What’s Up with Bitcoin?

One of the stories that has moved back into public view is bitcoin. With recent price spikes, interest in bitcoin has spiked as well, as investors try to get in on what looks like the latest hot thing. In fact, the price has more than doubled this year and has gone parabolic in recent weeks: up from about $1,000 in March to over $2,000 recently. What’s going on?

Bitcoin defined

Let’s start with some definitions. “Bitcoin” is essentially digital cash. It is created by computers running cryptographic algorithms. Its value is validated and confirmed by a network of independent computers using decentralized technology known as the “blockchain.” (If you’re interested in learning more, technical details are easily found on the web.)

Because of the way it works, bitcoin is the first of a class of assets known as “cryptocurrencies.” Many others have since been created—there are now more cryptocurrencies than there are government-backed currencies. Most of them are also doing well, but this is an important point we will come back to.

What’s the value?

From a user’s perspective, the value in bitcoin or any cryptocurrency comes from the underlying factors that drive any currency’s value: scarcity and acceptance. I wrote about what money is in a previous post, and the logic still applies. Bitcoin, by design, is scarce. By social construction, it is becoming more accepted. Bitcoin and the other cryptocurrencies, in this sense, have already established themselves as money and are likely to get even more popular in the years ahead.

As an investor, the best comparison is that bitcoin acts like digital gold. This comparison works for the following reasons. 

1. Lack of utility. You can’t actually do much with either gold or bitcoins, and their value is based solely on the fact that other people want them and that they are scarce.
2. Scarcity. There is only so much gold and so many (by construction) bitcoins. That scarcity supports prices: when demand spikes, supply can’t respond. As such, the price rises.
3. Rising demand. Speculation is that the demand is driven by Chinese buyers, trying to safeguard their own capital. But it doesn’t really matter who the buyers are. What matters is that there is a sudden surge, which is driving the price up.

We’ve seen this exact dynamic with gold. During the financial crisis, the price of gold more than doubled from 2008 to 2009 on rising fear and loss of confidence in other assets. As a supposedly secure store of value, gold attracted a number of buyers. With a limited supply, the price rose. This is the same effect we’re seeing with bitcoin and other cryptocurrencies. An index of the top 19 cryptocurrencies, excluding bitcoin, is up almost eight times so far this year.

Will the price continue to rise?

So, does this mean the price of bitcoin will continue to rise? It might, but the same was said of gold. After the spike during the crisis, however, gold retraced most of the gains and at this point has lost about a third of its value from the peak. While supply remained reasonably constant, demand dropped off when fear receded—and so did the price.

Scarcity, then, does not guarantee a stable value, much less an appreciating one, even when the scarcity (as with gold) is real. Although it is true that the supply of bitcoins themselves is scarce by construction, the total supply of cryptocurrencies is not. Right now, reportedly, there are more than 700 different cryptocurrencies, with 500 actively circulating and nearly 70 with more than $100,000 in daily trading volume. There may be a limited amount of any one. But, in aggregate, there's a lot of them—and the total supply is growing fast.

Big picture? We have a constrained supply of cryptocurrencies, plus spiking demand, which results in spiking prices. This might continue for a while. At some point, however, demand will slacken, even as supply of the asset class as a whole continues to rise. This is when we will very likely see prices start to drop, possibly by a lot.

Not a sustainable investment

Overall, bitcoin looks like the latest hot trend, rather than a sustainable investment. Any market that is driven by a surge in demand, rather than by strong fundamentals, is a slave to that demand. Any market with potentially unlimited supply—which is the case for cryptocurrencies in general, although not for any one—is subject to oversupply and price collapse. Any asset that has both characteristics, as bitcoin does, could get hit on both fronts at the same time.

Be careful out there.