Why Do Bitcoins Have Value? Bitcoin Explained

Bitcoin (BTCUSD) is often referred to as digital currency and as an alternative to central bank-controlled fiat money. However, the latter is valuable because it is issued by a monetary authority and is widely used in an economy. Bitcoin’s network is decentralized, and the cryptocurrency is not used much in retail transactions.

However, it can be argued that Bitcoin’s value is similar to that of precious metals. Both are limited in quantity and have select use cases. Precious metals like gold are used in industrial applications, while Bitcoin’s underlying technology blockchain has applications across the financial services ecosystem. Bitcoin’s digital provenance means that it might even be used as a medium for retail transactions one day.

Why Currencies Have Value

Currency is usable if it is a store of value, or, to put it differently, if it can reliably be counted on to maintain its relative value over time and without depreciating. In many societies throughout history, commodities or precious metals were used as methods of payment because they were seen as having a relatively stable value.

Rather than require individuals to carry around cumbersome quantities of cocoa beans, gold, or other early forms of currency, however, societies eventually turned to minted currency as an alternative. Still, the reason many examples of minted currency were usable was that they were reliable stores of value, having been made out of metals with long shelf lives and little risk of depreciation.

Currencies also demonstrate six attributes—scarcity, divisibility, utility, transportability, durability, and counterfeitability—that enable their widespread use in an economy. These attributes are used to establish monetary policies to control inflation and ensure that they are secure and safe to use.

Assigning value to currencies is a matter of debate. Initially, their value was a function of intrinsic physical properties. For example, gold—a popular currency—derived its value based on extraction costs and its qualitative factors, such as luster and purity content.

In the modern age, minted currencies often take the form of paper money, which does not have the same intrinsic value as coins made from precious metals. For a long time, the value of paper money was decided based on the amount of gold backing it. Even today, some types of currencies rely on the fact that they are “representative,” meaning that each coin or note can be directly exchanged for a specified amount of a commodity.

The idea of a currency’s value began changing in the 17th century. A prominent Scottish economist John Law wrote that money—currency issued by a government or monarch—is not the value for which goods are exchanged, but the value by which they are exchanged. In other words, the value of a currency is a measure of its demand and its ability to stimulate trade and business within and outside an economy.

This thinking hews closely to the modern credit theory for monetary systems. In this theory, commercial banks create money (and value for currencies) by lending to borrowers, who use the money to purchase goods and services and increase the velocity of a currency’s circulation in an economy.

After countries left the gold standard in an effort to curb concerns about runs on federal gold supplies, many global currencies are now classified as fiat. Fiat currency is issued by a government and not backed by any commodity, but rather by the faith that individuals and governments have that parties will accept that currency.

Today, most major global currencies are fiat. Many governments and societies have found that fiat currency is the most durable and least likely to be susceptible to deterioration or loss of value over time. The value for fiat currencies is a function of their demand and supply. The U.S. dollar is considered valuable because it is used in the world’s biggest economy and dominates the flow of payments in international trade.

The Value of Digital Currencies

Any discussion about the value of Bitcoin must be situated within the context of a reinvention in the nature of currency. Gold was favored as currency due to its inherent physical attributes. But it was lugubrious to conduct transactions using the precious metal. Paper money is an evolution, but it also requires manufacturing and storage. Besides, it does not have the mobility and ease of use for digital currencies. The digital evolution of money has moved the value of currencies away from their physical attributes to their function in an economy.

Here’s an example. During the financial crisis, then-Fed Governor Ben Bernanke appeared on CBS’s 60 Minutes explained how the agency “rescued” insurance giant American International Group (AIG) and other financial institutions from bankruptcy by lending money to it. Puzzled, the interviewer asked whether the Fed had manufactured billions of dollars. That wasn’t quite the case.

“So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed,” explained Bernanke. In other words, the Fed “manufactured” U.S. dollars through entries in its ledger. This marking up of an account size exemplifies the nature of currencies in their digital avatar. It has implications for the velocity and use of currencies because it simplifies and streamlines transactions involving them in an economy.

Why Does Bitcoin Have Value?

Bitcoin does not have the backing of government authorities, nor does it have a system of intermediary banks to propagate its use. A decentralized network consisting of independent nodes is responsible for approving consensus-based transactions in the bitcoin network. There is no fiat authority, in the form of a government or a monetary authority, to act as counterparty to risk and make lenders whole, so to speak, if a transaction goes awry.

The cryptocurrency does display some attributes of a fiat currency system, however. For example, it is scarce and can be divided into constituent units called Satoshis. It cannot be counterfeited. The only way that one would be able to create a counterfeit bitcoin would be by executing what is known as double-spending. This refers to a situation in which a user “spends” or transfers the same bitcoin in two or more separate settings, effectively creating a duplicate record.

