Bitcoins are getting more and more attention in mainstream financial circles.

Sebastien Galy, a currency analyst at SocGen has put out a note to clients on the nature of Bitcoins and how one might go about valuing them.

The analysis is pretty rough, but for the financially minded this is a good introduction to thinking about the economics of the currency.

The middle part offers to ways one might go about thinking about valuing Bitcoins.

Galy has kindly let us run his whole note, which is below the dotted line.

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This proved an interesting subject from a central bank/regulatory point of view. Please find below a more comprehensive view on bitcoins. I thank the many who gave me some info, in particular Steve, my super-quant (ex)colleague from MIT.



Bitcoins have a money supply that is theoretically increasing, following an algorithm approximating the effort of mining. As more hashing/solving power from miners appears on the network, the difficulty of solving the next problem increases.



Right now the BTC/USD is tightly following the mining cost of BTC. It tracks how many people are getting involved into it (the more people mining it, the higher cost to get it because of fixed weekly supply).

Some smart investors started to realize that under this situation, you really should buy and hold rather than mining it (obviously). As more buyers come in=>higher prices=>more miners=>more buyers creating a positive feedback loop, whose nature is quite questionable. I was told that



However, with confidence in this BTC potentially increasing, the market actually starts building up its intrinsic value as a means of exchange, which might eventually make it potentially more stable in the long-term. Some professional investors believe the BTC thing is going to rise, though through a very bumpy road in the next few months.



How can we value bitcoins intrinsic value?

-- Monetary Approach. One way to value bitcoins would be to compare the money supply of the US vs bitcoins (1bn USD or so). That simplistic approach would make bitcoins very valuable if they end up being able to buy the same USD asset. This is a supply approach and easily solvable.



-- Law of one price approach. On the demand side, a dollar is used to purchase, say, a piece of software, or game tokens within a game, or to pay someone for watching a video. There the reality meets the rubber. As far as I can see within a game, the value [of] the bitcoin is devalued as games introduce their own tokens (e.g. Metal storm has now three different levels of tokens depending on whether it is externally tradable, internally). If the bitcoin becomes too expensive it loses its usefulness as a numeraire used for exchange.



Structure of the currency:



-- Monetary Policy. With far more rapid advances in the technology of processing than mining, the rules have already been changed to stop some forms of mining which were too effective. This was effectively a form of revaluation of the currency.

-- Legal framework. From a technical point of view, the bitcoin is not yet a currency in the sense that the currency is not anonymous. Volume is low and hence it is easy to influence the price. There is no certainty that the supply of bitcoins will follow the original rules, these rules have already been changed and presume a trust in the ones able to issue the currency. In many countries, printing money is a state privilege that will come to bite in the future as this, like gambling, is regulated for good reasons. In the U.S., the government introduced rules to cover electronic moneys.

-- Technicals. From a trading point of view, we broke out of the upward-trending channel in an exponential upswing typical of aggressive bubbles. As [with] all bubbles, there is a good story behind it, the trick would be to measure both the supply side and more importantly demand side value of bitcoins.

Sources:

http://en.wikipedia.org/wiki/Bitcoin

http://www.guardian.co.uk/technology/video/2013/mar/22/bitcoin-currency-video

http://goo.gl/xcVc5 article on bitcoin in the Australian press

http://bitcoin.org/bitcoin.pdf Satoshi's whitepaper

Quips from the market:

“perhaps we should all move to second life...no bonus caps I am aware of”