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A Contradiction in Bitcoin’s Pricing

Five years ago the cryptocurrency ‘Bitcoin’ was created. It was the first of now over 300 virtual currencies to use a peer-to-peer network to transfer money via the internet. The technological details exceed the intentions of this blog as well as the authors abilities but the fundamental achievement was to redundantise trusted third parties (primarily banks) during transactions and by doing so massively reducing transaction costs and transaction time. While Bitcoin has repeatedly gained media attention it is still underrated as one of the most impressive modern inventions and based on that opinion I want to use this opportunity to gain some more attention while showing the contradiction in the pricing.

BitCoin Price Development

Figure 1: Bitcoin exchange rate into USD since the first transaction in January 2009. Source: blockchain.info

The figure above shows the massive fluctuations of the Bitcoin exchange rate since its release. Within two years the value went from close to nothing to exceeding the 1000$ mark. It seems instinctive to assume speculations, as the cause of this development. With no inherent value apart from its function as a medium of exchange, Bitcoin lacks basis to justify such immense price increases. Also the close relationship of media attention, represented in Figure 2 by google trends, and the price development indicates speculative behaviour rather than behaviour based on rational expectations in the sense of Eugene Fama.

BitCoin Trends Development

Figure 2: Google Trends used as a reflection of Bitcoins relevance since its start. Google Trends measures the quantity in which a term, here ‘Bitcoin’, is searched. The time with the highest interest is rated with 100% and the rest is illustrated in proportion. Source: Google Trends

While speculation is one potential reason for the immense price increase there is another which at first sight might seem far-fetched. Previously I stated the innovative character of Bitcoin which leads to gigantic potential in the financial markets. In that way there is the possibility for Bitcoin to replace less efficient transaction methods and with it their underlying currencies resulting in it as the primary medium of exchange. A uniform international currency if you want, even though there is no intention of world improvement in this essay.

Instead the focus is on the implications this possibility contains. From an investor’s perspective Bitcoin is valued based on its expected exchange rate. The sum of all possible future exchange rates weighted with their respective probabilities. Assuming that Bitcoin catches on and goes into a self-reinforcing cycle resulting in it as the primary currency, the demand would explode. Thus the value would rapidly increase based on simple concepts of supply and demand. BitCoin Money Supply

Core to this idea is not only the expansion of demand but also that Bitcoin’s money supply is predetermined. The inventor of Bitcoin, Satoshi Nakamoto, programmed the first Bitcoin code in such a way, that while the total amount of Bitcoin increases, it does so at a decreasing rate. Finally the amount of Bitcoins will reach its maximum of 21 million.

Due to the potential increase in demand and the restricted supply it can therefore be considered rational for investors to pay extraordinarily high prices for Bitcoins in expectation of future increases. But the problem that remains is that Bitcoin only has value based on its function as a medium of exchange and when the price of Bitcoins increase that is equivalent to a deflationary development. In consequence the original function is lost and value of Bitcoin should be zero. Considering the homo economicus and forward-looking agents, this development should be anticipated and the value of Bitcoins should never have exceeded zero.

Figure 3: The amount of Bitcoins available on the market cannot be influenced.

Source: European Central Bank: Virtual Currency Schemes, 2012

Lars Uden

References:

Nakamoto, Satoshi: Bitcoin: A Peer-to-Peer Electronic Cash System, 2008, to be found on:

http://nakamotoinstitute.org/bitcoin/

Pagliary, Jose: Ron Paul: Bitcoin coud ‘destroy the dollar’, 2013, to be found on:

http://money.cnn.com/2013/12/04/technology/bitcoin-libertarian/index.html

European Central Bank: Virtual Currency Schemes, 2012, published online:

http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf

Velde, François: Chicago Fed Letter: Bitcoin: A primer, The Federal Reserve Bank of Chicago, No. 317, 2013

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Author: studentnovasbe

Master student in Nova Sbe

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