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Understanding the value of Bitcoin means finding the right balance

As Bitcoin stabilises below US$500 for the first time since its eye-popping run to over US$1 000 in November 2013, many crypto pundits are scratching their heads and trying to make sense of the current weakness – especially given the excitement and innovation that we are seeing within the global Bitcoin community. Venture capital has also been pouring into Bitcoin startups at a rabid pace (north of US$100-million so far this past year). However, over the past couple of days, I’ve had numerous friends contact me asking the same question : “What’s happening with Bitcoin?”.

Bitcoin is currently trying to finding an equilibrium point – at least at the current volume levels – given all the recent disruptions to the ecosystem (including the recent MtGox collapse).

Equilibrium would be defined for me as the point of stability in price where there is symetric volume and consistent growth on a daily basis between buyers and sellers (Utopian, but right now there is asymmetric growth which is not being quantified – so traders are having a problem predicting where it would go).

History shows that it needs to find a very stable price point for a few months before it can really retest any previous highs. External factors like Russia, Ukraine, China, etc will contribute to Bitcoin volatility and changes in the supply/demand curve globally.

I spent some time at the CoinSummit conference in San Francisco last week and my panel discussion, “Bitcoin transactions — what are the barriers for merchant and consumer adoption?” was well received by the community.

It’s very clear that Bitcoin has amazing potential but the fact remains that we are still in the very early stages of its evolution – which many have likened to the internet in 1993. Mainstream consumer adoption is just not there yet. We’re waiting for the “Netscape moment” for Bitcoin.

I also don’t believe Bitcoin is suitable as currency – I think it’s a commodity that can be traded for goods and services. It may become a currency in time, but it just isn’t one right now. It’s a scarce, digital commodity – and the trading that takes place on exchanges really reflects the market sentiment around the value of this digital commodity.

In the not too distant future, entrepreneurs and technologists will use the actual Bitcoins themselves in new and interesting ways (think smart contracts, etc.) — how many will be ultimately needed is unknown, and that’s what creates the imbalance in price. Right now it’s all speculation as to what that future value of a Bitcoin will equate to. This is what makes the Blockchain far more interesting than the actual Bitcoin – but I’ll leave that for a future post.

I have some alternative views (i.e. not stuff the mainstream press totally gets), as to why Bitcoin is trading below US$500 right now, but I want to point out that I am a Bitcoin bull for the long term. I even predicted at the Silicon Valley Bitcoin Conference in May 2013 that it would reach over US$1 000 in 2013 when it was trading at US$100 to audible sniggers and laughs from a very Bitcoin friendly audience.

That said, conversely, here are the key reasons why I think the Bitcoin price may not organically reach US$1 000 again this year, without an external event shifting the supply/demand curve for Bitcoin. It is difficult to predict anything further out than a single quarter in the Bitcoin world, so instead of making bold predictions I would rather focus on highlighting some issues that are suppressing the Bitcoin right now.

TechCrunch recently published a story about the recent IRS rulings around Bitcoin – which classifies it as an asset, not a currency (which effectively makes transactions using it taxable). To be frank, anyone who thought that Bitcoin would not be subject to taxes in some form is living in a dream world.

Anyone who made 5000%+ returns over the past year or so should not be complaining about paying capital gains tax – it could have been worse and been classified as income tax. That said, it will have an impact on the price of Bitcoin as some people holding them will need to sell some of their coins ahead of tax filing next month.

The real impact is that the notion that Bitcoin is a “deflationary” currency versus the US Dollar has effectively been dispelled. Any deflationary gains have to be offset via capital gains taxes. This does not mean that it is not deflationary vs other currencies, but given the IRS has given strong guidance here – it’s effectively mooted in the USA. It will remain a store of value, but it clearly is not a currency in its current form.

