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Arguing for a bitcoin bubble difficult without clear valuation

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Arguing for a bitcoin bubble difficult without clear valuation

The meteoric rise in the price of bitcoin this year has prompted more critics to call the asset a bubble or even a fraud.

Bubbles form when investor exuberance causes the market price of an asset to rapidly rise far above its fundamental value. There is no clear valuation model to ascertain bitcoin's underlying value, and arguments have largely hinged on the idea that bitcoin is not real or that it lacks any intrinsic value. It is easy to predict a bubble, no matter the market price, if you believe the underlying asset is worthless.

This is largely due to bitcoin being a new asset class unto itself and fails to take into account its advantages. If we overcome these arguments, we see that bitcoin not only has value but is likely not a bubble.

The bitcoin mirage

Berkshire Hathaway Inc. Chairman and CEO Warren Buffett famously called bitcoin a “mirage” during a 2014 CNBC interview. JPMorgan Chase & Co. Chairman and CEO Jamie Dimon has called it an outright fraud. The reasoning often repeated by naysayers is that it has no government or financial institution backing and exists only in digital form.

Based on a 2008 whitepaper by the pseudonymous Satoshi Nakamoto, bitcoin was designed to be entirely decentralized and governed only by network participants. There is no central record of balances; instead, participants each maintain a copy of the transaction ledger. The total $320.24 billion bitcoin market lies only on a worldwide network of interconnected computers.

Fiat currencies are also digital entries, coins or pieces of paper. But we consider them valuable because they are backed by the governments that issue them. Equities have value because of the issuing companies and their associated revenues and assets. Commodities are tangible and can be used to create goods. Bitcoin has no backing or revenue and is intangible.

But the lack of central backing can be an advantage. Centralized power creates the potential for mismanagement. Governments can, and have, mismanaged economies, leading to declining currency prices. Corporations have also seen the equity value of their operations go to zero.

Decentralization prevents such problems with bitcoin. Hyperinflation, which is plaguing countries like Venezuela and Zimbabwe, is impossible because of a hard-coded maximum supply of 21 million bitcoin. In fact, bitcoin is designed to protect purchasing power, with new supply halving every four years.

Gold presents an interesting comparison because it is not government-backed and stands in limited supply. But as a physical asset, gold is difficult and costly to store and transport. Using it for large payments would be incredibly costly, while smaller payments suffer from the limited ability to divide a physical asset.

Here, digitally native assets have an advantage. Storing bitcoin requires only a set of cryptographic keys that can be held on a computer or mobile device. Sending bitcoin, no matter the size of the transaction, can be done in a matter of minutes for a comparatively low cost. And because it is a simple digital ledger entry, it is divisible down to 1/100,000,000 of a bitcoin.

Calling bitcoin a mirage or a fraud because it lacks characteristics of traditional assets does nothing to help us ascertain its true worth.

The intrinsic value question

Another prominent argument against bitcoin’s worth is that its market value is not tied to any underlying intrinsic value. Strip away the supply and demand of the markets, and you are left with something worthless. Broadly, intrinsic value can be thought of as the value of an asset due to its utility or worth to investors outside of what they could sell it for in an open market.

Equities have intrinsic value based on the underlying assets owned by a company, projected future cash flows from operations, and intangibles such as brand name or management. Commodities have intrinsic value due to their retail and industrial applications and in many cases their relative scarcity. Fiat currencies have intrinsic value because they are widely accepted as a form of payment.

Bitcoin has no underlying assets, no cash flows, no management team, and no use in industrial or retail operations. It is simply a secure global ledger maintained by a distributed network of verifiers. Bitcoin's intrinsic value stems from the underlying utility as a global medium of exchange.

Like gold, bitcoin serves as a viable store of value. It is scarcer than gold, of which the total supply can only be roughly estimated. Unique distributed and cryptographic properties also make it incredibly durable. It is immune to forgery and not subject to a single point of failure like centralized systems.

No clear model for valuation

While bitcoin has value since it is used as both a medium of exchange and store of value, it is difficult to model the appropriate price. It is perhaps best to compare it to other well-defined assets serving the same purposes, namely currency and gold.

If we consider bitcoin a global currency, it already stands as the fourteenth-largest in the world.

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As adoption rises and bitcoin becomes a legitimate asset class, it could be used by larger institutions and perhaps central banks. Bitcoin can act as a neutral reserve currency, without ties to a single government or regime. For central banks, the idea of a neutral currency could be appealing because it is immune from the policies of their country's trade partners and could become an alternative to large reserve currencies. This is especially appealing to smaller countries or those that lack a stable currency.

Many proponents of bitcoin advocate that it will become the global standard for exchange, eclipsing current government currencies. If we assume that bitcoin becomes more valuable than the largest reserve currency, the Chinese yuan, we would see the value of a single bitcoin reach $438,829. This would equate to approximately 20% of global currency supply, excluding bitcoin, today.

This is unlikely, as governments rely on their currencies to dictate a variety of policies, and reserve currencies such as the yuan, euro and dollar remain important for the global economy. Instead, assume bitcoin becomes marginally more important than it is now. If it reaches a value equal to just 1% of today’s money supply, we would see a price per bitcoin of $21,941. This would be 23% higher than the price of $17,777 on Dec. 19, 2017.

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There would, of course, be more complex market dynamics at play, and this idea relies on continued adoption of bitcoin. Caveats aside, we see that based on the possibility of bitcoin becoming at least a small settlement layer in the global financial system, the prices today appear justified.

A more defined comparison would be gold, another asset with limited supply and no central backing. Proponents of bitcoin believe that because of its advantages over gold, it will become an important alternative for investment and governmental purposes.

According to the World Gold Council, official sector uses and private investment account for 71,500 tonnes of total above-ground gold stocks. Based on a price per troy ounce of $1,264, the total value of this market would be $2.906 trillion as of Dec. 19, 2017. This excludes gold that has been used for jewelry or other purposes like industrial applications.

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If we assume that over time bitcoin does, in fact, become useful for the same purposes as gold, and achieves the same market size, the price would be $173,475 per bitcoin. This is another unlikely scenario, at least over the short-to-medium term. If, instead, we assume bitcoin only makes it a quarter of the way, we see a price of $43,369 per bitcoin. At a price of $17,777 as of Dec. 19, 2017, bitcoin was around 10% of the size of the investment gold market.

These illustrations are not meant as bitcoin price predictions. There will likely be volatility as the market works to reach a consensus on valuation. But if bitcoin achieves just a fraction of what many expect, then current prices could be justified.

There are numerous risks that could impede bitcoin’s growth. Our valuation scenarios assume its wide acceptance by investors and governments. Global consensus on an asset is hardly likely. New innovations could replace bitcoin. If bitcoin is unable to find an appropriate equilibrium, investors could tire of the volatility and move their savings into another asset. That said, the risks to bitcoin are not what many pundits have stated.

Prices will rise and prices will fall as they do in any market, but over the long term, it appears that bitcoin is anything but a bubble.