In part 1 I explained how money has always been a global ledger and Bitcoin is just a different implementation of one. The million dollar question remains, what should Bitcoin be worth in a currency we’re more familiar with, such as USD?
To illustrate the dilemma we’re faced with, lets look at three types of assets and how we price them.
Stocks: price is determined by the present and future profits, which is relatively straight forward.
Commodities (e.g oil): price is a function of supply (oil being produced) and demand (oil burned in engines or whatever).
Store of value: this is anything that is bought because it keeps its value. Most commonly it is precious metals like gold, but it can also be fiat currency or valuable works of art. This category is most fitting for Bitcoin. Pricing of a store of value is strangely arbitrary, I attempt to explain it below.
There are two kinds of demand. Actual demand is based in our everyday needs. For example we rely on combustible engines which consume oil. Engines burn oil (or its byproducts) converting it to exhaust gases, at which point it is no more. The more we drive, the more oil we burn, the higher the demand.
The second kind of demand is speculative. It is based on the expectation of a future price change. Speculators buy assets they expect to go up in price and sell those they don’t. When everyone wants to buy oil because they think the price is going up, its price does indeed goes up. But that is not directly related to the actual supply of oil from the ground (it often is, but not always).
In part 1 we covered how a sale is actually a loan, and how the seller ends up with tokens representing the value owed to the seller. The number of tokes (aka price) is a reflection of how we value things relative to each other.
When we buy stuff for everyday use we establish a price range that is driven by, for lack of a better term, common sense. For example we may think that a loaf of bread is worth a dozen eggs. If the price of something exceeds common sense, we will forego buying it. This means that the price has a direct effect on demand especially when it comes to everyday consumption items such as food or fuel.
Speculators have no respect for common sense and the right price. They are only concerned with the trend. It is possible for the speculative demand to drive the price way above the common sense level, we saw that when “peak oil” was a thing. But the price will eventually gravitate towards the common sense price.
Store of Value Price
In contrast, price for a store of value is purely speculative, which means the sensibility of the price does not apply.
Let’s take gold, for example. Intuitively we might reason that there is a (non-speculative) supply and demand for gold, but it’s actually illusory. The annual production of gold is minute compared to the total gold above ground, which means there is essentially no supply. There is also next to no demand, because gold cannot be consumed. There is never less or more gold available in the world, its quantity is fairly constant. Yet the price fluctuates. The only explanation for this is speculation.
There is simply no such thing as the “right price” for store of value. If I want to move a million dollars into gold, the price of gold is of no consequence to me, be it a thousand or a million dollars per ounce. So long as I know that it is stable, it is a good store of value.
The good news here is that no price is too high (or too low) for Bitcoin. 4K only seems high because a year ago it was 400. We tend to judge the price based on history, and there is good sense in that, indeed what goes up in value too much too fast often subsequently corrects.
Importance of Market Cap
Market capitalization is the price of all of the asset available in the world. It’s easy to compute the market cap for a stock because we know the number of shares outstanding. There is no such thing as a market cap for a commodity because it is continuously produced and consumed. When it comes to something like gold, we can estimate the market cap because we know approximately how much physical gold is above ground. Bitcoin, like gold, has an approximate market cap (approximate because it is not possible to know how much BTC has been lost).
Market cap size is critical for adoption of a store of value. It needs to be large enough to “fit” even very large amounts of fiat, ideally without affecting the market. Gold market cap is estimated at 7 trillion USD, which means that even the richest people can move all their assets into gold and not move the market. (At least one at a time. All of them at once will move the market big time).
Bitcoin market cap of about 70B USD is not large enough for even one of the richest people on the planet. This implies that if the market cap does not grow, Bitcoin is likely to fail as store of value.
What sets Bitcoin apart from all other crypto currencies is its extremely high hash rate. This means that a Bitcoin is orders of magnitude more “precious” than any other crypto coin presently in existence.
There is a definite correlation between the Bitcoin hash rate and the price. Some people argue that hash rate follows price, not the other way around, and it’s probably true.
Bitcoin’s high hash rate is what makes it the best store of value among crypto coins today.
Ultimately, I believe adoption is the most important factor in Bitcoin USD price. Greater adoption will increase the number of speculators willing to own Bitcoin, it will drive the price up, and hopefully bring it to a level comparable to that of gold.
The key to adoption is not ease of payment or volume of transactions like we used to think until very recently. The key to adoption is understanding of the mathematics behind Bitcoin. With all the hype surrounding it, only remarkably few understand how sound Bitcoin actually is. In many ways it is more sound than any other store of value known, including gold.
Regardless of whether Bitcoin becomes de facto digital gold or not, we are witnessing a historic transformation possibly bigger than the Internet itself.