What Gives Cryptocurrencies Their Value

The value of cryptocurrencies like bitcoin, just like any other kind of money, comes fundamentally from what you can do with it. As a follow up to What Backs Bitcoin, I want to dig into that value.

The idea, which comes from Austrian economist Carl Menger, is that just as a shovel’s value comes from its ability to dig, a currency’s value comes from its ability to help you do two things: transactions and savings.

Think of transactions as the money you carry in your wallet or checking account, and savings as the rest of what you have in the bank or buried in the yard. It’s worth mentioning here that that vast majority of money demand is indeed savings, making up 90% or more of all money demand.

The reason this matters is because if we know what transactions cryptocurrencies are good at, we can estimate how much money demand they’ll start pulling from fiat or gold, and therefore how much those cryptos will increase in price.

For transactions, some features that matter are cost and speed of transaction, anonymity, reversibility, counter-party risk, regulatory treatment. For savings demand, those factors are overwhelmed by the specific question of how well the currency keeps its price.

Supply and Demand Determine Price — Always

Price, as always in economics, is simply a matter of demand and supply. When demand is rising faster than supply, the currency will go up in price. And if demand is rising slower than supply, price will go down.

Since bitcoin was born in 2009, it has generally enjoyed demand rising much faster than supply, hence price has soared. While the US dollar, say, has gone down — has “price inflated” — because demand failed to keep up with dollar creation.

Those are the features, now what are the applications: what are people using money for?

When we’re looking at a currency’s price, because we’re looking at total demand we don’t care about the number of transactions rather the total amount transacted.

And here, the vast majority of money moving around in the economy is not goods and services — buying a cup of coffee, or a plane ticket — rather financial movements. Paying salaries, buying and selling stocks or bonds, investments and dividends. These occur mostly by bank transfer, which account for 80% of all money moved in the US. Another 15% goes by check, leaving just 3% for credit or debit cards, and 4% for paper cash.

Bitcoin Still under 0.01% of Global Transactions

A final part of the puzzle, what’s the competition to cryptocurrencies? Most money payments worldwide are, of course, denominated in fiat currency like dollars or yen — about 99% by amount. With the remaining 1% made in gold.

Note that fiat has both physical and electronic forms, such as credit cards and bank transfers. Even gold payments can be made with paper rather than physically moving the gold, including gold-based securities that trade in financial markets (so-called “paper gold”).

Now we’re ready to go through those features for each currency. On cost and speed of transaction, bitcoin’s fees nowadays average about $1, and don’t vary by amount you transfer.

You can send one bitcoin, worth $5,000, or 1,000 bitcoins, worth $5 million, and the fees are still a dollar. In contrast, banks typically charge a percentage of the transaction, which adds up on million-dollar transfers. Meanwhile, on speed bitcoin is much faster than banks; between 10 minutes and an hour to confirm a transaction, while banks take days.

So bitcoin beats on the most important application of money: financial transfers. The one caveat here is exchange costs. Just as you pay fees and spreads when you exchange your dollars for yen, every time you convert dollars into bitcoin you’ve got to pay fees and spreads.

This means that bitcoin’s low fees only really dominate if both the sender and receiver are keeping the money in bitcoin.

Bitcoin’s Exchange Rate Woes

On the other hand, if you have a bunch of dollars and want to buy a house from somebody who likes to keep dollars in the bank, then you’ll have to convert your dollars into bitcoin, send the bitcoin for a buck, then the other guy converts the bitcoins into dollars again. You saved on the transfer itself, but you had to exchange the money twice.

So, bitcoin as a technology is superior for the main type of transaction by value, but in reality that advantage is eroded if people are keeping their wealth in fiat. This isn’t really a flaw of cryptocurrencies per se, it’s just a standard penalty suffered by any minority currency — having to pay for conversion into the dominant currency.

To finish up on cost and speed, obviously physical cash or physical gold are fantastic on both cost and speed, but only if buyer and seller are touching each other. Given paper cash has only a 4% share today, touchable buyers and sellers is a very small part of demand.

For remote orders, then, bitcoin carries lower fees than credit and debit cards, but again with that double-exchange problem unless both buyer and seller are staying in bitcoin.

Bitcoin’s Potential to Outperform

Next up are some secondary benefits: anonymity, reversibility, counter-party risk, regulatory treatment.

Briefly, bitcoin is nearly anonymous unless the US government cares enough about you to put some serious people on you. In this sense it’s essentially like using cash, but with the advantage you can use it over long distances with those low fees.

In practice, the closest alternative is probably a pre-paid debit card that you buy at 7/11, which can cost several dollars in addition to the merchant fees, and isn’t going to work for large amounts nor overseas.

As for reversibility, the question is whether the buyer can cancel his payment. A problem for online vendors who get scammed by people who buy the product, get it in the mail, cancel the order and keep the goodies.

Credit card companies or Paypal famously always side with the customer, which can suck for the honest vendor getting ripped off online. Bitcoin, again like cash, is irreversible once it’s confirmed — so about 10 minutes to an hour. That’s slower than cash, but faster than Paypal or credit cards where buyers can reverse months later.

Fourth characteristic is counter-party risk; the idea that your bank could go under, taking your money with it. Remember bitcoin was invented in the wake of the 2008 financial crisis, where bank failures were common.

Because bitcoin is distributed across many computers and isn’t managed by a central organization, it has no single point of failure. On the other hand, cryptocurrencies do still have potential technical glitches that probably more than make up for that risk.

Regulation: Not If but When

Finally, regulatory treatment. This is where we’ll probably see a lot of change over the next couple years, as governments digest cryptocurrencies like bitcoin.

So far cryptos have enjoyed mostly benign neglect from regulators; tolerated, neither discouraged nor encouraged. On the bright side this has meant little regulatory burdens or fees, although this is changing in places like New York.

On the down-side, this regulatory grey-zone has meant a lot of companies and institutional investors are afraid to use, or even to buy, bitcoin. So increasing regulations could actually boost bitcoin demand, as those regulated users become unafraid to play.

As for what happens in the future, countries are gradually drifting into two camps: broadly enthusiastic (Japan, Dubai, Taiwan, Switzerland), broadly skeptical (China, Korea), with the USA and European Union still lurching between the camps.

Cryptos: For now, Only for Adrenaline Junkies

Now, given how much savings dominate money use, the elephant in the room is would you feel comfortable keeping your life savings in bitcoin.

As we mentioned, the key point here is how its price will hold up, meaning will demand grow faster than supply. While bitcoin has knocked the socks off dollars or even gold, rising 800% in the past year alone, even this soaring growth has come with the major downside that bitcoin also fluctuates a lot — easily up or down 50% in a month.

However, as with any product, service, or medium of exchange, the value of cryptocurrencies will depend on the future choices of countless users and consumers — based on their subjective valuations of the currencies themselves. Those who can successfully guess what will become more valuable in the future will become wealthy. But risks always remain.