Is bitcoin worth its price? (Note)

Purpose of the article :The purpose of this note is to highlight that the sharp rise in the price of bitcoin and the interest it is generating among new investors are mainly the result of a largely speculative narrative.

Summary:

• The spectacular rise in the price of certain cryptocurrencies, particularly Bitcoin, has attracted the interest of financial analysts and investors.
• To understand and interpret this rise, we will first analyze the economic nature of Bitcoin and the arguments used to justify investor interest.
• Following a process of elimination, we will highlight that the rise in the price of bitcoin follows an essentially speculative narrative in which investors hope that past performance will predict future performance.
• Bitcoin investors must therefore consider it as a purely speculative asset that must remain volatile or cease to exist.

« I can calculate the motion of heavenly bodies, but not the madness of crowds, » Isaac Newton is reported to have said following his risky investment in the South Sea Company, a company that, in^{the 18th} century, saw its share price increase nearly tenfold in one year before collapsing.

With its price also increasing tenfold between its low in March 2020 and its high in April 2021, Bitcoin seems to be winning over more and more people to its cause. In the wake of this spectacular rise, new studies and models have emerged with the aim of rationalizing successive price records after the fact, while dangling ever more « enticing » prospects. For example, the prestigious bank JP Morgan considered at the beginning of the year that Bitcoin could reach USD 146,000 in the long term[1] (the target was lowered to USD 130,000 in April 2021) and recommended the use of cryptocurrencies as a diversification asset (up to 1% of a multi-asset portfolio[2]).

At the beginning of 2021, Elon Musk also showed his support[3]by investing $1.5 billion through Tesla and declaring that the company would accept payments in Bitcoin… Before finally announcing in May 2021 that the acceptance of Bitcoin as a means of payment was suspended[4]. Other managers and analysts have also invested in crypto-assets, particularly bitcoin[5].

As is often the case, the enthusiasm and recommendations of these « late » investors and analysts come in the wake of spectacular new rises in the value of the asset in question. This illustrates both the mimetic phenomenon of trend following, which can be observed in financial markets, and the FOMO (Fear of Missing Out) effect specific to the psychology of certain operators who end up buying for fear of being excluded from the good deal of the moment.

However, financial analysts and investors who support bitcoin (and other « cryptocurrencies ») tend to believe that, despite its spectacular growth, we are not necessarily in the presence of a bubble. This time it would therefore be different (according to the famous formula of Reinhart and Rogoff, 2009). Proponents of a Bitcoin valuation that could still rise sharply rationalize their recommendations by attributing economic—or even moral, for example, anti-government—characteristics to this asset that seem hypothetical at this stage.

The main economic arguments presented in favor of Bitcoin are generally: i) its ability to act as an alternative currency, ii) its role as an alternative to gold as a safe-haven asset, iii) its use of blockchain technology, iv) its role as a diversification asset, and v) its role as an alternative to cash payments, notably by allowing anonymous transactions.

Let’s first analyze these different propositions in order to shed light on the true nature of Bitcoin and the reasons behind its soaring price.

1) Bitcoin marketing

1.1 Is Bitcoin a currency?

Economics most often defines a currency in terms of its ability to fulfill the following three functions: medium of exchange, unit of account, and store of value.

A number of economic actors accept or are considering accepting Bitcoin as a medium of exchange. However, there is currently no geographical area of major economic importance where acceptance of Bitcoin is a legal requirement and where, in fact, all economic actors would consider Bitcoin to be a medium of exchange. Bitcoin cannot therefore really be said to fulfill the primary function of money, even though some transactions can be carried out in bitcoin.

Its status as a unit of account—in other words, the fact that goods and services are denominated in Bitcoin—is undermined by its extreme volatility. Large fluctuations in the price of Bitcoin (in dollars or euros) would make the prices of real goods and services unstable and unpredictable.

Furthermore, apart from El Salvador( whose economy is dollarized), Bitcoin is not legal tender and is not the official currency of any country, which prevents it from formally fulfilling its function as a unit of account. With rare exceptions, Bitcoin cannot therefore be used to pay taxes or civil servants’ salaries. In this case, it is Bitcoin itself that is priced in legal tender currencies such as the dollar or the euro.

Bitcoin therefore does not fulfill the function of a unit of account.

