In Bitcoin We Trust?

The price of bitcoin is determined in the same way as the price of all other goods: by the forces of supply and demand. However, bitcoin’s limited supply means that changes in demand directly impact the price, and as can be seen by the price of bitcoin, demand has been growing substantially. Demand is growing for two main reasons. Fundamentally, the technology provides a useful service to users who want to trade value across the world without an intermediary. Bitcoin transactions can be sent at any time of day, to any place in the world, for a transaction fee ranging from $0.00 to $0.40 regardless of the transaction size. Bitcoin’s growing popularity as a payment system can be seen by the increasing number of transactions. Every day, approximately 315,000 transactions occur worldwide with a volume of roughly $100 million.

Secondly, speculators are buying bitcoin in hopes of profiting from price fluctuations. However, the recent price hike to more than €2,400 per bitcoin has left investors wondering if it is too late to get in on the action. Despite the strong growth in the price, exposure to Bitcoin is still a good decision in 2017.

• New Asset Class – Bitcoin represents a distinct asset class with unique fundamental and statistical characteristics. ARK Invest has outlined 4 main reasons that Bitcoin provides portfolio diversification: investability, politico-economic features, correlation of returns, and the risk-reward profile.^[5] Although only a limited amount of data is available, the historic prices of bitcoin have a low correlation with other asset classes. As stylized by Burton Gordon Malkiel in his fantastic book “Random Walk Down Wall Street”, adding an asset class with a low correlation with the other portfolio holdings can minimize the downside risk of the overall allocation.
• Ambiguity Aversion – Bitcoin is so young and nobody knows exactly how this invention will impact the world. Bitcoin’s price data only covers the past six years, which means there is basically no data available for statistical analysis. The Ellsberg paradox shows that people prefer outcomes with known probability distributions compared to outcomes where the probabilities are unknown.^[6] The estimation error associated with forecasts of bitcoin’s risks and returns may be negatively biasing the price downward. As time passes, people will become more “experienced” with bitcoin, which may reduce uncertainty and the subsequent discount it wields on the price of bitcoin.
• Big Investors – Bitcoin has a positive feedback loop. The more people that use bitcoin, the more valuable each Bitcoin is, which makes more people want to use it. In 2014, the New York Stock Exchange (NYSE) invested in the U.S. based bitcoin exchange, Coinbase. In 2015, the NYSE launched the Bitcoin Investment Trust that enabled IRA and Roth IRA investments. In 2016, over ten universities, including Stanford and Princeton, offered courses specifically on Bitcoin. In addition to compelling historical price data, the future prospects look encouraging. New business models, such as bitcoin banks, brokers, and custodians are being developed that enhance Bitcoin’s user experience and popularity.
• Negative interest rates – Hostility from government and banks towards bitcoin underscores the value of this technology. The ECB is printing €60bn per month and shows no sign of abatement. The ECB’s deposit rate of -0.4pc is effectively a tax on storing your money in a bank. The SNB is following suit in order to prop up Swiss exports to the Eurozone. Bitcoin provides an alternative to inflationary fiat currencies that incur fees for fractional reserve storage. Bitcoin’s total supply is fixed to 21 million and can be stored for free.
• Cashless Society – We are slowly moving towards a cashless society. The majority of fiat currency only exists digitally. As governments demonetize physical bills, more transactions will be made digitally. Bitcoin presents an alternative to credit card companies and banks that are frequently hacked, charge high fees, and freeze accounts. Offline or “cold” bitcoin wallets are protected by military grade cryptography and require no fees or paperwork.

b. Bitcoin – Digital Gold or Fool’s Gold?

Like bitcoin, gold also provides protection from negative interest rates and fiat demonetization. Importantly, the stock to flow ratio (StFR) of bitcoin is similar to gold’s. Gold has a StFR of approximately 64 years, while bitcoin’s is approximately 25 years. The entire amount of bitcoin ever mined totals approximately 16.32 million. That is the stock. Every ten minutes, the network mints 12.5 new bitcoins. Therefore, there is a daily inflation of 1800 new coins. In 2017, annual production will be approximately 657,000 bitcoin. That is the flow. By dividing the stock by the flow, we can see that bitcoin’s StFR is lower than gold’s. The StFR shows that a large gap exists between the annual production of bitcoin and total supply available. Not only is bitcoin scarce but also the available stock is relatively constant over time, which generates confidence in the money.

The StFR of bitcoin is expected to rise further over time because every four years the amount of bitcoin minted every is halved. The last programmed “halving” occurred in June of 2016. Therefore, the next halving will occur in 2020. At this time, the StFR ratio will increase to approximately 56 years.^[7] The StFR of bitcoin should surpass gold’s during the next five years. Figure 2 below shows the stock flow ratio of bitcoin over time. Prior to January 3, 2009, no bitcoin existed. Therefore, the stock to flow ratio was effectively zero. However, the rapid reduction in the amount of bitcoin mining over time is increasing the StFR. By 2024, only 3.125 bitcoin will be mined every ten minutes resulting in a StFR of approximately 119 years.