To value something we have to first define what it is and what it isn’t. And in the case of cryptocurrencies’, this is not exactly easy. Let’s start with the obvious. Bitcoins, ethereum, Litecoins, and the hundreds of other crypto tokens are typically thought of as currencies, as their names imply.

But what makes a currency? And do these crypto tokens check the mark?

A currency is measured by how well it functions as two things:

  1. Medium of Exchange: Currencies exist to make transactional commerce possible. This means that the currency needs to be accessible, transportable, and fungible in that it’s accepted by large amounts of buyers and sellers as legal tender.
  2. Store of Value: Currencies have to act as a reasonable store of value. Meaning, buyers and sellers need to feel comfortable keeping a certain amount of their wealth in it, knowing it will retain its purchasing power.

Let’s start with cryptos as a medium of exchange. We’re going to focus on bitcoin, since with a market cap of $100B, it’s the most popular of all the cryptocurrencies.

Here’s NYU Professor Aswath Damodaran on bitcoin as a medium of exchange:

The weakest link in crypto currencies has been their failure to make deeper inroads as mediums of exchange or as stores of value. Using Bitcoin, to illustrate, it is disappointing that so few retailers still accept it as payment for goods and services. Even the much hyped successes, such as Overstock and Microsoft accepting Bitcoin is illusory, since they do so on limited items, and only with an intermediary who converts the bitcoin into US dollars for them. I certainly would not embark on a long or short trip away from home today, with just bitcoins in my pocket, nor would I be willing to convert all of my liquid savings into bitcoin or any other cryptocurrency. Would you?

There are a number of reasons why bitcoin has failed to make large inroads as a medium of exchange. One reason is that as the tech stands now, it’s a costly and timely transaction process compared to the available alternatives.

Here’s BofA again:

The problem with bitcoin as a peer to peer payment system is that it’s expensive, relative to conventional alternatives. This comes from the mining process. Mining isn’t a zero sum game. The economics of mining are pretty simple. There is a fixed reward per block mined. At present, each block generates 12.5BTC. So, each block mined produces in Dollars around 12.5*bitcoin/dollar rate. At present, this is around $60k per block. This is a function of the bitcoin price. There are roughly 2000 transactions in a block, give or take. This implies that around $30 of bitcoin are created per transaction at present. Economically, we would regard this as a cost of the transaction, although this is not how people always view it.

Miners need to be paid because the cost of mining (of applying CPU to blockchain hashing) is becoming prohibitively expensive. It requires enormous and increasing amounts of energy. The chart below demonstrates such:

The electricity being used to mine bitcoin is now equivalent to the amount it would take to power over 1 million US homes!

Or to put it another way, the total energy consumption of the world’s bitcoin mining activities is more than 40 times that required to power the entire Visa network. The annual energy consumption is equivalent to 13,239,916 barrels of oil!

Not only are the costs of transacting and running the network absurd, but the speed at which transactions are processed are extremely slow. BofA lays out the problem:

To illustrate, Visa’s payment system processes 2,000 transactions per second, on average, and can handle up to 56,000 per second, if needed. Assuming similar transaction handling capabilities at other large payment schemes such MasterCard, UnionPay, AliPay etc, total digital payment transaction volume in the retail space can be an order of magnitude higher than the aforementioned 2,000 transactions per second. Assuming 20,000 retail transactions are processed every second, it would take about 100 minutes for one second’s worth of transactions to be recorded on the bitcoin blockchain.

Lastly, due to the astronomical rise of bitcoin and other cryptos over the last few years, the tokens have drawn quite a bit of attention. This has created a speculative fever where the tokens are not being bought for their value, or as a means to transact, but rather as a gambling vehicle used to bet on further price gains.

It’s a momentum driven market where everybody’s chasing returns. And that creates an issue because people don’t want to be like Laszlo Hanyecz and spend their bitcoins on a stupid Hawaiian pizza when those bitcoins could be worth many multiples of what they are today.

This creates a conundrum for cryptos. As Aswath Damodaran puts it, “It remains an unpleasant reality that what makes crypto currencies so attractive to traders (the wild swings in price, the unpredictability, the excitement) make them unacceptable to transactors.”

