Why does Bitcoin have value? Exploring the intrinsic value of cryptocurrencies

Since Bitcoin's inception in 2008 with a white paper authored by Satoshi Nakamoto, the token has rapidly evolved into a global phenomenon, captivating the attention of financial institutions, governments, and the public.

The asset's meteoric rise in popularity, coupled with its growing trading volume and widespread accessibility in the financial markets, has ignited a wave of curiosity and skepticism. This has led many to ask: why does Bitcoin carry value? And, how can we evaluate the intrinsic value of Bitcoin?

Understanding value in economics and financial markets

In economics, the concept of value has a long and important history, dating back to ancient times. Throughout this history, a widely held belief has remained strong: that value is derived from the "invisible hand." This metaphorical force supposedly guides market interactions and determines the worth of goods by considering the interplay between demand and supply.

In the modern financial world, the concept of value is commonly understood and categorized as market value and intrinsic value. Market value refers to the price at which assets are traded on the open market. Intrinsic value, on the other hand, represents the underlying worth of an asset as estimated by buyers and sellers. Various asset classes have distinct valuation approaches, for example:

• Stocks: Discounted Cash Flow (DCF) model summarizes the discounted present value of future cash flows a company can generate.

• Commodities: Analyzes and projects the demand and supply of a commodity to derive its intrinsic value.

• Currencies: Purchasing Power Parity (PPP) and Interest Rate Differentials (IRD) models derive the intrinsic value of foreign exchange currencies based on factors like purchasing power and interest rates.

Bitcoin's characteristics as commodities and currencies

Bitcoin demonstrates characteristics of both commodities and currencies, positioning itself as a unique hybrid asset in the financial landscape.

As a digital commodity, Bitcoin shares similarities with more traditional commodities like gold or oil. It has a limited supply, with a predetermined maximum number of coins that can ever be mined. Bitcoin's scarcity creates a sense of value and can be seen as a store of wealth. Additionally, Bitcoin's decentralized nature and the energy-intensive mining process contribute to its commodity-like attributes. Meanwhile, the Commodity Futures Trading Commission (CFTC) in the US defined Bitcoin as a commodity in 2015.

At the same time, Bitcoin also demonstrates clear currency-like features. It can be used as a medium of exchange for goods and services, enabling peer-to-peer (P2P) transactions globally. Bitcoin transactions are borderless, quick, and potentially more cost-effective compared to traditional payment systems with fewer intermediaries. What's more, Bitcoin's decentralized nature provides users with a high degree of financial autonomy and privacy.

Considering the points discussed above, it's important to explore how Bitcoin's intrinsic value is affected by its dual nature as both a commodity and a currency. It's also key to understand the dynamics of demand and supply for Bitcoin.

The utility and demand for Bitcoin

• Store of value: Bitcoin is often called "digital gold". It's decentralized and operates on a blockchain, which provides security and immutability. The limited supply of Bitcoin, capped at 21 million coins, creates scarcity and can offer protection against inflation. Moreover, Bitcoin's divisibility allows for small or large transactions, making it accessible to a wide range of users. The store of value proposition has attracted individuals seeking an alternative to traditional commodities like gold.

• The role of portfolio and institutional adoption: Bitcoin has emerged as a potential asset class for portfolio diversification. Institutions, including hedge funds, asset management firms, and corporations, increasingly recognize Bitcoin's potential to provide uncorrelated returns and improve the risk-adjusted return in traditional portfolios. The institutional adoption of Bitcoin through listed exchange products, such as exchange-traded funds (ETFs) and futures contracts on platforms such as CME, further drives demand and credibility of Bitcoin as an asset class. The entry of institutional players into the Bitcoin market has also helped with increasing liquidity and reducing the price volatility of Bitcoin.

