In my last article I discussed how an objective value for bitcoin could be estimated by computing its cost of production, i.e. the cost of mining bitcoins. This objective value serves as a lower bound below which a bitcoin miner would experience operating losses and therefore remove them self from the network. For example, if it costs a miner $2.50 a day in electricity costs to run hardware and the mining rig only finds an average of $2.45 worth of bitcoins during the same period, they would cease mining until the market price rose or else until the difficulty dropped. With a lower difficulty, the same mining rig that costs $2.50 in electricity per day to operate would find effectively more bitcoins per day - making mining a potentially profitable pursuit once again. This sort of analysis specifies a quantifiable lower bound on the observed price. In reality, the market price is likely to persist at levels above this theoretical floor, and will fluctuate by changes in supply and demand at any given moment.
This article instead aims to identify and evaluate subjective factors that influence value above and beyond its cost of production. Of particular interest is how the new applications of Bitcoin 2.0 functionality will be applied in novel and innovative ways to harness the power of the bitcoin network - and how this will alter what a bitcoin\'s value is, and may even change the fundamental definition of what a bitcoin is.
Speculators and Hoarders
Bitcoin miners are the only producers of new bitcoins, and as such, all bitcoins that currently exist were produced via mining efforts. A cost of production model relies on the assumption that producers operate in a competitive market and offer their product on the market as soon as it is ready for sale. Crude oil producers, for instance, compete with each other all over the world to sell their product on the open market. These producers are not in the business of storing oil, they are in the business of producing and selling oil. Therefore, they sell their product each and every day as it comes out of the ground. Bitcoin miners, on the other hand, tend to hoard some or all of their product. This prevents a potential supply of these coins from coming on the market on a regular basis, and a lower supply given a steady demand translates to higher prices.
In fact, the very good work of John Ratcliff has revealed that by analyzing the blockchain, an impressive 70 per cent of all bitcoins out there remain in their wallets for a full six months. Certainly this percentage does not represent only miners\' wallets, but will also include the wallets of non-miners. Still, if we assume that miners account for just 10 per cent of all wallets, and those miners follow the same 70 per cent distribution, then 7 per cent of bitcoins being are hoarded by miners.
Speculators also hold on to bitcoins without spending them on regular transactions, but unlike miners they are not producers. Instead, speculators obtain bitcoins on the various online exchanges in hopes of selling them later on at much higher prices. In periods of stable or rising prices, speculators keep some portion of the supply off the market, contributing to prices above the theoretical cost of production level. In periods of declining prices, however, speculators may sell their holdings – even at a substantial loss – which can actually serve to depress the market price below that floor. In fact, during the sell-off of 2014, many speculators who bought too high created such a situation.
Unique Features
Aside from the motives of miners and speculators, who do not behave as economic theory might predict, there are also subjective attributes of bitcoin that may confer value to individuals as a use-value. While difficult to quantify, these features are nonetheless important and influential on prices.
The decentralized nature of bitcoin is appealing to many for political and ethical reasons, from libertarians to anarchists to Marxists. Because bitcoin is fundamentally decentralized, many of the implicit and explicit costs associated with traditional financial systems are greatly reduced, and therefore of some value. To transact with other popular electronic banking systems such as PayPal, Western Union, or with credit cards, both the payer and payee can expect to pay a fee of at least a few per cent. A bitcoin transaction, on the other hand, incurs fees – which are optional – of only a few dollars or cents.
People greatly value anonymity. Because bitcoin transactions can only be identified by the alpha-numeric strings of users\' wallets they are effectively nameless. Illicit marketplaces on the darknet such as the Silk Road and Evolution have thrived because transactions are anonymous. Even though these sites have been plagued by government take-downs, corruption, or outright theft by their operators, the fact that they continue to reappear speaks to the value of remaining unknown. Anonymity is not just of value for crooks or buyers of illegal goods. Anybody seeking some degree of privacy in today\'s information age may benefit from this feature. Individuals who are worried that big data is tracking their purchases, even if it is just for targeted marketing campaigns, can avoid this nuisance by transacting in bitcoin instead.
While certain services, companies and websites that operate around the bitcoin economy may be vulnerable to hacking, cyber attack, or identity theft, the actual record of transactions embedded into the blockchain itself are virtually tamper-proof. Of course, a number of theoretical exploits exist – however, with the mining network now so vast and powerful, the chances of such events happening are largely diminished. Even with the possibility of such exploits, bitcoin transactions in and of themselves are arguably much more secure than when using a credit card or buying something online in the traditional manners. This security is also highly valuable.
The Blockchain and Bitcoin 2.0
The blockchain – the public ledger which contains each and every bitcoin transaction – not only exists across the distributed network, but is continuously verified and validated through the efforts of mining. Mining is the way in which new bitcoins are created, but the word \'mining\' is a misnomer. A more accurate description is that these miners perform validation work and are rewarded with a token for doing that work: bitcoins. The entire bitcoin mining network is, in fact, the world\'s most powerful validation engine. While this serves to secure internal bitcoin transactions between users\' wallets, Bitcoin 2.0 applications such as colored coins and open assets may prove to be the most valuable component of them all.
Taking the example of colored coins, somebody can identify some fraction of a bitcoin and attach to it a specific identifier so that it becomes unique. By default, all bitcoins are fungible in the sense that if you have 5 BTC in your wallet it doesn\'t matter which one is which or where they came from or when. They are all indistinguishable, interchangeable and effectively identical. A colored coin, on the other hand, is no longer fungible; it is made unique. A colored coin can be attributed to any number of externally located things such as to shares of stock or to bonds or to contracts. By embedding references to such real-world financial assets, colored coins enjoy the same powerful validation and verification as plain vanilla bitcoin transactions. To be sure, there are ambitious projects underway right now to transform the way the world does finance. By turning the bitcoin blockchain into a decentralized stock exchange, into an alternative for DNS and TCP/IP internet protocols, and into a registry to ensure intellectual property isn\'t stolen or plagiarized, the blockchain and its purpose is expanding beyond what its creators could have imagined.
The question becomes: why would people verify such important transactions such as settling and clearing financial assets – clearly valuable labor that is currently paid out to investment banks, stock exchanges, financial regulators and governments? The answer is because they want to earn bitcoins.
If Bitcoin 2.0 applications become a true force in the economy, the value of the validation work being done by miners must eventually become commensurate with the value of the tokens they are rewarded with. This will become even more important after the block reward is reduced to such a degree that transaction costs exceed the value of bitcoins rewarded. Take the stock exchange example as just one potential disruptive application. In 2013, the owner of the New York Stock Exchange, NYSE Euronext, which also owns and operates securities exchanges throughout the world, posted more than $3.75 billion in revenue – or about the market valuation of all the bitcoins in existence right now. If this application were to flourish on the blockchain, miners would demand to be paid a fair value for their part of the work.
Bitcoin 2.0 applications such as these will be the exciting next step for the bitcoin ecosystem, and how they confer value to bitcoins themselves in the future is uncertain. It could be that the blockchain of a different cryptocurrency takes hold instead of that of bitcoin. A completely new and better innovation could come along that makes the blockchain obsolete. Only time will tell, but the future of bitcoin certainly will be exciting and new.