The upside of the IRS guidance is that given it’s not classified of a currency, you can buy and hold Bitcoin for years and never pay taxes until you realise the gain. Contrast that against the treatment of foreign currency holdings (and subsequent appreciation against the US Dollar) and you’ll see it’s a fair outcome.

The IRS guidance, when coupled with unconfirmed rumours that China is “banning” Bitcoin, has led the mainstream press to postulate that these are the reasons for the current weakness in the price.

I’d like to offer some alternative views:

Merchant adoption is outpacing consumer adoption

This is a key issue that is creating sell side pressure for Bitcoin. The number of new merchants now accepting Bitcoin globally has grown in the region of 5-10 times in the past six months, especially since Bitcoin popped late last year and become an increasingly valuable (albeit volatile) asset to own. The number of consumers (and realistically, mainstream consumers) using Bitcoin has grown fractionally in the same period – partially due to the perceived price and some other issues which I’ll dive into below. One reason is that the promise of micropayments for Bitcoin has not been realised, which is what is holding back mainstream adoption.

What’s now happening when new merchants start accepting Bitcoin is that it’s giving people who have existing coins the ability to use it as a currency and effectively “sell” their coins to the merchant. The processors such as Bitpay then in turn either sell these coins to private buyers (off book) or via exchanges (such as Bitstamp) to exchange for local currency for the merchants. This money is understandably used to continue to replenish inventory and operate their business, and more importantly, pay taxes to Uncle Sam.

Although many Bitcoiners are hoping for more large retailers like TigerDirect and Overstock to adopt Bitcoin, it may have a negative impact on the BTC price as these retailers will most likely convert 90% of their coins to cash – putting additional selling pressure on Bitcoin. This outcome may not be as desirable in the short term, but it will create a better long-term outlook for Bitcoin given the liquidity options. Again, if you asymmetrically add large retailers without driving consumer adoption at the same time, the demand supply curve will shift undesirably.

As the number of transactions via Bitcoin processors increase, it ultimately creates more sellers in the marketplace – which obviously creates downward pressure on the trading price. Now, I’m not saying that this is a bad thing in the long term, but the problem is that if you have asymmetric growth in new Bitcoin users and Bitcoin “acceptors”, it will create a lopsided marketplace which will suppress the price – which is exactly what is currently happening. We’re seeing the impact of this in the market right now, I believe. There is another factor, which brings me to my next point.

Lack of trust with exchanges and limited ability to purchase

Consumers are spooked right now. MtGox ran away with US$500-million plus in Bitcoins and is bankrupt. No one really trusts any of the exchanges – even some smaller exchanges went under the past three months. The only “safe” place to buy Bitcoin in the USA is via Coinbase and they are not an exchange.

The US does not have a single licensed Bitcoin exchange and the rest of the world is reeling from MtGox. Bitstamp is proving to be the new global exchange of choice but the media has done a great job of keeping new potential Bitcoin users at bay with the usual inflammatory headlines whenever something negative happens in the Bitcoin space.

Most people I know who want to buy and sell Bitcoin are doing it “off-book” – which means the transactions are going instead via trusted networks. This will take buyers out of the marketplace and will ultimately mask the true supply/demand curve for Bitcoin. Anyone who doesn’t know a buyer will sell their coins via an exchange or via a merchant accepting Bitcoin which will put sell side pressure on the BTC price.

So instead of “buy side” money winding up in the exchanges which would be used to drive up the price, it’s sitting on the sidelines which has the impact of lowering the demand side of the equation within the marketplaces where Bitcoin is priced.

Loss of momentum

Given the above, the Bitcoin price has been struggling and this creates downward momentum. The good news is that it keeps out the “get rich quick” types (for now) who typically almost justify the reasoning of some of the non-believers who think that Bitcoin is a Ponzi scheme.

In reality, anyone who buys Bitcoin with the view that it can only go up and up forever is most likely a speculative and uninformed buyer who will sell at the first sign of blood. Although every new technology will have these buyers, the recent dip in prices is likely to keep these types away and as a result, less speculative buying which will allow Bitcoin time to find equilibrium, before it runs again (historically Bitcoin goes through spikes and consolidation phases regularly).

