Gauging the 'real' value of bitcoin

The theoretical rationale underlying market-determined exchange rates is that markets are efficient in pricing assets taking account of all “fundamentals”. One example of how questionable the assumption of fundamentals determining asset prices is of course gold, a metal with few usages (except for making ornaments) and little intrinsic value based on fundamentals and yet valued a hundred times more than steel, aluminum and copper, all metals far more useful for economies. Another one in the news lately is the bitcoin, an artificial currency.

 

Bitcoin is a digital currency, described as a peer-to-peer version of electronic cash, which would allow online payments to be sent directly from one party to another without going through a financial intermediary. It was invented eight years back, but awareness at the mass level is a matter of only the last few years. Bitcoin transfers take place by means of a computer-generated string of “0”s and “1”s (a computer does not “read” anything else in any case), which transfer bitcoins from one wallet (or account) to another, the accounts being maintained on a giant electronic ledger. The wallets are anonymous. Each string of numbers can be used only once (comparable to each currency note having a unique number?). The anonymous holder of the wallet can be anywhere in the world, thus making bitcoin a truly global, if electronic, currency: Transaction costs are negligible to zero.

 

A user needs to install a bitcoin “wallet” on his computer or mobile phone. The wallet generates an “address” on which bitcoins can be paid in, or paid out (the latter only if you have adequate balance in your wallet). All transactions are included in a “blockchain” whose integrity and chronological order are protected by cryptography. The wallet can be stocked by purchasing bitcoins on an “exchange” for real money. The price of bitcoins has been extremely volatile — ranging from a few cents at the start to over $4,000 currently. The number of bitcoins in circulation is limited to 21 million. But each bitcoin can be traded or transferred in fractions, as small as 0.0005. At the current valuation, the market capitalisation of bitcoins is $50 billion.

 

Perhaps, the simplest conceptual parallel to bitcoin transactions is shares of a company traded on an exchange through demat accounts with which we are all familiar. The “ownership” and transfers are evidenced only by entries in the giant ledger of the National Securities Depository Ltd. Other similarities:

  • The number of shares of a company outstanding at any time is limited, as is the number of bitcoins;
  • The price is determined by demand and supply on exchanges, so is that of bitcoins.
  • Some start-ups wishing to develop and market a new cryptocurrency are raising capital not through initial public offerings but initial coin offerings, where the investor pays traditional money and receives a certain allotment of the new cryptocurrency. 
There is one major difference between shares and bitcoins: Equity shares represent a claim on the assets of the issuer company, while bitcoin has no intrinsic value. But neither does gold, and yet gold was the standard medium of exchange for a long time, in both domestic and cross-border transactions. (John Maynard Keynes once characterised gold as a barbaric relic of human irrationality.)

 

As of now, only a very limited number of sellers of legitimate goods and services accept payment in bitcoin, which today is more a speculative asset than a medium of exchange. The US Revenue Department has ruled that bitcoin is property (or asset), not currency, and regulators have permitted bitcoin futures to be traded on an exchange. And, there are bitcoin investment funds.

 

Bitcoin is not the only cryptocurrency, like gold being just one of the “precious” metals — the newest is bitcoin cash, bitcoin’s offshoot, although bitcoin is by far the largest being traded. In yet another parallel, just as gold has been traditionally used for hiding undeclared wealth, for the last few years bitcoin is in demand for illegal trades, in drugs, for example, though its use as a means of exchange also seems to be growing. Both Visa and Master Card are offering to exchange bitcoins for real money.

 

The prices of precious metals and cryptocurrencies suggest that the value of an asset is what somebody is willing to pay for it — and has little to do with fundamentals. As for the current price of bitcoins, remember the dotcom boom in the 1990s?
The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com

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