$1,000,000 Bitcoin? Why not?

Bitcoin’s price crossed $100,000 for the first time in early December 2024. When new financial milestones are achieved, many explanatory theories emerge. I propose a simple theory to explain why Bitcoin’s price is again rising. These comments relate to Bitcoin specifically and not crypto in general.

Few topics elicit more passionate responses than crypto and Bitcoin. With everyone scrambling to justify Bitcoin’s higher price, I anticipate numerous spirited responses and welcome a healthy debate.

I have spent much of my life in the world of traditional fundamental equity and corporate valuation and have devoted considerable time to understanding how to value these assets. Although I find speculative assets fascinating, I spend significantly less time on them.

Fundamental value is derived from the cash an asset generates over its useful life. Price is when two parties disagree enough on fundamental value or future price to be motivated to exchange the asset. Price is generally anchored by estimates of fundamental value.

Speculative assets are assets that do not generate cash and therefore do not have a fundamental value. Price occurs for a similar reason. However, rather than fundamental value, the two parties disagree on what someone else will pay in the future. This is what Warren Buffett refers to as the kindness of strangers.

To determine an asset’s fundamental value, one estimates and sums all future cash flows the asset will generate, which is often not easy. Because speculative assets do not have cash flows (by definition), there is no fundamental value to calculate.

The advantage of trading fundamental assets is that the asset’s expected fundamental value acts as a reference point. If the price is below this value, one should be interested in buying the asset; if the price is above it, one should be motivated to sell.

There is no equivalent reference point for speculative assets. Therefore, any price is reasonable because there is nothing to anchor the price. Since any price is reasonable, all prices are reasonable. Bitcoin at $200,000 is no more or less reasonable than at $100,000.

The primary challenge of trading speculative assets is forming a systematic strategy for dealing with price changes because there is no fundamental value reference point. Should one buy more of a speculative asset if its price goes down, as is often the case with fundamental assets, or sell it because its negative momentum will encourage others to also sell? Equally challenging, should one sell a speculative asset if its price increases, as is often the case with a fundamental asset, or buy it because of its positive momentum?

We know from basic economics that the price of any commodity is the intersection of supply and demand, which is the point at which two parties disagree enough about the future to encourage an exchange between them.

Interestingly, because of Bitcoin’s fundamental design, its supply cannot respond to changes in price. More specifically, unlike virtually every other commodity, the supply of Bitcoin will not increase as its price increases. Bitcoin is more akin to a collection of identical collectibles.

Because Bitcoin’s supply growth is known (usually referred to as Bitcoin’s rate of inflation), changes in Bitcoin’s price are primarily a function of changes in demand, which can be positive or negative. Consequently, theories used to explain Bitcoin’s price changes focus on sources of demand, the most common of which are:

·???????? Bitcoin as a currency

·???????? Bitcoin as an inflation hedge

·???????? Bitcoin as a payment platform

·???????? Bitcoin as a source of value

I will discuss each one of these theories separately.

Bitcoin as a currency:

People use currency every day, yet few can explain it. Although there have been many elaborate theories proposed by economists over the years to explain currency it is best illustrated with a simple example.

I produce something of value (a good or service) and want to exchange that value into something I can consume. For instance, I get paid for my labor and want to spend that pay on rent, food and coffee at Starbucks. The challenge is that I (usually) sell my services to one firm but pay my rent to another entirely different entity. Currency allows me to split that transaction. I accept my pay in a currency that I am confident I can use to pay my rent. My landlord accepts my rent in that currency because she believes she can buy her Starbucks coffee with the same currency. Starbucks accepts that currency because they are confident that they can pay their employees with that currency and the cycle continues. Faith creates currency, and, in the end, currency is nothing more than a belief system.?

The simplest test of whether an asset is a currency is if you would accept payment for your goods or services in that asset. Ask yourself that simple question: when will you be comfortable accepting your monthly salary in Bitcoin?

There are two primary reasons Bitcoin will not function well as a currency. First, it is important to understand that rather than considering a currency’s “price,” one needs to think about the currency’s purchasing power or exchange value (for what goods and services it can be exchanged). Well-functioning currency is optimized specifically to be used for daily purchases. Note, following this definition, gold and silver are not well functioning currencies, although they are occasionally used for larger barter-type transactions.

If Bitcoin’s price increases faster than the inflation rate in a currency, Bitcoin’s purchasing power will increase in that currency. An asset that increases its purchasing power over time is a deflationary asset.

Deflationary assets do not function well as currency. Individuals realize that the asset’s purchasing power will increase over time, thus dissuading them from using it for current purchases. For instance, if they delay their purchase at Starbucks, they can buy more cups of coffee in the future. When given a choice, consumers would rather exchange an inflation currency (think US$) for goods and services and hold on to their deflationary assets. Bitcoin HODLers prove this point, ironically.

Therefore, paradoxically, if demand for Bitcoin increases based on the belief that it will emerge as a currency, Bitcoin’s price will increase. As its purchasing power increases, individuals will have even less incentive to use the asset as a currency.

The second reason Bitcoin is unlikely to be used as a currency is its high volatility. High-volatility currencies are usually avoided and substituted with lower-volatility assets. Therefore, Bitcoin’s volatility would need to decline significantly to be considered a reasonable currency, making it a less interesting speculative asset.