Again, a lack of buyers will leave Bitcoin with a lower settling price and equilibrium point in the broader market.

Miners margins being squeezed

If you were a miner two to five years ago, you could comfortably mine Bitcoins and make profit margins of 50-95%. Input costs would have been electricity and additional hardware. The difficulty of mining was low and it was not very competitive, so labour costs were cheap (hobbyists mainly) and you didn’t have to invest in chip R&D.. Since then, we’ve seen a surge in competition among miners and an astronomical increase in the difficulty index (far outpacing the price growth in the actual Bitcoin).

Miners were mining 50 coins every 10 minutes just over a year ago. With the geometric progression in the distribution of coins that happens every four years, the allocation is now 25 coins every 10 minutes. Less coins, albeit at a higher price. Even six months ago, miners were probably holding onto at least 50% of the coins they made and spending the other 50% on costs (electricity, salaries, hosting, hardware).

That number is now probably closer to 80% and dropping (lower margins at lower BTC prices and lower efficiency of mining equipment given the difficulty index). What does that mean? If miners need to cover their costs, they need to sell the BTC at market prices to pay the bills. If now they are only keeping 10% or less, then it’s another 22.5 coins on average hitting the exchanges every 10 minutes vs 12.5 coins in a 50% margin scenario (in actuality, the pools pay out on different timescales, but this is an approximation and oversimplification in order to make the point).

If someone wanted to track the flow of coins via the pools and see how many of them wound up on the exchanges or spent at retail, I think the results would be fascinating (let know if you or someone you know has or wants to do this).

Given the reasons above, I think that Bitcoin will be range-bound in the US$350-US$550 range for at least the next quarter, that is, unless an external catalytic event occurs. I do think we’ll see a point of equilibrium and stability where the price stabilises for a couple of months – when you see that, it should be a sign that a future surge is in the cards (based on historical evidence).

tldr: Bitcoin has a number of headwinds which is keeping the price in check. I’m expecting it to stabilise around the $400 mark for at least the next quarter (although predictions in the Bitcoin space are very hard to do past a couple of weeks).

Disclosure: I own Bitcoins personally and within my company, Gyft, which accepts Bitcoin as a payment method.

This article by originally appeared on Medium and it is republished with the author’s permission.

  • Neal Palmquist

    Every day is April Fool’s Day in the world of Bitcoin!

  • rrcatto

    the future value of a bitcoin is ZERO dollars and ZERO cents.

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  • Andysa

    Nice article Vinny, thank you. I think 2014 will be a slow year for Bitcoin in terms of headlines and volatility, which is not a bad thing.
    Bitcoin has moved forward a bit too fast for its own good and relied on unproven exchanges and software. There is also no or little accountability for people or businesses who fraudulently steal other people’s coins using the “we got hacked” line.
    So maybe 2014 needs to be a year of quiet contemplation for Bitcoin allowing better exchanges to be built, the protocol to be improved and the regulators to regulate thereby enforcing law not only to users but to those who are trying to defraud users.
    If I were to make a prediction, 2017 will be the year of Bitcoin.

  • Andysa

    Agreed. And so will everything be zero to the Dollar as it will no longer exist.

  • Aliice

    If I was to make a prediction BItcoin will be in the dirt by 2017. They will roll out a whole lot of bitcoin ATMs that no-one uses and they will pull all of them out again.

  • Aliice

    My thoughts as well. Its an ugly little black currency that only crims want to be paid in and only druggies need to pay with. No-one really wants to buy jack with bitcoin. Its a pain in the bum. It goes up and down like a yo yo. Its got no stability, no backing and no regtulation to protect consumers. It isnt worth a pinch of salt.

