Bitcoin and any other cryptocurrency remains unbacked by a government. Bitcoin isn’t pegged to gold or the US dollar either, so what gives it a value deserving of the market cap of large tech companies?
If you want to brush up on what Bitcoin is, here’s a very basic explanation of blockchain technology.
A large part of a cryptocurrency’s value is speculative – meaning it’s priced at exactly what other people are willing to pay for it (if you want more details, there’s more information available at xCoins). If people decide that they’re not going to sell their Bitcoin at below $10,000, then the price is going to be $10,000. If even one person in the market place decides to go below that point, then the price goes down. The same is true for upward movements.
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Speculation is the key reason why cryptocurrencies are so incredibly volatile.
Let’s think of a stock – a share in a company like Alphabet, which is around $1000. For Alphabet to reach this price, the market has to decide that the value of holding this slice of the company is somewhere in the realm of $1000. This is done by financial analysis and methods such as measuring P/E ratios or other company fundamentals. Alphabet is required by the SEC to provide financial details to the public in the form of various reports, such as the 10-Q and 10-K (the Indian equivalent to the 10-K is the Annual Report). These financials help investors gauge whether Alphabet is truly worth $1000 or $20, according to their analysis. Most investors will agree that the share value of $1000 is a decent place for Alphabet to be considering its finances.
With cryptocurrencies, there are no finance fundamentals since it’s not a traditional company. There are no sales, profit margins, goods sold or year-on-year revenues. It’s an asset class that depends on other people buying your fraction of the total market cap. If the market decides that 1 Bitcoin is worth $10 instead of $10,000, then the price will reflect that. Therefore a large part of speculative volatility is because it’s largely based on investor sentiment and not financial analysis.
After having said all of that about speculative value, it’s important to point out that there IS and always will be some inherent value in a cryptocurrency, simply because of the nature of the technology.
There’s something called a network effect; the value of a network increases proportional to the number of people involved in the network. This is true for all forms of telecommunications, but is very important for cryptocurrencies, because you can directly measure the value of your involvement in the network through the price of the crypto asset. All things being same, the more people using a cryptocurrency, the more the price will increase.
Cross Country Value Transfer and Remittances
The functional difference between a cryptocurrency like Bitcoin and regular fiat currency is this:
- For cryptocurrencies, sending money across national borders costs the same whether you’re sending $10 or $1 million.
- So far, there are no entities that will take a percentage based cut (except for exchange fees that you’ll use to convert crypto into fiat). Taxes apply to both crypto and fiat.
Therefore, sending money across national borders is a potential, and very basic use case, for cryptocurrencies. That’s just 1% of the potential use cases; there are a ton of other more complicated ones such as revolutionising supply chain and logistics, creating micro-grids to distribute energy efficiently, and ensuring tamper-proof real-time access to smart contracts.
The remittance industry is worth over $600 billion a year. Cryptocurrencies and blockchain technology will play a major role in de-risking international fund transfers. This means traditional businesses like Western Union won’t be able to charge such exorbitant rates for remittances when competing with the safer, faster and cheaper blockchain alternative.
Security of the Network
Speaking of safety, there’s an inherent value assigned to the safety of an asset. This is why some countries can have negative interest rates on their treasury bonds. Safety is not just in its storage or transfer, but in the resilience of the system as a whole.
Bitcoin’s $10,000 value is partly because of the Bitcoin network’s stability and resilience to hacking and malicious attacks. In its 9 year history, Bitcoin has been subject to numerous attacks, but not once has the blockchain faltered. A transaction made in 2013 is just as safe as a transaction in 2018, and will continue to be Byzantine Fault Tolerant. Bitcoin is cryptographically secure, which means it can’t be “brute forced”. No computer is thermodynamically powerful enough to crack the hashing algorithm and take over the network.
The “Bitcoin hacked” news you read in the media is always related to the exchange or wallet, a third party interacting with the Bitcoin network, rather than the Bitcoin blockchain itself. Mt. Gox was the largest cryptocurrency theft in the history of crypto. However, to this day, the Bitcoin blockchain remains safe and secure.
Lack of Liquidity
Another major reason why prices are so volatile is the liquidity of cryptocurrencies, or lack thereof. The majority of participants in cryptocurrencies still want to be able to exchange their crypto-assets for fiat currencies. Currently, there still aren’t many ways to do that. Bottlenecks exist in the form of exchanges that are new and definitely not infallible, and banks that succumb to regulation or withdrawal guidelines. Even in the cryptocurrency world itself, the exchange markets are tiny compared to even a smaller stock exchange.
It should be pointed out that there are built-in limits within blockchain tech that adds to the liquidity problem. Bitcoin can only transact about 7 transactions per second. Ethereum can do about 30 transactions per second. This is because the current mainstream cryptocurrencies rely on proof-of-work systems that value security over speed. Unless most transactions are happening off chain (with Lighting Network or on the exchanges), there will always be an upper limit to volume and liquidity.
The majority of Bitcoin or any cryptocurrency’s value is purely speculative. That isn’t to say that all cryptocurrencies are worthless, because fundamentally, even fiat currencies are a speculation on the wealth of a nation. The correlation of crypto prices with network effects means usage will always be a strong indicator of its price. Aside from that, there’s intrinsic value in crypto today because it allows for cheap and safe value transfer. The security of the network is an added bonus, but the lack of liquidity in crypto markets are going to ensure extremely volatile prices in the short to medium term.