It should be noted that not functioning well as a currency does not preclude Bitcoin from being treated as a reserve asset. Reserve assets are often held for diversification or other purposes other than daily currency-based transactions.

Bitcoin as an inflation hedge:

This claim needs more specificity to test its validity. We need to know in what currency and over what time frame the claim is made. The annual inflation rate in the US has been low for much of the past 25 years, which means that it is hard to test the inflation theory, at least in US$. That changed in 2022 when inflation in the US hit a 25-year high. Ironically, Bitcoin’s price in US$ went down as inflation accelerated, and its price increased as the US inflation rate began to subside. Bitcoin’s ascent to $100,000 happened just as the battle with inflation in the US looks to be ending. Both price movements suggest that Bitcoin is inversely correlated with inflation!

Many people predicted that Bitcoin’s shining moment would be when inflation inevitably accelerated in the US. I can only imagine the surprise and disappointment they felt when their prediction proved to be wrong. Time will tell what Bitcoin’s future relationship with inflation will be, but to date, it has failed to be a good inflation hedge, at least in US$.

Bitcoin as a payment platform:

The current payment systems in developed countries are sophisticated and complex. They are also exceedingly efficient. Understanding the full complexity of the underlying technology of modern payment systems is beyond the scope of this essay. Despite their complexity, all payment systems satisfy two needs: payment and settlement.

Payment is the start of the transactions. The payment system authenticates the purchaser and authorizes the purchase. Settlement is the completion of the transaction. The payment system transfers the proceeds to the merchant or service provider. Modern payment systems are optimized for the first half of the transaction, with most purchases usually taking less than a minute to complete. Settlement is much slower and can take a few days for domestic transactions and a few weeks for international transactions.

Crypto offers significant improvements on the settlement side of the transaction because both payment and settlement happen simultaneously. With crypto, the full transactions can be settled in a few seconds to a few hours, significantly faster than the few days it can take to settle even a domestic transaction. Using Bitcoin as a payment system would benefit the merchant significantly, hence one of its appeals. However, using Bitcoin would penalize the payment side of the transaction because it would take at least 10 minutes (on average) to complete the purchase (assuming the transaction is settled after a single block has been written to the chain). This delay is a prohibitive constraint for Bitcoin being considered a viable payment system, at least for everyday type transactions because completing the purchase would increase from less than a minute to at least 10 minutes (at a minimum). It is hard to see anyone waiting 10 minutes at Starbucks for their cappuccino and Starbucks will not take the transactional risk, particularly since there are so many highly efficient payment alternatives, including the Starbucks app!

There are two additional considerations: cost and scale. The cost of settlement on the main Bitcoin network has been volatile and far more expensive than traditional payment systems, which cost pennies, and make using Bitcoin as a payment system inefficient and significantly more expensive. Current payment systems are engineered to handle tens of thousands of transactions per second; Bitcoin is engineered to handle hundreds of transactions per minute. Both constraints would have to be improved significantly for Bitcoin to challenge traditional payment systems.

Bitcoin as a store of value:

In all fairness, many people in the crypto world realize that Bitcoin is unlikely to emerge as the core technology for the three prior sources of demand. Alternatively, most of these individuals consider Bitcoin a store of value analogous to digital gold. The primary argument in favor of Bitcoin as a store of value is the attribute articulated above concerning Bitcoin’s predictable supply and inability to increase supply as its price increases (which is not true for gold, by comparison).

To understand Bitcoin’s store-of-value properties, we need to clarify that when people say store of value, they mean a good store of value (not to nitpick, but the comment is important for the next step in the conversation). We must define what it means for an asset to be a good store of value. For instance, a ham sandwich can be a store of value but not a good store of value.

The value in the store of value comes from the assets’ purchasing power, which is the same argument used to discuss inflation above. Therefore, a good store of value is an asset whose purchasing power remains the same or increases over time. The challenge is that one cannot assess if an asset is a good store of value until its future purchasing power is known, which will be revealed only as time passes. Consequently, there is no such thing as a priori good store of value asset because the assessment of how well the asset maintains its value will not be known until the future. Therefore, it is impossible to claim that Bitcoin will be a good store of value because we will only know if that is true with the passage of time. At best, individuals can claim that they believe Bitcoin will be a good store of value, which is nothing more than a speculative bet and the point of this essay.

As a longtime believer in Occam’s razor, which is often referred to as the principle of parsimony and sometimes paraphrased as "The simplest explanation is usually the best one," I am drawn to simple theories, particularly if their explanatory power is high.

So, what is BTC?

·???????? It is a speculative asset with a relatively fixed supply whose price will be determined by incremental demand.

·???????? If demand increases faster than the (modest) increase in supply, then its price will increase. The reverse is also true. If incremental demand turns negative, the price will decline.

·???????? Paradoxically, the growing false belief in the above theories, particularly Bitcoin as a store of value, will increase demand for Bitcoin and drive its price higher, potentially creating a virtuous cycle.

·???????? Interestingly, the insight that Bitcoin is a speculative asset with fixed supply is all that is needed to explain the changes in Bitcoin’s price. Occam’s razor is satisfied.

·???????? All other narratives are unnecessary and generally wrong!

Because Bitcoin has no fundamental value, every price also can be viewed as silly. And 10 times silly is also silly. $1,000,000 Bitcoin? Why not!

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