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Bitcoin - Part II
In this Featured Article, I describe what a Bitcoin actually is and re-examine the question I asked in a previous Featured Article on this topic dated 21st August 2017 - are bitcoins a currency, an asset or a mirage?
Bitcoin - A Description
A Bitcoin is a digital address identified by 27 to 34 alphanumeric characters, a string of characters stored on a computer with your digital address identifiable on a public ledger. Bitcoins are often stored on cryptoexchanges.
There are no physical bitcoins, only balances kept on an online public ledger that anyone has transparent access to, that - along with bitcoin transactions - is verified and protected by a massive amount of computing power. In other words, the underlying blockchain technology facilitates instant payments or transfers of value independent of banking systems.
In terms of security, I guess you could write your unique alphanumeric characters down on a piece of paper and place it in a safety deposit box, similar to how you might store physical gold. Cryptoexchanges have been hacked before and then there is the likelihood of the emergence of other cryptocurrencies, which creates uncertainty regarding the validity of the 'limited supply' argument.
The obvious question is: why should bitcoins have a value? The following is an article that we wrote for the Sunday Times (Irish Edition) on 6th December 2020. Readers might also like to read our indepth article on gold, in a Featured Article titled Goldeneye - Key Insights to Understanding Gold - published on 4th September 2020.
Bitcoins - Curreny, Asset or Mirage?
"Bitcoin is making the headlines again, as the price re-tests its 2018 high of over $19,000, with many predicting much higher prices.
Bitcoin has always had its tech enthusiasts who, following the Global Banking Crisis in 2008, could see the need for a currency and a store of wealth outside the traditional systems of banking and government. Gold has played this role for 5,000 years, but bitcoins are both easier to transport and to store.
The real question is: are bitcoins a store of value? The principal argument among its legion of supporters' rests on the fact that there is a limited supply of them. A maximum of 21 million bitcoins can be produced electronically by some set future date.
Plastic debit cards, for example, and the underlying technology transfer monies within the traditional banking systems, but the plastic card itself has no value, even though it facilitates the execution of transactions and the transfers of money. I see parallels between the humble plastic debit card and bitcoins.
Supporters of bitcoin argue that paper monies (fiat currencies) have no intrinsic value and can be printed at will by central banks, and therefore, in contrast to bitcoins, act as poor stores of value. It's a fair argument, to a degree.
Paper currencies (or fiat currencies) - both bank deposits and government bonds - are backed by their respective governments, and a government can tax its population now and into the indefinite future to ensure that it can repay its debts and support the value of its currency.
And, yes, the danger is always lurking that a government overspends and imperils its currency, thus reducing the value of both bank deposits and government bonds against real goods and assets. Think Germany post the First World War and the Second World War. Today, think Venezuela, Argentina, Syria and maybe even Turkey.
For this reason, paper currencies have never been an ideal store of value. They are, however, a decent medium of exchange as paper currencies can be expanded at the rate needed to settle trades in the global economy.
The supply of gold, in contrast, has never been flexible enough to expand at the same rate as global trade, and therefore gold was never an ideal medium of exchange in settling transactions. As gold often acted as a constraint on the money supply, central banks eventually ceased tying their currencies to gold, with the US Dollar the last to cut the tie back in 1971.
Nonetheless, gold's unique characteristics make it an ideal form of money and a good store of value. Because the tap of new gold supplies cannot be turned on at will, it protects against inflation, as it did very well during the 1970s when inflation ravaged paper currencies.
However, as central banks got on top of inflation in the early 1980s, investors no longer saw the need for gold. Bank deposits and government bonds were, once again, offering high real returns i.e. decent returns after inflation.
So, the gold price, which started the early 1980s far above its intrinsic value - or basic worth - lost 70% of its value over the next 20 years as investment demand for it, as a hedge against inflation, waned.
Despite this calamity for gold investors, gold has a basic worth, as jewellery. Today, it costs circa $900 to produce an ounce of gold. Add on the miner's profit margin and one can point to a base price for gold of around $1,200 an ounce.
In other words, even if gold is no longer required as money, and investment demand for it wanes permanently, it has a basic value - an alternative use value - as jewellery. Therein lies its store of value or intrinsic worth.
I believe that the essential question for bitcoin investors is not the 'limited supply' of them but whether they have an alternative use value. If, or when, paper currencies once again start paying a return above inflation, investment demand will most probably wane for both gold and bitcoins at that stage. When that is likely to occur, I have no idea.
Unlike gold, however, bitcoins do not appear to have an alternative use value and, therefore, no floor value regardless of what people are paying for them today.
Aristotle, the great Greek philosopher (384-322 BC), allegedly stated that money has five characteristics - divisibility, durability, consistency, convenience and an alternative use value.
If you are deciding whether or not to invest in bitcoins, I believe those five attributes are the true tests.
A limited supply of something does not give it intrinsic value, and so I obviously think that bitcoins are a mirage, or a solution in search of a problem!" (end of Sunday Times article)
As an aside, some argue that the value attributed to bitcoins by investors ($19,000 a bitcoin as I write) represents the value of the underlying blockchain technology and that it is this underlying technology that is bitcoin's 'alternative use value'.
Again, I'm not so sure. The Internet has no value in and of itself. Companies using the Internet to deliver new products and services have a value, if they can find customers willing to pay for these new online products and/or services. In the same way, the underlying blockchain technology can have a worth, if companies or others can deliver new prodiucts or services and generate revenue from customers for themselves.
Personally, however, I fail to see the link between blockchain technology and a value for bitcoins simply because the technology creates bitcoins during the processing of transactions and/or transfers online.
7th Dcember 2020