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: mining.com). 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.