Bitcoin and cryptocurrencies are among the most discussed topics in finance blogs and newspapers.
In this post we will try to analyze its characteristics by discussing the positions of those who consider Bitcoin a real revolution in the world of finance in opposition to those who decline it to a mere speculative bubble.
Price is what you pay, value is what you get
To better understand the nature and characteristics of bitcoin let’s start by saying that not everything can be valued, but almost everything can be priced.
To understand the distinction between value and price, we would like to mention the Damodaran blog according to which each investment falls into one of the following categories:
Asset is an activity that generates cash flows (present or future).
The characteristics of the cash flows refer to their amount (with the same invested capital it is preferable to receive a higher cash flow than a smaller one), the time horizon (the earlier the better) and the risk (given the same amount and time horizon the less risky cash flow is preferable to the riskier one).
Some examples of assets are: properties, stocks, bonds, …
All assets have cash flows that can be assessed; therefore, assets with high cash flows and lower risks should be valued more than assets with lower cash flows and higher risks.
Assets can also be valued on a relative basis using the relative price as a standard for comparison. This typically takes place with shares for which price multiples are compared (PE ratios, EVs / EBITDAs, Price to Book or Value / Sales) in similar companies to identify those that are undervalued compared to others.
In this case, however, the analysis disregards the intrinsic value of the asset, it only tells us whether that specific asset has a relative price higher or lower than the others within the sample considered. However, an asset that is undervalued on a relative basis may not be in an absolute sense.
A commodity has value tipically related to its utilization as raw material to satisfy basic needs, be it energy, food or shelter.
In this case, the valuation is more difficult in view of the fact that commodities do not directly generate cash flows.
It is easier to determine the price instead , which depends directly on the dynamics of supply and demand in relation to the availability of the commoditiy itself.
A currency has 3 main characteristics: medium of exchange, method of payment and reserve of value.
Currencies can not be valued as they do not produce cash flows, it is only possible to determine a price compared to other currencies.
We do not want to enter into complicated macroeconomic theories, however we can simplify by saying that more widely a currency is accepted as a medium of exchange and maintains its purchasing power over time, the more it should see its price increase compared to currencies that do not have such characteristics.
In the short term, however, other forces may come into play in determining the relative price of a currency, including governments seeking to manipulate exchange rates.
Collectibles typically do not produce cash flows but often have a value linked to an aesthetic appearance (as in the case of a painting or sculpture) or an emotional aspect (a baseball card or a team shirt).
A collectible can not be evaluated because it too does not generate cash flows, but a price can be attributed to it as a function of people’s desire to possess it and its relative scarcity.
Investment or trading
Summarizing what we have just said, assets can be both valued and priced, commodities can be priced much more easily than can be valued, while currencies and collectible items can only be priced.
To invest in something, you need to calculate its value, compare it with the price and then act accordingly, buying if the price is less than the value and selling if it is greater.
Trading is a much simpler exercise, in which one bets on increasing or decreasing something within a certain period of time in the future.
You can succeed in both activities but keep in mind that these are 2 different games that require different skills, approaches and tools.
So, what is Bitcoin?
At this point the first step to understand the mechanisms underlying the investment in Bitcoin and its prospects is to try to define what is Bitcoin.
Bitcoin is not an asset, since it does not generate cash flows in itself, with the exception of any capital gain for those who bought at lower prices and now resells.
Bitcoin is not a raw material that can be used in the production of something useful.
It remains to be decided whether it is a currency (as its proponents believe) or a collector’s item (as its detractors claim).
Now let’s see if and how Bitcoin has the characteristics of a currency that we have listed above.
Bitcoin can be considered as a medium of exchange because the expectation / confidence on the possibility of using Bitcoin in other exchanges is linked to its intrinsic characteristics: scarcity, fungibility, incorruptibility, homogeneity.
Those features, unlike the “real” gold, are guaranteed by the technology on which it is based, the blockchain.
Does Bitocoin have a payment function? To date there are some realities that accept bitcoins as a means of payment but these are still too limited cases, moreover because of its volatility risks being inefficient in carrying out this function.
Precisely because of this volatility, it seems very difficult to attribute the function of value reserve to the cryptocurrency.
Long story short: at the moment, the Bitcoin can not be defined as a currency; rather it is a means of exchange.
In the future, however, things may change.
Scenarios for the future
In an extremely positive case, Bitcoin could become the global digital currency, gaining wide acceptance in transactions all over the world.
For this to happen, certain conditions must be met: it must become more stable (compared to other currencies), central banks and governments all over the world must accept its use (or at least not actively try to prevent it) and the halo of mystery that surrounds it must vanish.
Another possible scenario is that Bitcoin can not reach the status of digital currency but it becomes a safe haven like gold. Ironically, even the Bitcoin language is full of mining terminology. Moreover, the fact that the amount of Bitcoin is predefined and not incremental (21 million) is rather compatible with the scenario according to which Bitcoin will replace gold in the function of safe haven.
If this scenario develops, Bitcoin will eventually behave like gold, appreciating during the crises.
In the last scenario, the worst one, the Bitcoin could become the tulip of the 21st century, with its price that after having had a violent surge will be subject to an equally spectacular fall.
The limits of Bitcoin and the competition between cryptocurrencies
As mentioned, the real added value on which Bitcoin is based is its technology, represented by the Blockchain.
The blockchain is nothing but a record on which transactions are tracked. Each unit of the register is a “block”, and the blocks are linked together in the order in which they were created.
Blocks are connected using cryptography, which binds them in a virtually non-editable way.
The blockchain therefore have a double function that guarantees the security of the whole system: register transactions and make sure that the transaction is never canceled
How the Blockchain works – Business Insider
One of the reasons why it is so difficult to change blocks is that a blockchain is based on a widespread network of computers, which must approve all the changes that occur on their network.
This procedure is a sort of “consent”, and is considered one of the main advantages, regarding safety, of working on a blockchain.
On the other hand, this also represents one of the potential limitations of this system that makes transactions rather slow.
In terms of speed, Bitcoin has much lower performance than Ripple and Ethereum.
Bitcoin transaction costs are also significantly higher than other cryptocurrencies as well as potential scalability.
Therefore the real challenge of the future will be among the different blockchains to define what will be the most widespread.
Finally, there seems to be an energy problem as well.
Bitcoin “mining” – the process of generating new currency units by confirming bitcoin transactions on the blockchain – requires enormous computing power, which is used to solve the complex mathematical algorithms underlying the system.
The equations are so complicated that the devices that should solve them are enormously heated and seem to consume the equivalent of the electricity requirement of the whole Denmark!
It is hard to say with certainty what the fate of the bitcoin will be, but we must be aware of the scenarios and incorporate them into our investment strategies.
If you are oriented to short-term trading, you may not be interested in bitcoin evolution in a few years. Basically all you need is the price rising in a few days or weeks after you buy.
If you are oriented towards the long term, however, you must bear in mind all the implications related to the risks including the growth of other cryptocurrencies or the development of the underlying technology.