You have to distinguish between market value and intrinsic value — and cryptocurrencies have no intrinsic value.
The best (and worst) thing about blockchain technology is that it’s free, which means anyone can create a coin out of thin air, name it whatever they like and start using it to trade with other people.
It’s hard to go a day without someone asking me a question about bitcoin.
What is it? Why is it so valuable? Should I buy some? How do I buy some? The guy down on the corner in the pawn/gold exchange shop said he could buy me one. (Yes, this is actually happening!)
It seems bitcoin BTCUSD, -1.81% and the cryptocurrency craze has truly reached the mainstream, and the implications of that are unknown. What we do know is that it’s attracting every shady crook and scam artist in the world. And why not? There’s tons of money to be made. I hope the following column sheds light on what bitcoin is and isn’t.
Let’s start our discussion with the technology that made bitcoin possible. It’s called “blockchain.” In simple terms, blockchain technology is a record of all transactions ever done in bitcoin. Imagine a gigantic piece of paper that lists every transaction ever completed. Then imagine that there are thousands of copies of this paper, and all of them are automatically updated when any two people agree to exchange bitcoins. Every time a transaction takes place, all these copies are checked for consistency to make sure you actually have the bitcoins you claim to have. If everything checks out, the new transaction is added to all the pieces of paper at once.
This is the heart of the genius idea that is blockchain, and what makes it possible to have certainty over a bitcoin balance someone owns, without needing any central party (such as a bank) to verify it. If all the pieces of paper agree, then the balance is correct, and trying to doctor or fake all the pieces of paper at once is impossible. The best (and worst) thing about this technology is that it has been made available for free to anyone who wants to use it.
Bitcoin is simply the oldest known use of blockchain technology. Someone, a long time ago (in technology terms), decided to create a coin called a “bitcoin” using blockchain and started trading it with other people. This was quickly picked up by all types of criminals as a way to exchange money without having to go through a bank. Fast forward a few years, and everyone and their mother wants to own one because they saw it on TV.
Cryptocurrencies, or e-coins
The best (and worst) thing about blockchain technology is that it’s free, which means anyone can create a coin out of thin air, name it whatever they like and start using it to trade with other people. It literally takes less than 24 hours to do so for someone with mediocre tech skills. The only difficult part is convincing suckers, er sorry, I mean lovely people, that the coin you created is worth something. This simple fact has led thousands of scam artists throughout the world to create their own coins and sell them to unsuspecting retirees and “I wanna get rich quick” targets.
You may have heard there is a limit to the number of bitcoins that can be created and, therefore, the supply is limited, which, in turn, is used as a justification for its price. For a number of technical reasons, this is true. However, there is absolutely no limit to the number of cryptocurrencies that can be created.
Have you heard of bitcoin cash? How about bitcoin gold? Bitcoin silver? Ethereum? Litecoin? There is an even a Dogecoin, as in Doge-coin. I am not kidding; Google it. It was created as a joke, and it now has a $700 million market cap. Yup, they all exist, 1,365 different coins as of last count, and thousands more will be created as long as people are willing to throw real money at them. So much for the “you can’t make more of it!” argument.
Intrinsic value vs. market value
How is it possible that something so easily created and with nothing to it other than a name and a story can be worth so much money? It all comes down to the difference between intrinsic and market value.
Market value is simply determined by the difference between supply and demand. If demand exceeds supply at any point, the price will go up, and vice versa. You can easily observe this “in the wild” each Christmas. A few years ago it was the PlayStation 4 that was bought up by “investors” and resold at ridiculous premiums to desperate guilt-ridden parents wanting to make up for not being around all that much. The PS4’s sticker price was $500, but on eBay EBAY, +1.62% they were selling for well over $2,000. The demand for PS4s far exceeded supply during that Christmas period.
Fast forward to 2017, and PS4s are on sale for $299.
Has the PS4 changed since that $2,000 Christmas? The answer is, of course, no. So why is it so much cheaper? It’s because fewer people are competing to buy a far larger supply of PS4s on the market. The PS4’s market value has changed drastically, but its intrinsic value has moved very little.
Gasoline has intrinsic value because you can burn it to move your car. In turn, your car has intrinsic value because it can move you from place to place. Your stock holdings have intrinsic value because they are expected to eventually pay you dividends. Your home has intrinsic value because you can sleep in it, and it can keep you warm and dry. Your dollars have intrinsic value because the government guarantees you can pay taxes and buy government services with them.
The intrinsic value of anything is simply the tangible value it provides, and may or may not equal the market value at any one time. A good way to think about intrinsic value is as a floor to the value of any object. If the market value falls below that floor, enough people will simply choose to use the object rather than sell it, since they get more value out of keeping it. This, in turns, reduces supply and increases the price back up to intrinsic value.
