Bitcoin's recent plunge is a stark reminder of the cryptocurrency's volatile nature. Until the bloodbath, it was thought that the cryptocurrency had finally come of age after building up a significant following among institutional and retail investors. As big-name Wall Street firms piled into the cryptocurrency, it even looked as if bitcoin might become a new asset class.
With a market capitalisation of about US$650 billion (as of this writing), the bitcoin market is significantly larger than that of Walmart, a multinational company with more than two million employees worldwide. With such a hefty valuation, a further meltdown of the bitcoin market will not only wipe out many investors, the ensuing deleveraging can spill over to other financial markets and even the real economy. Because of the potential for disaster, it is important to understand what is happening in the bitcoin world. But to make sense of the recent volatility, one must first know what bitcoin is and more importantly, how it is valued or in Wall Speak, priced.
Limited supply
Created in 2009 by a mysterious person (or persons) called Satoshi Nakamoto, bitcoin is essentially an electronic reward for validating transactions made with the cryptocurrency. Very little is known of Nakamoto except that he published a paper in 2008 that laid down the workings of what we know today as bitcoin. Since then, bitcoin has emerged from its obscure beginnings to become the world's largest and best-known cryptocurrency. From just pennies in the beginning, one bitcoin is now worth about US$35,000.
Anyone can offer their computer power to help validate bitcoin transactions. Once a block of transactions is verified, a bitcoin is given out as reward. This decentralised feature also means that bitcoin exists outside of the traditional financial system where no individual, organisation or country can control the cryptocurrency. Furthermore, because bitcoin is secured by an ingenious public ledger technology called blockchain, fraud is virtually impossible.
Crucially, the total number of bitcoins that can ever be created or "mined" is capped at 21 million. This inbuilt mechanism means that there can only be a finite number of bitcoins out there and once the maximum number is reached, no more will be created. Close to 19 million have been released so far and the remaining ones will be awarded at a decreasing rate until around the year 2140.
Digital gold or ether?
Bitcoin is often compared to gold. Both are scarce and require a lot of energy to produce. The two are also used as a medium of exchange and store of value – though admittedly, bitcoin remains deficient in those functions. But this is where the similarity ends. Unlike its bullion counterpart, bitcoin is intangible. So while gold has various industrial applications, bitcoin has none whatsoever.
Neither is bitcoin considered a productive asset by traditional standards. Productive assets like stocks, bonds and real estate generate a cash flow in the form of dividends, interest payments and rental income, respectively. This income-generating feature allows owners of productive assets to recover their capital over time. With no obvious cash flow, bitcoin investors can only look to capital appreciation.
Fundamentally, bitcoin has no intrinsic value. Businesses have intrinsic values because of the physical assets they own. In the event of bankruptcy, these assets can be liquidated to repay shareholders. The practical implication of not having intrinsic value is that bitcoin can leaving investors with nothing in the worst bear case. What bitcoin does have though is imputed value; in other words, its value is whatever people think it is.
Sources of imputed value
Bitcoin is valued because of its finite supply. Not only is bitcoin scarce, it is thought to be rarer than gold because the number of bitcoins is fixed while the supply of gold is not. The total number of bitcoins in circulation is actually fewer since some are already lost or destroyed. If bitcoin is rarer than gold, then it should be more valuable than the precious metal, so the argument goes.
Bitcoin is also prized because central banks are debasing their currencies. With loose monetary policies around the world, cash is no longer king. Bitcoin, on the other hand, becomes more valuable as fiat currency is debased. This emphasis on "sound money" resonate with those investors concerned about the ongoing money printing by central banks. To many bitcoin investors, the cryptocurrency is seen as a safe haven in the face of rising inflation.
Thirdly, bitcoin is boosted by the macro-shift toward a cashless society. Compared to physical cash, bitcoin is more portable and exchangeable internationally. Furthermore, as an efficient means of transferring money over the Internet, bitcoin allows people without access to traditional banking infrastructure to transfer funds often at no fees. As millions around the world still lack access to traditional banking services, bitcoin's potential as a payment transfer system is huge.
Volatile by nature
Even if bitcoin is not entirely worthless and serves certain functions, having only imputed value makes it an extremely volatile asset. At least for now, most bitcoin investors seem to care only about its imputed value – not its intrinsic value (or lack thereof). But since there is no accurate and systematic way to price the cryptocurrency, extreme volatility becomes endemic.
Bitcoin's future is also clouded by the real possibility of a major government crackdown. Ironically, the more successful bitcoin is as an alternative to fiat currency, the more likely it will be outlawed since no government will let the cryptocurrency overshadow its own currency. Turkey's recent ban on the use of cryptocurrencies for payment is a good example. More crackdowns, especially by a bitcoin powerhouse like the United States or China, will almost certainly kill the cryptocurrency.
It is easy to forget that bitcoin has only been around for about a decade and there is no guarantee it will be for another. Amid the steep valuation, bitcoin's future is also by no means secure or certain, and that just adds to the cryptocurrency's volatility. There is a saying that great things take time. Unfortunately, time is a luxury that bitcoin may not have.
(Photo: Ivan Radic)