by anything except the words of the US government. It's only the people's belief in the US government that is holding the dollar's value up. But, that is sufficient! US assets are worth nearly $225 trillion. That means that one's holdings in dollars can always be exchanged for actual assets when desired. On the other hand, when there is no pure Bitcoin based economy bitcoins can only be exchanged for other currencies and never any hard assets. That means that there will always be somebody holding bitcoins when the music stops. But, we can use the same argument against the US dollar, might be the refrain! That is the doomsday scenario covered in a previous post and God help us all if that actually comes to pass.

Thus, we see that bitcoins value starts and stops at them being used as a means of money transfer.

Bitcoin vs Paypal (Bitcoin Inc. - Remittance service?)

Now, let's examine its value as an e-commerce vehicle. If Bitcoin adopted the business model of Paypal of charging transaction fees for providing services, then every money transfer will involve the following steps. At the point of origination, every dollar to be transmitted would be converted to a bitcoin (and the dollar taken out of circulation), the bitcoin would be transmitted and finally converted back to the original dollar at the destination. However, at the destination not all the transmitted dollars would be provided to the recipient but some would be kept by Bitcoin as transaction fees. Thus, bitcoins would actually be created and destroyed and will only remain in circulation as long as actual money is being transferred electronically. If no money is changing hands then no bitcoins would be in existence.

If Paypal adopted Bitcoin's business model, it will eliminate all transaction fees and show a growing customer base as the justification for its stock price in the market. Paypal will make no revenues or profits and it will pay its employees not in dollars but in Paypal shares. And the only way shareholders, management and employees will make money is if there is continuing demand for Paypal shares in the stock-market.

What is the actual value of Bitcoin?

Here is an article claiming that each bitcoin is worth at least $10000 by comparing the bitcoin network valuation to that of the US economy, comparing it Zuckerburg's worth and the total value of gold in the world. However, this is widely off the mark because Bitcoin's only viable application is as a competitor to the existing money transfer services.

We have seen above that if Bitcoin were designed purely for transferring money then bitcoins would have been created and destroyed with every transaction. However, instead of steady sequence of creation and destruction, bitcoins are created once and simply re-used for the next transaction. Since, the "real" value of a bitcoin needs to arise not from speculators holding bitcoins but from its actual use, this assumes that every money transfer is immediately be followed by another.

Keeping that in mind, we can calculate what the sustainable value of 1 BTC is. First, let's examine whether $1000 for 1BTC is sustainable. From the following links

1. https://blockchain.info/charts/total-bitcoins
2. https://blockchain.info/stats
3. http://www.forbes.com/sites/jonmatonis/2012/07/31/top-10-bitcoin-statistics/

we can see that there are 12 millions bitcoins in existence. Assuming one cycle of money transfer takes about eight minutes (it takes about eight minutes for all nodes in the bitcoin network to validate the transfer), the Bitcoin network needs to be processing nearly $12 billion dollars every eight minutes. However, we can see that the network is merely processing $400 million dollars in one day. That means, the sustainable value of 1 BTC is actually only about $2.2.

Can bitcoin value and network be sustained long term?

As bitcoins become more and more difficult to create (mine - in Bitcoin parlance) the incentives for bitcoin newcomers to support the network decrease. Note that the network will new compute power if it has to sustain the increased number of money transfer transactions that it is hoping to carry out. The only way the limited number of bitcoins available can completely sustain the newcomers is if each bitcoin is valued really high. In any case, by 2140 all bitcoins would have been created/mined. What will happen when all the bitcoins have been mined? The only way forward would be for the haves (owners of bitcoins) to share their wealth with the have-nots. Otherwise, the sustenance model would have to shift towards more and more transaction fees which takes away from the attractiveness of Bitcoin. What's to stop a similar upstart Bitcoin-II from stealing the market share away from Bitcoin in the future? The Bitcoin community hopes that by the time that happens, it would have entrenched itself so well as a currency that it would be difficult to displace. The chances of this happening are small because:

1. A pure Bitcoin based economy is not viable due to limited bitcoin supply. Therefore, Bitcoin has to justify its existence as a pure money transfer service.
2. The model as a pure money transfer service is not viable either - it is equivalent to a money transfer service company that makes no revenues but its stock price keeps going up purely as a function of its customer base.
3. It will crumble under the weight of its own contradictions. Note that Bitcoin was created as a decentralized community but, the bitcoin wealth will eventually become concentrated in the hands of few, the current haves who will be the only ones with the incentive to keep the network running. And the network will end up no longer being as decentralized as the Bitcoin followers would believe.
4. The current e-commerce players like VISA and PAYPAL are not going to sit idly by and let Bitcoin take over their business. What their strategy would be to negotiate the bitcoin waters is yet to be seen but, the chances of there being one are very high.

