Bitcoin Series 5: What are the elements of valuing bitcoin?

Valuing bitcoin is a complicated exercise because there is no clear valuation method that has been accepted.  

I am not going to attempt to value it here, but I will present some initial thoughts regarding what will drive demand for bitcoins and, therefore their value:

(a)    “Velocity of money”  - how much money is tied up in bitcoin while transactions are being made.

(b)   “Laziness” – A lot of people or businesses that decide to use bitcoin will keep some (small) amounts of money in bitcoin just for convenience.   I certainly did not login to Paypal every time someone sent me money to move it to my bank account and this same logic will apply here.

(c)    “Fun/speculation” – People spend $40 billion annually gambling in Macau and $10 billion annually gambling in Las Vegas.   Day-trading and speculation in bitcoin, something that can be done 24 /7 / 365 from any PC, is not going to go away.

(d)   “Diversification / store of value / disaster planning”:  This is discussed in detail in the ‘Store of Value’ post.   It is perfectly rational for people in certain situations to keep some percentage of their assets in bitcoin.

(e)   “Native bitcoin” – There will be classes of activities (aka machine-based economic transactions) that will be natively in bitcoin and will stay permanently in the bitcoin ecosystem.   These will increase over time.

Demand for bitcoin will be (a)+(b)+(c)+(d)+(e).    How quickly each of these areas develop is really a matter of psychology and regulatory approaches rather than hard finance.   We will delve into the potential for each area later.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
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Bitcoin Series 4: . Is bitcoin a currency or an asset?

One genuinely difficult question is whether bitcoin is a currency or an asset. 

Bitcoin has several characteristics that are commonly associated with currencies:

-          It is almost infinitely divisible

-          It is fungible

-          It is remarkably portable (more portable than any asset or currency to date)

-          It is liquid (can be converted to traditional currencies 24/7/365 on one of several exchanges)

Despite that, my conclusion is that it is simpler in a variety of ways to consider bitcoin an asset for now for regulatory purposes. Once this characteristic is accepted then a lot of ‘issues’ with bitcoin start to fade.  

-          Bitcoin is hardly the only volatile asset class nor does it have to take on the burden of being the bearer of monetary policy or the unit of account the way national currencies do. 

Nobody has said ‘derivatives in IBM stock aren’t going to succeed because it won’t be practical to price Club Monaco sweaters in them’

-          Furthermore tax treatments become clearer.   Gains from buying and selling on an investment basis will be short-term or long-term capital gains depending on the holding period.    Gains from running a trading operation will be ordinary income.

Over a period of many years and in a narrow context, one might consider scenarios where bitcoin acts as a full-blown national currency.   But that is not today's problem nor is it necessary for bitcoin to be a success.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
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Bitcoin Series 3: Bitcoin would be a terrible national currency (and why that doesn’t matter).

One common debate between bitcoin evangelists and economists is the question about how well bitcoin could serve the role of a national currency and a unit of account for a country as a whole.  

The two main points that economists make are:

(a)    Bitcoin is too volatile at this point to be a day-to-day currency.    This is true right now (though this will mitigate over time).

(b)   Bitcoin as a national currency would be deflationary, take away monetary policy as a tool for economic management and herald the return of the gold standard 2.0.     Or, to take a more modern example, is the situation that the southern European countries have placed themselves in by tying themselves to the euro, a currency that they don’t have effective control over.

On this topic, the economists are right and the bitcoin enthusiasts are wasting their time arguing the point.    They should just concede that bitcoin would not be a good national currency and move on to any one of 20 other areas where bitcoin is unambiguously useful.

Besides the fact that the economists are correct, there is no chance that any serious national government will replace their central banking powers with bitcoin any time soon.    At best, this could be an option a few years from now for a country in complete distress (aka Zimbabwe during its recent hyperinflation phase) that needs to latch themselves to an outside metric (like Zimbabwe did with the dollar), but it is not relevant for any credible central bank (US, Europe, etc).

So, team bitcoin, in my humble opinion, needs to stop having this battle and practice saying:

“You are right, bitcoin would be deflationary if it were a national currency or the main unit of account for any particular country.   Fortunately it is not a national currency in any country today so none of these issues apply now or in the foreseeable future.   Now, can you please explain to me why in the current financial system in the year 2013 an international wire transfer (a few thousand bytes of data) takes 3 days to clear when I can transfer a video (hundreds of megabytes of data) in a few minutes?”

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
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Bitcoin Series 2. Decentralization is the key characteristic of bitcoin

Decentralization is not an important characteristic of bitcoin; it is the be-all and end-all important characteristic.   Without decentralization, bitcoin would not survive.

Decentralization provides two critical benefits to bitcoin that no digital or private currencies have previously had.

(a)    Bitcoin can make credible promises about money supply because there is no central party that can renege on its promises to keep money supply stable. Any centralized issuer of a digital currency poses the risk that the rules of the road regarding money supply will change later on.   Even the central banks of traditional currencies present this risk.

It is impossible to overestimate how important this is in building confidence in bitcoin.

(b)   Bitcoin is more or less invulnerable to regulatory shutdown.   Any particular bitcoin business in any particular jurisdiction can be shut down and certainly a more negative regulatory environment would slow down bitcoin adoption.   No regulator, however, can make bitcoin itself go away.    Like a new solution to a mathematical problem or email or P2P file sharing, bitcoin is here to stay.   You would have to shut down ‘the internet’ to really put a dent in it and that still will just put it into hibernation until you have to turn the internet back on.

So, decentralization should be the key characteristic by which proposals regarding digital currencies should be measured.   If someone says “I can solve this problem in bitcoin by making bitcoin v2 that has [centralized party] doing [x]”, it is almost certainly a bad idea.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
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