The price of Bitcoin is currently around $57,000 (see Chart 1). But what is the price of Bitcoin based on? It’s just a bunch of code that exists only in cyberspace. It’s not backed by the state. There’s no recourse to a central authority. There’s no underlying asset, no stream of income. There’s just the thing itself. But does that mean it has no inherent worth? The code on which Bitcoin is based does give it scarcity value. Only 21 million Bitcoin will ever be created. And that might be worth something. That scarcity is why some people refer to Bitcoin as ‘digital gold’. But the very scarcity on which Bitcoin is based might also be its undoing. Its scarcity may even, ultimately, render Bitcoin worthless.
Chart 1: Bitcoin price in US dollars
Satoshi Nakamoto said in his/her/their (the creator or creators remain anonymous) canonical paper, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, that ‘a peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution’. This was the driving force behind Bitcoin: create a payments system outside of the existing official financial architecture – a form of digital money, with no official entity standing behind it, just the strength of the underlying computer code.
Now, so far, Bitcoin has not performed well as money. Quick recap: money issued by central banks, fiat money, acts as a ‘store of value’ – it preserves the spending power of income and wealth, so that you can be confident that a pound, say, will buy about as much in a year’s time as it would today. It’s also a medium of exchange – you can use it as payment. And, largely by dint of satisfying those two criteria, the denomination of money – be it in the form of dollars, pounds, seashells, whatever – tends also to be used as a unit of account (a means of pricing other things in general). Figure 1 shows the traditional functions of money, based on this hierarchy.
Figure 1: Functions of money
Now, Bitcoin is far too volatile to act as a reliable store of value. The average 30-day standard deviation of Bitcoin has been a whopping 3.5% since 2015, four times higher than the S&P 500 over that period. It’s not used widely for payments – just try spending it at your local supermarket. And it’s not used as a unit of account (consider the last time you saw something priced in terms of Bitcoin).
But if there is one thing that Bitcoin was designed to be, it was a unit of account. In Satoshi’s vision for a peer-to-peer electronic cash system, Bitcoin is nothing more, or less, than the unit of account in which transactions are denominated. You can’t have an altogether new payment system, separate from fiat money, without its own unit of account. What is incidental, in the case of traditional forms or money, is fundamental, in the case of Bitcoin (Figure 2).
Figure 2: Functions of Bitcoin
The problem is that, unlike traditional forms of money, Bitcoin isn’t used to price things other than itself. As Bitcoiners themselves are fond of saying, ‘one Bitcoin = one Bitcoin’. But a tautology does not a currency make. Put differently, simply being recorded on a ledger does not render something a unit of account in a general sense – which is the important meaning here – any more than having a record of staff leave balances in the HR system makes a days’ leave a unit of account. ‘One-days’ leave = one-days’ leave’, but that doesn’t make it money. Does it also mean that Bitcoin has no inherent worth?
To understand whether Bitcoin does have inherent value, we need to understand what Bitcoin is. A Bitcoin is a unit, a one, on a distributed ledger – a shared database maintained by multiple participants, with no central repository. The ledger is comprised of a series of batches, or blocks, of transactions, each of which references the block before, in a chain (hence blockchain). If you were to compile all the information stored on the blockchain, you might think of it as like a spreadsheet of accounts. Now, given that anyone can edit their version of the chain, to avoid version-control problems (and cheating), a network of computers (miners) continuously confirms the validity of changes to the ledger, only adding a new block if agreed by a majority.
Importantly, in reaching consensus, new Bitcoins are emitted – currently 6.25 Bitcoins every 10 minutes, approximately. Those Bitcoins are awarded to the lucky miner that was first to combine, or hash together, the information contained in a new batch of transactions in such a way as to generate a single numeric output that satisfies the requirements for the block to be added. It can take a lot of tries, or ‘work’, before a satisfactory output pops out. The reward for generating this proof of work – the evidence of the effort put into helping maintain the integrity of the ledger – is the newly emitted Bitcoin.
So, if a Bitcoin is just a 1 on the ledger, what is a 1 on the ledger worth? Why might anyone want to own it? The only real intrinsic feature that Bitcoin has is scarcity. There will only ever be 21 million Bitcoins created, finite supply being a cornerstone of the design of Bitcoin. The hope was that by having a hard-coded limit on the number of Bitcoins ever to be produced, the value of a Bitcoin couldn’t be inflated away by an endless supply of new coins.
If it is true that there may be some inherent value in Bitcoin, is it also conceivable that it might one day gain acceptance as a medium of exchange? There are certainly already a few places willing to accept it as payment. Elon Musk famously caused Bitcoin to rally in March, when he announced that Tesla would start accepting Bitcoin, and then to fall, when he reversed that decision, due to environmental concerns – the mining process uses vast amounts of energy (about ½% of total world energy consumption, according to the Cambridge Bitcoin Electricity Consumption Index). It might even start to be used to price other things – become a unit of account in the general sense. ‘One pint of milk = 0.00001249 Bitcoin’, or 1249 satoshis (sats), the affectionate term given to one hundred millionth of a Bitcoin, the smallest possible fraction permitted by the code (55p, in case you wondered).
It’s even possible that Bitcoin will one day become an effective store of value, once adoption plateaus, speculative gains and purported diversification benefits are exhausted, and the price discovery process has run its course – assuming it ever does. Bitcoin might eventually trend (up, down or sideways) to some non-zero equilibrium value and be relatively stable (see Figure 3), rising in line with other nominal things, or acting as a simple proxy for generalised risk sentiment.
Figure 3: Bitcoin price forecast (up, down or sideways)
There is a problem, however. And the problem lies in precisely the thing that gives Bitcoin value: its scarcity. At some point, the last Bitcoin will be mined. There are nearly 19 million in circulation at present (see Chart 2). Estimates suggest that the 21 millionth Bitcoin will be emitted sometime in February 2140. What happens then? There’s nothing in the code to deal with what happens next. Simple economics points to some potential outcomes, though.
Chart 2: Bitcoin in circulation
For one thing, it’s likely that transaction fees will rocket, as miners try to replace revenues no longer provided by the emission of new Bitcoins. Past episodes of high transaction volumes have seen transaction fees rise as high as $60 (see Chart 3). While the numbers vary, day to day, the current fee per transaction is around $1.88. With miners receiving around $47.8 million per day in block rewards and transaction fees, and only $402,000 of that coming from fees, replacing lost block rewards would require fees to rise to over $223 at current prices.
Chart 3: Average fee per transaction
Fees of that size would make Bitcoin much less useful (useless, really) as a medium of exchange. Transactions might even become prohibitively expensive, and dry up altogether, with many balances effectively stuck on the chain, uneconomic to move. An overnight fall in revenues – due to the combination of no new Bitcoin and a fall in transaction volumes – would probably cause at least some miners to switch off their computers. Miners aren’t providing a public service, after all; they’re in it for the profit.
A sufficiently large decline in computing power would undermine the security of the ledger, perhaps catastrophically. The hash rate – number of tries at finding a winning block – per second is currently around 158 million trillion per second (see Chart 4). If enough miners leave, a single entity could gain control of over half of the hash power on the network, enabling them to reorganise the balances on the blockchain at will. The integrity of the whole ledger could disintegrate.
Chart 4: Estimated daily terahashes per second
That being so, and absent some intervention by the disparate group of developers and miners that preside over the Bitcoin codebase, simple game theory tells us that a process of backward induction should, really, at some point, induce the smart money to get out. And were that to happen, investors really should be prepared to lose everything. Eventually.
Thomas Belsham works in the Bank’s Stakeholder and Media Engagement Division.
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