So bitcoin fails (currently) to meet the requirements of a proper medium of exchange.

What about store of value? Are cryptos a fiat currency similar to the US dollar, as many crypto fans proclaim?

Here’s economist Brad deLong’s take:

Underpinning the value of gold is that if all else fails you can use it to make pretty things. Underpinning the value of the dollar is a combination of (a) the fact that you can use them to pay your taxes to the U.S. government, and (b) that the Federal Reserve is a potential dollar sink and has promised to buy them back and extinguish them if their real value starts to sink at (much) more than 2% / year (yes, I know).

Placing a ceiling on the value of gold is mining technology, and the prospect that if its price gets out of whack for long on the upside a great deal more of it will be created. Placing a ceiling on the value of the dollar is the Federal Reserve’s role as actual dollar source, and its commitment not to allow deflation to happen.

Placing a ceiling on the value of bitcoins is computer technology and the form of the hash function… until the limit of 21 million bitcoins is reached. Placing a floor on the value of bitcoins is… what, exactly?

Bitcoins lack the essential qualities to make it a viable medium of exchange and store of value. Hence they can’t and shouldn’t be thought of as currencies or valued as such.

The things that make bitcoin a libertarian’s wet dream such as its decentralized nature and the fact that no one has control over the system, also means that it doesn’t have any true intrinsic value.

 

Its value is based completely off of people’s beliefs… and more importantly, people’s beliefs about other people’s beliefs.

Crypto fans call this the network effect — which is a term used to describe companies whose values increase the more people use their products, like Facebook. But this is a limp comparison.

Network effects when applied to tech companies are important because they lead to greater earnings power and value creation — the more people use a social network, the more others want to join, and the more advertisers will pay for access to the network and so on.

Real network effects actually create more value for the owners of the company and users of the product.

 

Bitcoin doesn’t sell anything and doesn’t produce any cash flows. It’s a non-currency that doesn’t quite work as a medium of exchange or a store of value.

 

It’s “value” is based purely off the beliefs of those who buy it. And this belief is that bitcoin is valuable because other people think it’s valuable. “If I buy it now, I’ll be able to profit at a later date by selling to somebody else”.

In trading parlance, this is called “Greater Fool Theory” or GFT.

Wikipedia explains GFT as:

The price of an object is not determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems “foolishly” high because one may rationally have the expectation that the item can be resold to a “greater fool later.”

The Oracle of Omaha, Warren Buffett, agrees.

He calls bitcoin a bubble, stating “You can’t value bitcoin because it’s not a value-producing asset”. But “people get excited from big price movements, and Wall Street accommodates” making bitcoin a “real bubble in that sort of thing”.

Maybe bitcoin should then be thought of as equity in a pre-revenue biotech startup. A startup with no leadership (it’s decentralized), no product yet of intrinsic value, and a growing number of nearly identical competitors entering the market every single day.

But the shares of the 1,000+ various cryptocurrencies have a total market cap of $176B and growing. New shares are being issued every single day. Many, some, or maybe none, will eventually create intrinsic value somehow… but nobody knows exactly how quite yet.

A better comparison of how to think about bitcoin’s value might be trading cards (think Magic or Pokemon) or in-game artifacts like a flaming sword in World of Warcraft (I don’t know if the flaming sword is a thing but let’s pretend it is).

Unlike a pre-revenue startup that may produce actual value someday, trading cards and in-game artifacts only have value because they have devoted fans and there’s a false scarcity of these objects injected by their makers.

Neither of these have intrinsic value of any sort, but they have a price that fluctuates according to their popularity. So yeah, that’s a better comparison. Bitcoins are like a $6,000 Pikachu card.

Do you want to buy some bitcoin now?

Summary:

  • Bitcoin is neither a good medium of exchange or a good store of value, making it a terrible currency
  • Bitcoin is “valued” purely through its popularity and Greater Fool Theory — making it more similar to a Pokemon card than a real currency
AK has been an analyst at long/short equity investment firms, global macro funds, and corporate economics departments. He co-founded Macro Ops and is the host of Fallible.