Humans are considered rational beings. Every once in a while greed and exuberance trumps rationale we end up with a Bubble. Bitcoin is a bubble and it will fall precipitously. Here’s why:
Value of any product is arrived at through a process that matches demand and supply. If there is a lot of demand for a product and few people offering it, the price go up. There is a greater perceived value for it since the supply is limited — Everyone who wants it, cannot have it. The vice versa is also true. But as with most things in life there are certain exceptions to this rule. High-end luxury products have an aspirational value and hence the higher the price the higher the demand tends to be. These are called Veblen goods. There are also Giffin goods where this effect is seen with inferior goods.
Either way, in all of these cases price is a consequence of consumption.
There is another case where prices can be made to rise artificially, through hoarding and creating artificial scarcity. The hoarder buys large quantity of a good and waits for the price to rise high enough before beginning to sell it slowly to the actual consumer at an elevated price.
Markets play an essential role is matching demand and supply, which results in price discovery. Markets are the price discovery platform that most of us depend on. We have markets for everything, stocks, currency, commodity, bonds, etc. Most of these trades take place through instruments that are representative of the same. Stock is a company is represented by shares — Stock here represents the assets of a company and the ownership is attributed through shares. There are similar trading instruments for everything that is traded.
The place where this trade is managed, which I referred to an a market earlier, is known as an Exchange. An exchange is where trades are executed and the instruments change hands between the buyer and the seller. The job of an exchange is to provide a framework, to regulate and enable the trade to take place.
Let us say you have a Rs. 10/- currency note. You take this note and buy tea from a tea stall. He in turn takes the note and pays for the fuel bill. He in turns takes the note and pays the school fees for his child. The note has been used for several transactions but we do not know where it originated from and how many hands it changed. If this note were an online token we could track it all the way through.
If there are a set number of tokens in circulation and each of the token can be tracked, there is no way that any fake token can be introduced without changing the total number of token in the system. Furthermore if an anomaly is found, it can be quickly tracked back to its origin.
A Blockchain is a chain of records which are called Blocks. Each block represents one transaction and hence the entire history of an single instrument can be tracked from beginning to the end. A blockchain is what makes it possible for us to track every token. Research on blockchain began in 1991 but the distributed blockchain, which is the basis of all modern blockchain was invented in 2008. The distributed blockchain kept the block of records on every computer that is a part of the system. This redundancy is the secret sauce that make blockchain a phenomenal technology.
This makes it near impossible to fake any transaction because that fake transaction. It is not enough to enter a fake transaction in your own block, the same transaction needs to exist in every copy that is part of the system. Each copy is protected by public key encryption on each user’s system (If you wish to know how encryption works). If any anomaly is found, it can be quickly localized and eliminated.
Bitcoin is one of the implementations of blockchain as a currency. Bitcoin tokens can be mined by solving mathematical problems, but the total supply of bitcoin available is limited by the algorithm. The more bitcoins get mined, the harder it becomes to mine further. The mathematical problems are solved using the computer but the problems take longer and longer to solve as times goes on.
Now, once you have these Bitcoins, you need a way to transact, for which bitcoin wallets exist, where these coins get stored. The wallet is your copy of the blockchain.
Some people thought, “Hey! Why not trade bitcoin?” and they created Bitcoin exchanged. Just like a stock exchange, Bitcoin is bought and sold on Bitcoin exchanges. There are several across the world and they execute bitcoin sale and purchase.
Individuals and companies have been mining bitcoins since it was introduced. Today this mining has assumed industrial scale with more and more people getting interested and mining becoming harder and harder. There are entire server farms that are being committed to mining bitcoins and in all likelihood these are being hoarded for a future date when it would likely be sold.
Value of any product finally lies in its consumption
The value of anything is down to consumers finally adopting the product and using it. This is where demand invariably arrives out of. Whether it is businesses or individuals, utilisation is the key. Keeping something does not create value unless it is an antique. Bitcoin is definitely not an antique.
Consider confirmed Bitcoin transactions per day. At its lowermost it is about 130,000 and at its peak its at about 365,000. It averages out at about 275,000 per day. Let me just add some perspective. Visa processes about 24,000 transactions per second. So in about 12 seconds Visa does the entire days worth of transactions on Bitcoin!
Although this is not a straight comparison since Visa is a method of exchanging money while Bitcoin itself is a store of value. The market capitalisation of Visa as a company stands at USD 230 Billion while that of Bitcoin stands at USD about 70 Billion dollars. A third of the value of Visa? Comparing it with gold, which is a store of value unlike Visa which is a transaction mechanism akin to Blockchain; Comex which is a commodity exchange based out Chicago (one of many across the world) does about 289,000 gold contracts per day. The number across the world would probably be in the millions, not to mention the transactions that take place through stores, banks and other means.
There are about 16,500,000 Bitcoins available today. Out of this only about 640,000 is exchanged everyday.
Hoarders will dump
I think the value ascribed to bitcoin given its abysmally small circulation is purely due to the hoarding that many are engaging in. Most of the people just buy bitcoin for the purposes of speculation.
People buy bitcoin and then they keep it. Since nobody is selling (Would you, if you know what you have is doubling in value every 6 months?) — Prices rise. People hear prices are rising — They clamor to buy. Demand rises — Price rises. Some of the early hoarders keep releasing small amounts of it.
For price to rise, the demand has to be high; this demand should be powered by consumption and not hoarding.
My take on this is that the price rise of Bitcoin is speculative. It is powered by speculators who are willing to pay more and more in the hope that prices would keep rising. The limit on the supply is additionally helpful in driving the prices up and keeping them there.
Looking into the past
There are plenty of cautionary tales of bubbles but for me the one that most closely matches this is — The Tulip Mania. Tulips by themselves had no great value.
Tulip was a unique flower and was used for royal gifting. The prices of tulips shot up suddenly on speculative purchase of tulip futures. There were, many who made money during the upsurge. After a couple of years of frenzied buying, the demand for buying newer and newer contracts seemed absent. There was no inherent value in it. Panic set in and ultimately it suddenly collapsed in Feb 1637. Within 3 months all of the value was wiped out, because there was none to begin with!
The same is true of Bitcoin today. Its not like Bitcoin is the preferred currency for transaction or that people are switching to transacting through bitcoin at unforeseen pace. A crazy number of speculators are buying into it for the sake of speculation. There is no inherent value and one day in the not so distant future people will realise it.