What makes double-spending unlikely, though, is the size of the Bitcoin network. A so-called 51% attack, in which a group of miners theoretically control more than half of all network power, would be necessary. By controlling a majority of all network power, this group could dominate the remainder of the network to falsify records. However, such an attack on Bitcoin would require an overwhelming amount of effort, money, and computing power, thereby rendering the possibility extremely unlikely.

But Bitcoin fails the utility test because it is hardly used for retail transactions. The main source of value for bitcoin, then, is the economics of its supply and demand. The argument for bitcoin’s value is similar to the one for gold—a commodity that shares characteristics with the cryptocurrency. The cryptocurrency is limited in quantity to 21 million.

Its value is a function of this scarcity. As bitcoin’s supply diminishes, demand for the cryptocurrency has increased. Investors are clamoring for a slice of the ever-increasing profit pie that results from trading of its limited supply.

Bitcoin also has limited utility like gold, which is used mainly for industrial applications. Bitcoin’s underlying technology, called blockchain, is being tested and used as a payment system. One of its most effective use cases is in remittances across borders to bump up speed and drive down costs. Some countries, like El Salvador, are betting that Bitcoin’s technology will evolve sufficiently to become a medium for daily transactions.

When that happens, the cryptocurrency’s economics will ensure that it is ready. One bitcoin has a much bigger divisibility factor as compared to standard fiat currencies. It can be divided up to eight decimal units into constituent units called Satoshis. A fiat currency, say the U.S. dollar, is generally equal to 1/100th of a unit.

If bitcoin continues to gain in price over time, users with a tiny fraction of a single bitcoin will still be able to take part in transactions involving the cryptocurrency. Development of side channels, like the Lightning Network, should further boost the value of Bitcoin’s economy.

The Challenges of Valuing Bitcoin

One of the biggest issues is Bitcoin’s status as a store of value. Bitcoin’s utility as a store of value is dependent on its utility as a medium of exchange. We base this in turn on the assumption that, for something to be used as a store of value, it needs to have some intrinsic value, and if Bitcoin does not achieve success as a medium of exchange, it will have no practical utility and thus no intrinsic value and won’t be appealing as a store of value.

Throughout much of its history, the current value of Bitcoin has been driven primarily by speculative interest. Bitcoin has exhibited characteristics of a bubble with drastic price run-ups and a craze of media attention. This is likely to decline as Bitcoin continues to see greater mainstream adoption, but the future is uncertain.

Bitcoin’s utility and transferability are also challenged by difficulties surrounding cryptocurrency storage and exchange spaces. In recent years, digital currency exchanges have been plagued by hacks, thefts, and fraud.

An Example Valuation of Bitcoin

In order to place a value on Bitcoin, we need to project what market penetration it will achieve in each sphere. This article will not make a case for what the market penetration will be, but for the sake of the evaluation, we’ll pick a rather arbitrary value of 15%, both for bitcoin as a currency and Bitcoin as a store of value. You are encouraged to form your own opinion for this projection and adjust the valuation accordingly.

The simplest way to approach the model would be to look at the current worldwide value of all mediums of exchange and of all stores of value comparable to Bitcoin and then calculate the value of Bitcoin’s projected percentage. The predominant medium of exchange is government-backed money, and for our model, we will focus solely on them.

Roughly speaking, M1 (which includes M0 or the total amount of money in circulation in an economy) is currently worth about $4.9 trillion, which will serve as our current worldwide value of mediums of exchange.

M3 (which includes all the other buckets) minus M1 is worth about $45 trillion. We will include this as a store of value that is comparable to Bitcoin. To this, we will also add an estimate for the worldwide value of gold held as a store of value. Though some may use jewelry as a store of value, for our model, we will only consider gold bullion.

The U.S. Geological Survey estimated that, at the end of 1999, there were about 122,000 metric tons of available above-ground gold. Of this, 48%, or 58,560 metric tons, was in the form of private and official bullion stocks. At an estimated current price of $1,200 per troy ounce, that amount of gold is today worth upward of $2.1 trillion.

Because there has in recent years been a deficit in the supply of silver and governments have been selling significant amounts of their silver bullion, we reason that most silver is being used in industry and not as a store of value, and we will not include silver in our model. Neither will we treat other precious metals or gemstones. In aggregate, our estimate for the global value of stores of value comparable to Bitcoin—including savings accounts, small and large time deposits, money market funds, and gold bullion—comes to $47.1 trillion.

Our total estimate for the global value of mediums of exchange and stores of value thus comes to $52.1 trillion. If Bitcoin were to achieve 15% of this valuation, its market capitalization in today’s money would be $10.8 trillion. With all 21 million bitcoin in circulation, that would put the price of 1 bitcoin at $514,000.