Part 2 – Mining and The Valuation of Bitcoin

DISCLAIMER: this is an OpEd piece. Opinions expressed are my own. Do not take it as or use it as advice on investments.

In part 1 of this article, I discussed how decentralization is really a measure of security in the network and having a more secure network means having one that costs more to corrupt it than to work within its rules.  This in turn results in a system that is trust-minimized, which means you need to trust 3rd parties less to ensure everyone plays by the rules.  This is the basis of why Bitcoin can actually work as a currency, but you have been reading my blog, so you already knew that, right?

In this segment, I would like to breakdown and explain the components that comprise the Bitcoin price, in terms of economic drivers.  I will apply some high level fundamental analysis on Bitcoin, to see if we can tease out what factors affect it’s price, and whether or not that price is stable.

The current market Bitcoin price is composed of 4 components:

  1. Hoarders Value
  2. Mining economics Value
  3. Speculative Value
  4. Medium of Exchange Value

The first people valued it for ideological reasons, from libertarian anarchists to those from the Austrian school of economic thought.  These are the hoarders and will be the last to sell.

The second element is the value supported by the current industry in mining.  Each miner is a net seller of bitcoins as they profit by creating the currency and their profit and expenses are denominated in fiat currencies.  They have massive real investments in their businesses, from server farms to personnel to land permits.

The largest portion of the value right now is made up by Speculators.  This includes businesses, venture capitalists, and also traders and individual buyers who expect that the value will hit 1,000USD in the short term.  They expect the currency to appreciate, or their businesses to turn a profit, therefore bringing them a return on investment.

The final component makes up for only a tiny portion of the value, that of Bitcoin as its utility as a method of payment for goods and services.  This fraction is small, and is mostly made up of businesses that are not exactly legal in their jurisdictions and thus it is hard to quantify how big.  Sure, there are the occasional legal merchants that accept Bitcoins, but they universally aren’t seeing much flow and payment processors like Bitpay tapping out completely.  For those who doubt the only meaningful real commercial use of Bitcoin at present is to buy illicit substances, take a listen here to a real interview with a dealer.  The reason for this is that honest law abiding people have a hard time justifying the need to use Bitcoin for everyday use.  There are some exceptions to this, of course, e-commerce is perhaps one, remittance maybe another, though the prospects of saving costs over the existing system seems dubious.

If we were to draw out the price components as a percentage of the current price, it would look something like this. The actual components are on the left total about $450/BTC which was around the price when I wrote this. (values are estimates are represented in USD value invested, not by current market price of BTC holdings)

Screen Shot 2016-01-17 at 18.47.09

Now the important thing to note is that the smallest portion, the value as a medium of exchange, is the most important in determining a money’s long term durability and store of value!  Why? Because as much as the hoarders would like it not to be, the fact is that if a money is only good for hoarding value, then it will be no better than collecting Franklin Mint Commemorative Coins.  Sure, they are worth more than the legal tender face value, but I certainly wouldn’t use them to transport and store my wealth. This has nothing to do with the fact that they are physical, but because I would have a hard time finding somebody to exchange them with!  Sadly, as much as the hoarders would like to deny it, this is the current state of Bitcoin.  To be fair, Bitcoin has faired better and gotten further than any other man-made money in the post fiat age, but this is not something that we can just declare victory on and rest on our laurels.  Why? Because in order for Bitcoin to survive, Bitcoin must grow.

Bitcoin will either be worth a million dollars, or it will be zero.*

“Why must it grow? Why can’t it just stay at this relatively stable price of 250-450 USD perpetually?  It seems to be doing a great job doing that over the last year.”  That is the opinion of those who likely also believe that a stocks performance is defined by its historical performance, without understanding the fundamentals of the company.

The full breakdown scenario boils down to this:  Unless Bitcoin can build out a large enough percentage of its value being supported by its use as a medium of exchange, then it will die.  To understand how this may play out, consider that most of its value today is based on speculators.  These speculators are only in Bitcoin because they expect a certain ROI.  When this fails to manifest, (and the supply of new speculators into the economy is limited and will be exhausted) then the bag holders will sell.  When they all sell off, we will drop until we reach the next level of support below the speculators, the miners.

The miners each have a break even price under which they will be mining at a loss.  (most of them are around 150-180USD).  If the price drops below this, then miners will soon have to switch off mining rigs.  As miners start to lose enough money, new mining projects are put on hold, and investments dry up. As investment money starts looking elsewhere to park itself, other competing projects (like private blockchains etc) start making progress, and further reduce the speculative value of Bitcoin due to reducing the expected payout of a Bitcoin business or play.  If this happens enough, then you start to get the third and final constituency affected, the holders.

The holders/hoarders bought in at a low price, back when being in Bitcoin was all about being rebellious and a crypto-phreak.  Their entry into the market was around the 10-100 dollar mark.  If these levels are breached and they start selling off their holdings, that would be the end of Bitcoin.  The network effect will have successfully unravelled.

This is why no other crypto today can successfully break above the 10 USD level, it is because all the people needed to fuel that rise are currently still heavily invested in Bitcoin.  But if miners started to switch off, and investments start to wane, then even they will start to look to buy into some other crypto project.  Incidentally this is why we can never “reset” the mining economy in bitcoin (and why we would never want to!) the mining economy represents a large portion of the ‘actual businesses’ dependant on a healthy Bitcoin network.  To get rid of them (say by changing the PoW algorithm to something more GPU-friendly) is suicide.

So you see, we are not out of the woods yet.  In order for Bitcoin to reach a stable orbit, we need that last stage of the rocket booster to fire, we need its component value as a medium of exchange, or a unit of commerce to grow, at least to match that of the other factors.  No money in the history of man made it to global acceptance without first being universally recognized as a acceptable means of exchange.  One only has to look at how gold or silver is universally accepted but platinum is not. (platinum was never universally accepted in any society as a common means of exchange).

Until we reach that point, Bitcoin is still susceptible to failure.  Not from government or network attacks, but it’s own failure to establish itself as a medium of trade between people.

*I don’t remember who said this exactly, but I have a feeling it was Andreas Antonopoulos
Where do these numbers come from??? Good question. They are guesstimates. The hoarders generally ranged around the price of BTC before 2012, the miners trigger price is from mining insiders profitability numbers in China, the rest up to current daily close price is assumed to be the speculator valuation (I believe in efficient markets) the dark markets one is a guess only. But as I don’t believe we can rely on dark markets being the only use of Bitcoin upholding the economy I am happy to wait for better data. Estimated sales using Bitcoin is less than 10 million a year given Overstock only made 3million in sales.  I will update the numbers as the year goes on.

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