Life on Bitcoin

Bitcoin went on another massive price run yesterday, hitting an all-time intraday high of $328 on the Mt. Gox exchange, and closing the day at $310, up nearly 17.5 percent. Today, it’s already up another 11 percent to $344 (as of 8am PST). There’s no single explanation for the massive rise, other than more people apparently believe that the price of bitcoin will continue to go up than go down. In other words, it’s speculative.

A more interesting question to ponder, however, is whether bitcoin is in a bubble that is bound to pop, or is the price appreciation healthy and sustainable based on its link to gains in the general awareness and desirability of the cryptocurrency as a value store? There are strong cases in both regards.

For historical context, the last time bitcoin went on a massive run up in price over a short time was in April 2013, when it ran up from $30 to more than $260 over a five-week period. The bulls who were screaming bubble from the rooftops at the time were seemingly proved right when the market crashed back below $70 in a matter of days. However, that massive “correction” was largely the result of a string of DDOS (distributed denial of service) attacks around that time that threatened to shut down Mt. Gox, then the world’s largest exchange.

But bitcoin has survived that and several similar systemic shocks since, including the Department of Homeland Security seizures of Mt. Gox’s US bank accounts and the FBI shutting down the bitcoin denominated online black market, Silk Road. Mt. Gox was even surpassed as the world’s largest bitcoin exchange by China’s BTC China and Slovenia’s BitStamp. In other words, the bitcoin market seems far less susceptible to a single point of failure than it once was.

One argument put forth yesterday by bitcoin bears — those who believe it is a bubble — is that the run up in bitcoin prices occurred as there was a decline in trading volume, perhaps attributable to the absence of Silk Road. Such a disconnect between price appreciation and trading volume is often viewed as a sign of unsustainability in more traditional stock and commodity markets. But while transaction volume is down, dollar value transaction volume is actually up, meaning that fewer trades are happening but they are growing larger in size. In other words, people are making massive bets that bitcoin will continue to go up in value. This same phenomenon was observed in the April run up.

For an overall sense of the bitcoin market, we can turn to The Federal Reserve Bank of Chicago  which released a report noting that there are now approximately 30 transactions conducted each minute (compared to 200,000 Visa transactions per minute), at an average amount of 16 Bitcoins, or $2,000 (compared to visa’s $80 per transaction). In other words, it’s still a relatively small market, but its a non-trivial one that continues to grow.

Another interesting quality of the bitcoin market is there is no “short pressure.” This means speculators can’t sell bitcoin they don’t own, or purchase derivative instruments to that effect in an attempt to bet that the price will fall in the future. Those who don’t believe in bitcoin must simply sit on the sidelines and observe.

Bitcoin is an unusual hybrid of a currency and a gold-like commodity. As a currency, rapid fluctuations in value, even when they are moving up, is generally considered a bad thing. People transacting in a currency rightly fear instability. Spending 10 bitcoins on something that the next day, or several days later, would only cost five is not a situation that instills confidence in the consumer. In other words, even if the price only moves up, rapid fluctuations in the value of a currency can be a bad thing. Inversely, selling something for 10 bitcoins and having them worth only half as much the next day, or several days later, is a terrifying proposition. So rapid declines aren’t much better.

But only a fraction of bitcoin transactional volume today is centered around commerce. There are many people trying to change that, including small businesses that now accept bitcoin as a method of payment – often as a marketing stunt – and the broader infrastructure players like bitpay that hope to see every business in the world accept bitcoin. That said, bitcoin commerce today is largely a novelty.

If bitcoin is viewed as a commodity like gold and used for storing value, however, then the picture is less clear. The total value of all bitcoins outstanding is more than $4 billion. But this is just a small fraction of global wealth, which is measured in the hundreds of trillions of dollars. Those arguing the bull case for bitcoin say that, as more people realize its potential to act as a borderless currency, independent of governmental or central bank manipulation, and free from global transaction fees, then more people will choose to hold their wealth in this asset class. And because the number of bitcoin in circulation is fixed based on a mathematical formula, this increase in demand opposite a fixed supply will naturally send the price upward.

As ConvergEx Group chief market strategist Nick Colas wrote in a note to clients earlier this week:

In the 4-ish minutes it has taken you to read this far, the most new Bitcoins that might have been issued is 25, or $6,250 [$8,500 at today’s prices]. In the same timeframe, the Federal Reserve has pushed another $7.8 million into the financial system with Quantitative Easing.

AngelList founder Naval Ravikant made a case for the power of the bitcoin currency in a Wired magazine article, writing:

Bitcoins are scarce (Central Banks can’t inflate them away), durable (they don’t degrade), portable (can be carried and transmitted electronically or as numbers in your head), divisible (into trillionths), verifiable (through everyone’s block chain), easy to store (paper or electronic), fungible (each bitcoin is equal), difficult to counterfeit (cryptographically impossible), and can achieve widespread use – many of the technologists that brought us advances on the Internet are now working overtime to improve Bitcoin.

The price of a bitcoin is affected by many things including macroeconomics and human psychology, but its level of adoption has far and away the most important effect on its price today. We have seen exactly this scenario play out in the market over the last 9 months where, save for the April crash, the price has steadily risen nearly tenfold as global bitcoin awareness and adoption has grown. Viewed on a logarithmic scale, which is used to display exponential growth rates like viral adoption of a social network, and the rise in bitcoin prices looks rather steady and predictable. It’s reasonable to expect this phenomenon to continue until saturation approaches and the curve slows then starts to level off.

The use of bitcoin as an alternative to unstable local currencies in markets like Argentina, Greece, and across Africa is widely documented. The more widespread this phenomenon grows, and thus the broader the adoption, the higher the value of a single bitcoin will climb, again due to its fixed supply.

Much of the world is still discovering bitcoin today. Others are for the first time getting off the sidelines and dipping a toe in the digital currency world. It would be foolish to expect that the price of bitcoin will continue to rise indefinitely, or that its trajectory will be entirely stable and devoid of major spikes and falls. But there’s a compelling case to be made for why Bitcoin at $340 is not wholly irrational. It’s no more irrational, for example than Google stock was at $600 per share less than two years after its IPO at $85 – after all, it took the company some time to grow into that valuation, and there were corrections along the way. But nine years later, it now trades near an all time high at $1,017 per share.

The bitcoin market may have raced to this point at a more rapid clip than it can sustain, and thus we may be in store for a correction in the coming days and weeks. But when that correction comes, it shouldn’t be viewed as evidence that bitcoin is a bust. The global market for this alternative currency is as large and mature as its ever been, as evidence by the way it’s responded to recent systemic shocks.

Don’t be surprised if you wake up one day in the future and see bitcoin trading at $400 or $500. Similarly, don’t be surprised if your mother-in-law tells you over Thanksgiving dinner about the speculative bet she made in cryptocurrency.

This is a brave new world, and burying your head in the sand is no longer a viable option.

[Image via Life on Bitcoin]