Why is Bitcoin a separate currency and what is its inherent value?

Bitcoin has surged to values beyond $900 (as of November 27, 2013). It took a while for it gain attention but once it did, it caught on like wildfire. It was launched in 2009 but, it was in 2013 that things started moving to such an extent that even the US senate wanted to understand what it was all about.

Needless to say, Bitcoin is a fascinating innovation of open source computing. To understand Bitcoin fully, one has to understand three facets of it. The first is the macro-features of Bitcoin that make it an attractive alternative to VISA/MASTERCARD/PAYPAL for internet commerce, the second is Bitcoin's status as a separate currency and its implications as an investment destination and the third is the algorithmic innovation and behind-the-scenes computer science that makes the first two facets possible.

To get a grip on the first facet, we can visit Bitstamp.net to understand the features that make Bitcoin attractive to consumers and merchants. We would have to warn you to take the rest of the claims outside of "CONSUMERS LOVE BITCOIN" and "MERCHANTS LOVE BITCOIN" with a heavy dose of salt. Here's Alex Likhtenstein the owner of EVR (a club in Manhattan, NY) giving credence to Bitstamp.net's claims (quote: "Lower fees and no chargebacks are great. We also see deposits in our account less than 24 hours after the sale; credit cards transactions that go through banks usually take about three days.") In our opinion, the main attraction pushing the adoption of Bitcoin based commerce is the elimination of 2-3% transaction fees that credit card companies usually charge merchants.

To understand the second facet, one can visit multiple primers online including the ones we found especially useful from Bitcoin Wiki and Washington post.

Finally, for the third facet of technology, the Bitcoin Wiki page and the Wikipedia page on Bitcoin are excellent resources.

Our main question that couldn't be answered even after scouring the internet was: Why should Bitcoin be launched as a separate currency? Surely, the security features and the advantages of decentralization could be made available to merchants and consumers without having to launch a separate currency? After giving it some thought, it hit us! Executing and implementing the transactional features of internet commerce requires resources and resources cost money - be it the resources of a central authority (e.g. VISA/MASTERCARD/PAYPAL) or the resources of the open source community. There has to be some reward to the owners of the resources for making them available for the purposes of internet commerce. These rewards are in the form of make believe money (bitcoins). This way instead of charging the customers and merchants for enabling the transaction, Bitcoin community rewards itself using bitcoins. This is why Bitcoin is way cheaper than VISA/MASTERCARD/PAYPAL and other e-commerce vehicles.

This brings us to the next question, what value do bitcoins really have? Note that, currently, there is no pure bitcoin based economy. Merchants and consumers do not directly deal in bitcoins. Bitcoins are only used as a temporary medium of transmitting the dollars the merchandise is actually valued in. So, where is the current value of $900 coming from? It is only coming from the belief that a bitcoin has value and people continuing to believe it has value. This is exactly the same belief system that drives Gold prices.

The inherent value of bitcoin is what merchants and consumers are willing to pay for ensuring a successful transaction over the internet. The rest is all speculation!

YouTube video - economics for the uninitiated

A very nice youtube video introducing economics to lay people. Although, the Austrian bent to the video distorts the picture a little bit.

The Role of Money in the Economy - I

In this series of posts, I would like to cover the role of money in today's economy and I hope that by the end of the series that I am able to convey the reasons why I have been avoiding bringing money into my discussions. Let's start off by understanding why money is important in the functioning of modern economies.

To begin with, one can imagine a primitive village economy with very few people that is able to work solely on barter/exchange because:

1. Each villager produces something of value that every other villager needs
2. Each villager produces just enough over the year to meet the entire village's need for that product and for that year
3. All villagers bring their produce to the market place once every year and leave with their respective share
4. Villagers are able to engage in one-on-one barter/exchange in the market place because of the assumption in point 1 above. 