Its status as a store of value is primarily linked to its price expressed in a currency that is officially accepted by a country and is legal tender (such as the dollar or the euro), rather than to changes in the price of goods and services that Bitcoin could be used to purchase. Bitcoin’s ability to preserve purchasing power is therefore not only a function of the level of inflation affecting the prices of goods and services, but above all of changes in its own price. From this point of view, bitcoin can be considered an extremely volatile store of value. It should also be noted that bitcoin is obviously not a cash investment asset precisely because of its extreme volatility.

Thus, the fact that Bitcoin is extremely volatile and does not have legal tender status seems to preclude it from being considered an alternative currency at this time.

1.2 Is Bitcoin an alternative to gold and therefore a digital commodity?

One of the arguments in favor of Bitcoin is its relative scarcity, or at least the algorithmic guarantee that the number of Bitcoins in circulation is limited (to 21 million). The parallel has thus been drawn with commodities, particularly gold, to liken Bitcoin to an asset that cannot be « produced » at will, unlike fiat currencies. The term « Bitcoin miner » aims to reinforce this perception and promote its assimilation into a kind of digital commodity.

Gold is a physical commodity whose physical and chemical characteristics are natural constants. The characteristics of Bitcoin are defined by an algorithm and therefore remain artificial and duplicable. This explains why a number of cryptocurrencies have flourished following the success of Bitcoin. While the number of tokens in circulation derived from the « Bitcoin » algorithm is effectively limited, it would be entirely feasible to launch a similar program offering the same algorithmic characteristics.

The main difference between Bitcoin and a commodity such as gold is therefore that the characteristics of the latter cannot be duplicated ex nihilo, unlike the characteristics of Bitcoin. Admittedly, the number of original Bitcoins in circulation is limited, but in a completely artificial way. The scarcity of Bitcoin is therefore itself artificial, unlike that of gold.

Furthermore, gold, beyond its function as a store of value, is also used as a raw material in certain production processes and, of course, exists physically.

These fundamental differences therefore seem to disqualify Bitcoin as an alternative to gold or as a raw material.

1.3 Does the use of blockchain technology justify investing in Bitcoin?

Blockchain technology allows information to be stored and transmitted via a decentralized protocol that guarantees security and transparency. This technology can be used for multiple applications and is therefore of great interest despite its significant energy cost. Bitcoin is not a title to ownership of blockchain technology. The fact that it uses this technology allows it to benefit from the advantages—and suffer from the disadvantages—associated with it, but does not give it any value. Many cryptocurrencies have been launched following Bitcoin, using the same type of technology—or even more powerful technologies—without necessarily achieving the same success. It is therefore not the use of blockchain technology that can justify the value of Bitcoin.

Furthermore, it should be noted that the computing power required to operate the Bitcoin system (and crypto-assets in general) imposes an overall energy cost that could hinder its development.

1.4 Is Bitcoin a diversification asset?

This is doubtful. Bitcoin’s relatively short price history and high volatility make a statistical analysis of this question irrelevant at this stage. However, we can note that during the stock market crash in the fourth quarter of 2018 (when the S&P 500 fell by nearly 20%), as well as during the crash of 2020, when the S&P 500 fell by 34% between February 19 and March 23, bitcoin lost more than 40% of its value each time. Similarly, the spectacular gains that bitcoin recorded in 2017 and since March 2020 were achieved during periods when the stock markets, particularly in the US, experienced very strong growth. It is therefore reasonable to question bitcoin’s ability to act as a diversification asset.

Furthermore, the very use of Bitcoin in trading tends to make it a more pro-cyclical than counter-cyclical asset. It therefore seems difficult to find a reason that would intrinsically justify its diversifying nature.

1.5 Is Bitcoin an alternative to cash payments?

The anonymity guaranteed in principle by Bitcoin payments makes it, from this point of view, an alternative to « cash payments. » Criminal or covert activities therefore create a natural demand for crypto assets[9].

The speed of Bitcoin payments, although not instantaneous at this stage, again argues in favor of cryptocurrencies as an alternative to cash payments.

