Bitcoin: Bubble or Boom?

This post was originally published on April 8, 2013 here @ p2pconnects.us

Lately, I’ve been receiving phone calls, text messages, and emails from friends, family, and clients who have been watching the price of the peer-to-peer currency Bitcoin skyrocket over the past few weeks. They’re asking if they should buy-in, and whether or not I think the “bubble” will burst soon. While I have no crystal ball which can predict the future actions of the billions of people on this planet, I do have reason to believe that we are not experiencing a bubble at all, but rather a quite sustainable boom.

To explain how I distinguish between a “bubble” and a “boom,” let me first define how I am using these terms:

Bubble: a period of unsustainable growth which will inevitably cause prices to “pop” and come crashing down to a more “natural” or “sustainable” level i.e. prices that market fundamentals can support long-term.

Boom: a period of rapid growth associated with a bull (buying) market, which can either level off to become the “new normal” or take on the characteristics of a bubble if the market fundamentals cannot support the higher prices.

In the Bitcoin market, the fundamentals are as follows:

  1. The number of bitcoins available
  2. The number of people in the market buying and selling bitcoins
  3. The security of the Bitcoin network
  4. The market’s understanding of the above factors and how they affect the price

Changes in either of these fundamentals will cause the price to go up and down.

1. The number of bitcoins available is *kind of* predictable. We know that the number of bitcoins that will ever be released by the software is hard-coded at 21 million (making it a scarce good that takes work to create, like gold), that around 11,008,375 are in circulation at the time this is being written, and that 25 coins are released every ten minutes as a reward for securing the network via a process called “mining.” This reward number halves every four years, and the last bitcoin is predicted to be mined around 2140. However, as solid as these numbers sound, they do not actually tell us how many bitcoins are being made available in the marketplace. Miners could keep the coins they have earned, and there is nothing forcing people who already have bitcoins to sell them. So in times like this, when the price is going up and up with no end in sight, many are holding on to their coins for dear life, in hopes that they will be worth more in the future. This could put a pinch in the market called a “liquidity shortage,” or more sensationally, a “liquidity crisis,” that must be resolved by an upward price correction.

2. The number of people in the bitcoin market is probably the most elastic of the fundamental factors, because people may enter and exit the Bitcoin market at any time and for any reason. The market size has gone from a small group of several hundred or thousand people when the software was first released to potentially millions of people now. Since every Bitcoin user can own multiple addresses and wallets, it’s impossible to be certain the exact number. However, we can use trade volume as a guide to show that, indeed, the market is growing and trade has been increasing greatly in tandem with the price.

3. The Bitcoin network itself is accepted by virtually all cryptography experts to be very secure, and unlikely to be broken any time soon. Even if methods for cracking the encryption that secures the Bitcoin network are discovered, developers could modify the Open Source software and push an update which fixes the problem. So consider the security of Bitcoin the “foundational fundamental” which ensures that bitcoins will always be worth something in the future, since a breach of the security will cause bitcoins to no longer be a scarce good and, correspondingly, worthless.

4. The market’s understanding of the above fundamental factors is the hardest to measure, but perhaps the most important factor when determining the price since the price is simply an expression of the market’s desire (demand) for a scarce good (supply). If the market does not understand why a product is valuable, then it is quite easy to convince some market actors that it is indeed not valuable. “Because the price is going up” is not a valid reason for why something is valuable, since the price could just as easily go down. A sell-off by one uncertain party may cause a panic as others begin to ask “why is this person selling for below market price? What do they know that I do not?”

What do these fundamentals reveal about the current rise in price for bitcoins, and do they answer the question of whether or not we are experiencing a bubble?

June 2011 saw a rise in the price of bitcoins from under $10 to over $30 in a matter of days, partially (if not entirely) fueld by a Gawker story entitled “The Underground Website Where You Can Buy Any Drug Imaginable.” Despite the focus of the article being the Silk Road website, the real star of the show was the means to purchase items from this mysterious market: a little-known cryptocurrency called Bitcoin. Fear soon set in as the market became uncertain about the sustainability of this rise, and prices fell within minutes to around $15, where they hovered for about a week. Then, major Bitcoin exchange Mt. Gox announced that they had been hacked, which caused a huge selloff, pushing the price down to near-$0.

What happened in June 2011 was a shaking of the 2nd and 4th fundamental. People who did not understand why Bitcoin was valuable panicked when the unexpected happened (a dramatic rise in price, followed by a large exchange being hacked), causing a sell-off which pushed the price down. These people were originally speculators who were intrigued by all of the press surrounding Bitcoin at the time, hoping they could cash in on the buying frenzy. They almost certainly did not understand the fundamentals that make up the price of Bitcoin, or they wouldn’t have been so quick to sell.

People who do understand Bitcoin’s fundamentals are therefore fundamentally different: they understand that Bitcoin as a payment protocol is extremely secure, which ensures that bitcoins will remain a scarce, valuable good. Even if the State cracks down on regulated merchants and exchanges, as long as people can buy illegal products, gamble, and trade stocks (but I repeat myself) with relative anonymity using bitcoins, they will still have value. Add to this utility the fact that bitcoins remain a decentralized, peer-to-peer currency which is very difficult to steal or counterfeit when proper security protocols are followed, and you have the makings of a robust global payment system that is here to stay.

After laying out the fundamentals and examining the causes of the previous Bitcoin bubble, we can now make an educated guess as to whether the current market is a “boom” or a “bubble.”

I believe that the fundamentals are much stronger this time around. The huge amount of news stories about Bitcoin, including the hit pieces, are more accurately describing how Bitcoin works and what makes bitcoins valuable. This is leading to an increased understanding of the fundamentals that make-up the price of bitcoins, which leads to people being more likely to hang on to their coins.

But wait – if people are hanging on to their coins as the price keeps going up, how will more people enter the market when no one is selling?

These questions lead to the point I made earlier about an “upward price correction.” Everyone has a selling price. Everyone. And if the Bitcoin market reaches deadlock, that price will be found. Because bitcoins are currently divisible to 8 digits past the decimal point i.e. to .0000001BTC (and this is an easy change in the source code of the Bitcoin software if need be), there are plenty of “satoshis” to go around for everyone. Even if the price of one bitcoin goes up to $1,000,000, commerce will continue, except we’ll be paying with micromillibitcents, or some other creative denomination, rather than whole bitcoins. The growing Bitcoin market will lead to less price volatility, as market movements will be less able to move the price very drastically. Instead of fluctuating several dollars per day, the price will eventually only fluctuate by fractions of a penny per day unless an early adopter with a massive store of coins performs a huge below-market sell-off. Even this would only cause a temporary fall in price, and the market would soon stabilize as people trade on the newly available store of coins.

In conclusion, as long as the “foundational fundamental” of Bitcoin – the security of the network – remains the same, the number of bitcoins in circulation continues to drop as more people buy and save, and the number of people entering the Bitcoin market continues to grow with the increasingly viral interest being generated by the aforementioned “huge amount of news stories,” I can say for absolute certain that the price of bitcoins will continue to go up.

Welcome to the 2013 Bitcoin Boom!

Disclosure: author is long bitcoins

**Erik Vorhees, head of marketing and communication for BitInstant, published a similar post on Reddit this morning entitled “An insider’s opinion on the crazy Bitcoin market” which prompted me to finally put my responses to my family and friends in a format more appropriate for this blog. Thanks for the push, Erik!

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