One can see that this setting works well and it does not need money to continue functioning.

However, we know that things are not that simple. One can easily imagine a scenario where there are so many villagers participating in the economy such that:

1. One-on-one barter/exchange is no longer possible because now the village is replete with mismatched pairs where one person desires what the other person produces but is unable to offer something in return. However, we assume (very important) that every villager produces something that some other villager wants even though the two might not be able to form a one-on-one barter/exchange pair. Therefore, for villagers to obtain something from another villager (whom they can not pair with) they:
1. have to set up a complex sequence of barters/exchanges with multiple other villagers till they are able to obtain something that the target villager actually wants,
2. have to group enough people people together so that when they pool a portion of their produce everybody is able to find what they want from that pool and walks away happy
3. or most simply write an I Owe U (IOU) to the other villager who in turn can use it to barter with other villagers till it reaches somebody who can actually cash that IOU in. Note, again, the assumption that there is necessarily such a villager present otherwise the IOU has no value.
2. There is uncertainty in whether some villagers are able to produce consistently ever year although they are able to on average in the long run. In such cases, these villagers would have to write IOUs for their share of produce till they can come good on their IOUs.
3. Some villagers can not bring their produce into the market place at the same time as other villagers and hence will have to write IOUs that the other villagers can cash in whenever the requisite produce is ready.
4. Villagers can barter one kind of IOUs with other kinds and the exchange ratio between IOUs can be determined by the market place. E.g.
1. An IOU for one bag of cashew nuts is worth three IOUs for one bag of rice each. 
2. An IOU for a house is worth three hundred IOUs for one bag of rice each.
3. As a result an IOU for a house is worth one hundred IOUs for one bag of cashew nuts each.
4. etc.
5. Villagers are able to barter IOUs because they know they can eventually cash their IOUs in by going to the issuer of a particular IOU whenever the time is ripe.

One can immediately see the potential for abuse with IOUs. Some villagers might simply use the concept of IOUs to mooch off others. We can see that although IOUs are the most convenient way to make the complex barter/exchange system work one would need a central authority (the government), rules and laws that together can first endorse the villagers issuing the IOUs and then enforce the honoring of those IOUs.

Now, we the see faint outline of what money is. Basically, money is a form of IOU backed by government decree and oversight that allows smooth functioning of a complex economic ecosystem where simple barter/exchange is no longer possible. In the subsequent posts, we will explore further what a government backed IOU means and what the complications are in an IOU based economy.

The Economy of the Future - II

We saw in the previous post what the economy of the future looks like if Martin Ford's prediction comes true and a small fraction of the society ends up producing all the goods that meet the demands of the society. If we do not let the government intervene and let the market evolve on its own, under free-market principles, most of the people will be shut out from the economy and be forced into poverty. The GDP of the society will shrink with the economy just large enough to cater to only the productive members. If we do not want the majority of the society to be mired in poverty then the government has to step in and employ most of the people to provide them with some means of sustenance.

We saw in http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html that the government can do this in either of two forms:

1. Raise taxes on all the productive members to pay for the government programs that support the non-productive members of the society. This essentially means that the government is forcing the productive members to produce for others without expecting anything in return.
2. Hand GOUs to all productive members in return for supporting the non-productive members. This results in a continuously rising debt (However, this may not be an issue as outlined in "is public debt really that terrible?") parts of which the productive members can redeem if and when they find something appealing in the market place.

The second approach is what will appeal to the human psyche because it allows the productive members to gain something in return for selling their goods in the market. What they gain are GOUs that they can redeem for whatever they find of value in the future. We will have to get used to mounting debt and not view it as a bad thing. This is similar to accruing paid time off (PTO) in your company but with no accrual limits and unlimited roll-over from year to year. However, just like you would avail yourself of your PTO savings only when the need arises the "rich" would only be able to avail themselves of their savings only when there are services available. Looked at in a different way, the second approach is simply providing the productive members with access to more services than others and first dibs at those services in the society. Once everybody understands how the new economy works we will continue to have a thriving market economy.