However, the real alternative to cash payments will more likely come from the introduction of central bank digital currencies (CBDCs) launched on the initiative of central banks[11]. Indeed, legal tender status appears necessary for a digital currency to fully replace cash, offering not only instant payments but also the possibility of developing « smart contracts. »

2) The true nature of bitcoin

2.1 Value and price

If Bitcoin is neither a currency nor a credible alternative to gold, and if the technology on which it is based does not give it any value in itself, it is neither a security comparable to a share (in other words, representing a portion of the capital of a company backed by an economic model with the potential to create added value) nor a debt security, and its diversifying nature is far from obvious, how can it be classified and how can the rise in its price be justified?

Bitcoin is a dematerialized, private asset, created ex nihilo without any legal or economic counterpart. This type of asset, which has no intrinsic or fundamental value (given that bitcoin is not legal tender and that the present value of future cash flows attached to holding the asset is zero), can therefore be created at will, as thousands of cryptocurrencies have been following the success of bitcoin. The number of bitcoins held ultimately represents only information with no tangible value and relates to an asset that pays neither interest nor dividends.

The usefulness of Bitcoin for criminal activities is certainly real, but it seems difficult to justify the spectacular rise in prices. Furthermore, the development of CBDCs and the strengthening of the regulatory and legal framework could limit the use of Bitcoin as « alternative cash » in the future.

On the other hand, Bitcoin has the advantage of being an asset that can generate particularly significant gains quickly. The possibility of getting rich quick is certainly the main motivation for many investors to buy Bitcoin. In this case, it is a purely speculative asset.

With no intrinsic value or utility in any production process, the price of bitcoin can effectively continue to soar without any economic consequences other than an increase in the wealth of buyers. Thus, the price of bitcoin below $6,000 in March 2020 was no more justifiable or absurd than its price exceeding $60,000 a year later. The prospect of prices multiplying by 2 or 10 contributes to giving Bitcoin an increasingly wide audience, thereby supporting price growth and enabling the existence of a cycle of self-fulfilling prophecies.

Bitcoin is a product whose performance is almost entirely supported by a « narrative process » as defined by Robert Shiller[13]. The initial narrative (the idea, the story initially presented) originated in particularly effective marketing that presented Bitcoin as a currency (hence its name) or even as a digital commodity (hence the use of the term « miner »). Today, it is above all the hope that Bitcoin’s past performance will predict its future performance that is generating interest and attracting new investors. It is therefore now a mainly speculative narrative.

2.2 Bitcoin must remain volatile or it will cease to exist

In April 2021, JP Morgan pointed out that a decline in Bitcoin’s volatility (which could match that of gold in the long term, according to the bank’s analysis) would attract institutional investors to the cryptocurrency and support its price rise[14]. However, there is a risk that the opposite could happen in this case.

In fact, while Bitcoin’s volatility is seen as one of the obstacles to it achieving true alternative currency status, it is this very volatility that justifies the current interest in it and its price. As a speculative asset, Bitcoin must regularly reach new highs and quickly erase the lows that punctuate its price history. Without its spectacular price increases, Bitcoin would lose its « speculative narrative » and would no longer be judged on its functional and intrinsic value.

Bitcoin must therefore remain volatile in order to maintain the possibility of significant profits, and its price must continue to rise spectacularly in order to attract new investors. From this point of view, investing in bitcoin is similar to a Ponzi scheme, where investors’ returns are entirely dependent on the funds contributed by new entrants.

Conclusion

« Today, we know the price of everything but the value of nothing. » Oscar Wilde’s famous quote seems particularly appropriate for Bitcoin and cryptocurrencies more generally.

Indeed, although it exploits innovative and certainly promising technology, Bitcoin remains a private virtual asset, created ex nihilo with no intrinsic value. From this point of view, Bitcoin and other cryptocurrencies can be likened to digital Monopoly money, whose price increases are supported by a powerful speculative narrative.

Bitcoin and private cryptocurrencies remain useful for activities requiring anonymity and fast, difficult-to-trace transactions. However, the legal and regulatory uncertainties surrounding crypto-assets and the likely future competition from CBDCs may ultimately limit interest in private cryptocurrencies.

The fact remains that the spectacular fluctuations in cryptocurrency prices maintain the possibility of quickly reaping significant profits and thus naturally attract the interest of investors and speculators. From this perspective, Bitcoin is probably doomed to regularly set new price records, otherwise, deprived of its speculative narrative, it could see its price collapse rapidly, along with the interest it generates. Indeed, let’s not forget that for Bitcoin investors, the main motivation is to make profits not in terms of the number of Bitcoins, but in dollars or euros…