• Digital currency and network effect: Bitcoin's utility as a digital currency allows for seamless and global P2P transactions. Through the use of cryptography and mining, transactions are securely recorded on a decentralized public ledger, empowering users with control over their funds and instilling trust in the system. The network effect plays a pivotal role in enhancing Bitcoin's utility. As large corporations started embracing Bitcoin as a payment method, the network effect took hold by creating a positive feedback loop. More participants joining the network amplifies its utility, leading to increased liquidity and widespread acceptance. This positive cycle strengthens Bitcoin's position in the eyes of many as a robust and practical digital currency.

• As a legal tender for less stable economies: Bitcoin has gained attention as a potential reserve currency or legal tender in economies with unstable fiat currencies. Unlike traditional currencies tied to specific governments or central banks, Bitcoin offers a diversified and stable store of value, which can help mitigate the impact of economic fluctuations. Notably, El Salvador became the first country to adopt Bitcoin as a legal tender in 2021, aiming to promote financial inclusion and stability for its unbanked population. The demand for Bitcoin in these scenarios arises from a desire for a reliable and globally accessible financial asset.

The limited and fixed supply of Bitcoin

Bitcoin's creator, Satoshi Nakamoto, designed cryptocurrency with a hard cap on supply to increase its scarcity over time. This unique feature sets Bitcoin apart as its supply is limited to 21 million coins — a fixed upper limit encoded into the network's code that can never be altered. This distinguishes Bitcoin from commodities like gold, where the exact unmined amount remains uncertain. The finite supply of Bitcoin reduces uncertainty and positions it as a scarce commodity, bringing the asset distinct advantages.

Bitcoin mining is the process by which transactions on the Bitcoin blockchain are verified and new Bitcoins are created. Miners use powerful computers to solve complex mathematical problems. When they successfully find a solution, they're rewarded with Bitcoins. This mining process plays a crucial role in protecting the security and integrity of the Bitcoin network.

Mining Bitcoin is resource-intensive, requiring significant computational power and consuming substantial amounts of electricity. As the number of miners increases, mining becomes progressively more challenging. The rewards for mining also diminish over time, which is commonly known as Bitcoin halving. Consequently, Bitcoin miners must make economic decisions regarding the allocation of their efforts and resources towards mining. Their collective decisions dictated the rate at which new Bitcoins were supplied into circulation.

Different kinds of Bitcoin valuation models

Similar to traditional asset classes, there are multiple ways to estimate the intrinsic value of a digital asset. This is no different for Bitcoin. Below are some commonly seen valuation models for the coin. Each takes a slightly different approach by focusing on the different unique aspects of Bitcoin as an asset.

• Total addressable market (TAM) model: This model estimates the potential market size for Bitcoin by considering its use cases and the total value of transactions it could capture. The model emphasizes Bitcoin's monetary properties.

• Stock-to-flow model: This model compares Bitcoin to precious metals like gold and calculates its value based on its scarcity. It measures the rate of production (stock) versus the existing supply (flow) and suggests that a higher stock-to-flow ratio corresponds to a higher value.

• Metcalfe's law: This values Bitcoin based on growth of network effect. It assumes that the value of a network grows exponentially with each additional user. By analyzing historical price and user growth data, analysts can forecast how the price will react as the network adds more participants.

• Cost of production model: This model values Bitcoin based on its cost of production, which includes the computational work and electricity required to mine new coins. The idea is that the cost of production sets a lower limit on the price of Bitcoin.

What does the future hold for Bitcoin valuation?

Bitcoin, as a relatively new asset, has gained acceptance across individuals, institutions, and some governments. The growing accessibility of Bitcoin through regulated exchanges and the availability of listed financial instruments have contributed to enhancing the mechanisms for price discovery and valuation of this cryptocurrency. The limited supply and decentralized nature of Bitcoin, rooted in its blockchain technology, establishes its enduring value.

As the asset class progresses in maturity, many expect the emergence of more sophisticated and transparent price discovery mechanisms and valuation models to eventually improve Bitcoin's liquidity and adoption in the financial landscape.