If there is a sudden interest in a product, the market value often goes far above the intrinsic value, and then settles back down once the hype dies down. Thus, financial bubbles of all kinds are born.
In some cases, calculating intrinsic value is fairly easy (bonds, loans, mortgages, investment real estate), and in other cases it’s much harder (new technologies, your own home, time spent with family).
The good news is that calculating the intrinsic value of bitcoin is extremely easy.
Let me get my calculator out — drum roll, please — it’s exactly $0!
It’s essentially the same thing as printing your own fraud-proof monopoly money. Should people stop wanting to buy your monopoly money, the only intrinsic value it would have is a certain bathroom function, which is still more than you can do with an e-coin.
Coins vs technology
Investors usually disagree on the intrinsic value of something, and bring up arguments about the future potential of a technology to justify valuation. However, remember, bitcoin is not a technology; it is an electronic piece of paper with transactions listed on it. Just a bunch of 1s and 0s in a bunch of computers backed by absolutely nothing. Blockchain itself is a valuable technology freely available to anyone. However, you are not buying blockchain when you buy bitcoin; you own none of the tech behind it.
To illustrate, imagine someone had found a cure for cancer and posted the step-by-step instructions on how to make it online, freely available for anyone to use. Now imagine that the same person also created a product called Cancer-Pill using their own instructions, trademarked it and started selling it to the highest bidders. I think we can all agree a cure for cancer is immensely valuable to society (blockchain may or may not be, we still have to see). But how much is a Cancer-Pill worth?
Initially, with no one else making cancer-curing pills, and people hearing about the trademarked name, it’s likely that the profits would be large, and the price of the pill ridiculously high. However, as the money flows in, another person would without a doubt create a pill using the same freely available instructions and call it Cancer-Away. Cancer-Away may not initially be as recognizable as Cancer-Pill, so it might fetch a smaller price, but eventually both prices would converge as they are essentially the same thing. Over time, with more and more cancer-curing pills with different names arriving on the market, the price of all of them would converge to something very close to the cost of production (i.e., materials + time to make it). I think we can all agree this is a good thing, as it means the maximum number of people will be able to cure cancer at the lowest possible price.
How does this apply to bitcoin? Well, bitcoin is simply the initial Cancer-Pill, but as mentioned above there are now 1,365 different “pills” in production — and counting. While creating a cancer pill, even with step-by-step instructions, would require some materials, equipment and incur some costs, the production of a random generic e-coin costs pretty damn close to $0. All you need is a website and some hype.
The bottom line is that while a cancer pill would be valuable, it would not be a good investment to buy up the pills for far above the cost of making them, if the formula for making them is freely available to anyone. Similarly, buying bitcoin, or any other e-coin, is a bad investment even if you truly believe blockchain technology will change the world.
It’s amazing to see all those coins get created and their “inventors” claiming theirs is for some reason a slightly better version of blockchain, and then selling you the damned coin instead of the supposedly superior tech! Next time you see one of these guys on TV, notice how deftly they switch between the term “coin” and “blockchain,” creating an illusion that it’s all the same thing. Believe me, those people know exactly what they are doing.
So is it all just a pile of poop?
No, not at all, the technology used in creating bitcoin is great. However, at this time, I’m not aware of anyone offering a good practical use for it. The problem with the current crop of e-coins and blockchain applications is easy to illustrate.
Imagine a world where only bitcoin exists, and you are going to buy some milk. What would be the price printed on that milk carton?
1 BTC? Or 1.5 BTC Or 2 BTC?
Aside from the fact that, at current prices, this would be some seriously expensive milk, the answer is that no price could be printed. That’s because if a price was printed, a poor grocery employee would have to sit there with an eraser and pencil, and every minute or so change the price. And then by the time you got to the cash register, the price would have changed again.
The point is that a real currency’s primary “intrinsic” value is as a medium of exchange or a measuring stick for value. If a centimeter or inch on a measuring tape were constantly changing in physical size, it would not be particularly useful to ask for a six-inch sub. It might end up being the size of an airplane.
The thing that makes cryptocurrencies such a speculative craze, their stratospheric increases in value, is also the reason the current crop will likely fail in their intended use as currencies. However, out of the ashes of that, it’s likely that a new use of blockchain will emerge. The decentralized fraud proof ledger might be used to keep track of balances in another exotic currency called the Canadian or U.S. dollar or euro.
On that note, if you still want to invest in e-coins, I would like to invite you to buy my brand new UB coin for only $1 per coin. I don’t have blockchain up yet, but I’ll keep track of all your purchases in my Excel, and the second I hit 2,000, I’ll spend two days to get the blockchain up and running. It’s your opportunity to get in on the ground floor before it’s worth $10,000 per coin!
Ah, sometimes I wish I had looser morals ...
~ Contributed by The Unassuming Banker, an unnamed CFA charterholder and blogger. Published: Jan 10, 2018 8:47 a.m. ET.