Digging deep into bitcoin
In previous blogs, we have explored several techno-economic characteristics of bitcoin and similar cryptocurrencies. Cryptocurrencies have attracted a lot of attention recently due to the spectacular rise and fall of the price of bitcoin. However, despite its recent rollercoaster ride, at the time of writing bitcoin is still priced at around $11,000, or nearly twice its November 1 level.
The comparative novelty of cryptocurrencies and the spectacular prices bitcoin continues to command has led Goldman Sachs head of commodities research Jeff Currie to liken bitcoin to gold. Others, however, such as Nobel prize-winning economist Joseph Stiglitz, doubt that bitcoin can even be considered a legitimate currency. He claims that “bitcoin is successful only because of its potential for circumvention, lack of oversight,” and “ought to be outlawed.”
One consideration that shouldn’t be lost amongst the complex and often confusing commentary generated by hordes of economic and technical commentators is that, in many ways, bitcoin may more closely resemble gold than the raft of fiat currencies such as the US dollar, which it is thought to be challenging.
Components of a successful currency
To recap, a successful currency acts as a medium of exchange, a unit of account, and a store of value, exhibiting characteristics of durability, portability, divisibility, uniformity, and acceptability. Arguably, bitcoin demonstrates all of the relevant currency characteristics, albeit that its acceptability for transactions is restricted to the community of users operating the relevant electronic wallet software. This is not unusual amongst currencies — the US dollar, for example, is accepted as legal tender only amongst those parties that agree (or are required by legislation) to use it for payments.
However, in the wake of bitcoin’s recent continued volatility, doubt has been cast on its ability to act as a store of value in the long-run despite the fact that the current standard deviation of daily returns is not particularly high (compared to its 7 years of price history). Nevertheless, the bitcoin/dollar volatility is still considerably higher than the volatility of the gold price (in USD), which in turn is considerably higher than the volatility of the EUR/USD exchange rate.
Yet similar doubts attend the ability of at least some fiat currencies also to act as long-term stores of value. Ultimately, the value of fiat currencies is underpinned by faith in the government in whose name the currency is issued. If that trust fails (as it did spectacularly in Argentina in the late 1980s and again in 2002), a currency can lose value very rapidly.
It has been argued that cryptocurrencies are less secure than fiat currencies because it is far from clear who “manages” their value. Indeed, the defining characteristic of bitcoin is that no one stands behind it — rather, trust must be placed in a bunch of mathematical algorithms encoded into sophisticated software. However, such claims overlook a particular characteristic that distinguishes bitcoin from fiat currencies — the cost of creating new supply of the currency in the first place. And here the likeness to gold emerges.
Mining the core issue
In the past, using a physical commodity such as gold as a currency (or tying the value of the currency to the price of gold or the amount, and hence value, of gold held in reserves) created a tangible benchmark underpinning the currency as a store of value. The price of gold is a function of the cost of mining it, current and expected future available stocks, and the demand for it as a commodity in its own right. While gold reserves held by governments no longer explicitly back up currencies issued in their name by their Reserve Banks, they implicitly influence currency values by providing some tangible assurance that those governments are credibly able to meet at least some of their obligations in the event that confidence in them and therefore their fiat currency starts to fall. Although the price of gold typically includes a component relating to the demand for it for these reserves and other purposes, at the very least, it will reflect the opportunity cost of obtaining (mining) more of it, within the constraint that only a fixed amount of it in total will be available.
The analogy between bitcoin and gold is nowhere more apparent than in the process of bitcoin “mining” — the competition between the thousands of computers competing to be the first to solve the mathematical puzzles associated with each transaction and ‘close and seal the block’ in the distributed blockchain ledger. The wallet associated with the winning computer is rewarded with a small share of newly-minted bitcoin, plus any other associated transaction costs, also paid in bitcoin. It will only be worth engaging in bitcoin mining activities only if the expected returns at least meet the costs of procuring and operating the computers and software (the single biggest cost being the electricity required).
The value of bitcoin must therefore be a function of the costs of mining if the currency is to continue to be successful. Like gold, the total possible quantity of bitcoin is restricted (to 21 million for the cryptocurrency), and the share of new bitcoin minted is set in the software to decrease as the number in circulation and transaction numbers increase. This means either or both of the value of each bitcoin or the transaction fees paid must be positive if there are to be miners competing to operate the system in the first place. Recall that miners are an essential part of the system since they have the incentive for new blocks introduced to be correct and to be accepted by the system in the long run. If a block that had been mined is first accepted and later on rejected (perhaps because an error was detected) then the miner of the bad block would lose the bitcoin that had originally been allocated to them since that allocation appears in that very block and nowhere else.
As their payments are made in bitcoin, miners have strong incentives to maintain the price of bitcoin at a level that allows them to recover their expected long-run operating costs (the mathematical puzzles solved by the miners are designed so that in the long run, the probability of any miner ‘winning’ any given competition – and hence long-run expected payoff – is no greater than that of any other miner). When all possible bitcoin are in circulation, miners will be rewarded by transaction fees alone – but as they are denominated in bitcoin, they too will come to reflect the expected costs of mining activities. The more highly-valued bitcoin is as a transacting currency, the more transactions will occur, and an equilibrium price will likely emerge determined between the number of miners operating and the transaction fee. The equilibrium price will be affected by bitcoin transaction volume, the volume of exchanges from other currencies into bitcoin (causing prices to rise), and from bitcoin into other currencies (both crypto and fiat, causing prices to fall).
Of course, this does not mean that a run on bitcoin will never occur — just that if it does, it will not necessarily be generated by changes in trust in the entities standing behind the bitcoin system, as occurs for fiat currencies. Rather, as with gold, confidence in its future relies most on those with the greatest stakes in trading with it rather than an external entity “managing” its supply and demand to meet other objectives. Arguably, the most significant threat to bitcoin’s long-run value likely comes from technological or other changes leading to a step-change in the cost of generating electricity. By analogy, this parallels the effect of the discovery of an otherwise-unknown store of mineable gold on the price of this commodity.