  • Aliice

    Yep April fool! Bitcoin the new innovation of the modern world free of governments (as if governments are the problem and not criminals)…
    Yeah in Utopia libertaria where anything goes….your bitcoins went….ha ha.

  • Andysa

    Governments are the biggest criminals out there with their double standards and one set of rules. Time to wake up Alice, you living in wonderland.

  • Aliice

    Actually we hear this time and time again from the anti government crowd. Its a little tired. Many of us would prefer to live with government than with what you lot suggest (ie total anarchy). You have way too much faith in mans humanity to man without any centralised controls. Even Adam smith said the markets needed this. Yes some in government are corrupt but not all, and that only happens when the controls which separate the functions of government from private sector start to break down ie as in regulatory capture. You fight that, not good government. Time for you to wake up. There is no point in lurching to extremes. You do as much damage as any corruption by suggesting throwing the baby out with the bathwater.

  • Andysa

    Sorry to bore you but we find the pro goverment tethoric just as tiring. Especially when we see the facts mounting against the system and yet some people,like you, think it’s better to be controlled by a few in power who wage wars with big bombs killing many many people.

    I never mentioned anarchy at all but since you raised it; anarchy does not mean lawlessness, it means living without the dictatorship of a government. So we could still have rules of live by with a police force, fire brigade, hospitals to serve the sick and all other services needed just without a centralized few.

    The beauty of Bitcoin and other crypto currencies is the block chain, an open ledger that shows every transaction made. As these municipalities are smaller they could’ve monitored by the citizens of that area to ensure corruption is limited. Even if the idea of a centralized government had to keep existing the idea of an open ledger means accountability, something governments lack.

  • Andysa

    Alice, you have it wrong (like so many other ignorant people who do not take the time to understand Bitcoin).
    There are many well established businesses that accept Bitcoin ( Tiger Direct, Overstock.com and Gyft to mention a few).
    The dollar is the dirtiest of all currencies. The dollar puts Bitcoin to shame if you start to calculate how many deals in drugs, bombs, guns and lives have been transacted. Try going down the road to your dirty corner drug dealer and ask him if he accepts Bitcoin or if he would like cash rather. At least Silk Road (which did only 3% of all sales in Bitcoin) was a clean place with rules for people to get their fix.
    It swings because it is still finding its feet. Given time Bitcoin will stabalise.
    As for regulation, this is happening right now which will mean laws which will mean protection of consumers.

    Keep in mind Bitcoin has only been been around for 5 years. It is only in the last 2 years that Bitcoin has been thrown into the spotlight. It’s doing pretty well in terms of adoption and regulation in the time span I think.

  • Aliice

    Andysa. You know that video killed the radio star yeah? Yet you still think people are going down the road to meet the ugly drug dealer? Even that world is changing thanks to the internet and online drugs. Its no accident more and more street dealers are switching to online and bitcoin payments. Does that mean they should be hidden and outside the law? Bitcoin does this. For someone who probably loves the innovation of bitcoin it utterly amazes me that you think dirty drug dealers dont innovate. Oh and there was nothing clean or safe about Silk Road. I dont recall ulbricht hiring any quality control staff, needing dealer IDs, and we all know user ratings can be invented.

  • Aliice

    Er um what rules exactly were required by Silk Road from people who wanted to get their fix, that made it so safe? The only rule was they paid in bitcoin which makes it safe for the dirty drug dealer to hide. Utter nonsense Andysa speaks.

  • Aliice

    So you are making the classic mistake of thinking smaller is beautiful. There were small counties in the UK at one stage in english history and they were quite capable of being taken over by the few you seem to admire and treated their citizens with abominable cruelty whereas another might not. I suppose you think all these small
    Municipalities will also happily free trade with each other and that local spiteful monopolies and other forms of coercion and control wont exist? Only in heaven Andysa. There is no socially engineered utopia out there including yours.

  • Andysa

    I’m over trying to enlighten you. Stay in the dark Aliice if you feel that’s where you belong.

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