The case for a $188k Bitcoin
But don’t buy quite yet. Or do, but you didn’t hear it from me.
There is much speculation, after the end-of-2017 Bitcoin craze and subsequent crash, about how Bitcoin will trend. Will it crash to zero, as Allianz thinks, or will it soar to new heights?
Most arguments about either scenario have little weight behind them. Some, like the above Allianz piece, are based on little more than prejudice (Allianz claims that Bitcoin will disappear because it has no intrinsic value. After admitting that the same is true for gold, they brush that comparison aside). Others, such as the numerous crypto chartists, are engaging in divination rather than analysis.
Sorry, but putting a ruler on a chart is not a way of making market predictions. Image from CryptoChartist.com
What Bitcoin can be
As I wrote before, we currently do not know what blockchain is, and the same holds true for Bitcoin. It can be many things, but what it will end up being is entirely speculative. I can see at least 4 different futures for Bitcoin¹:
Nothing: Bitcoin disappears entirely
A currency: people use Bitcoin on a daily basis for regular purchases
A medium for wires: Bitcoin is not used in daily purchases but only for international or inter-bank transfers, instead of other systems such as SWIFT
Wealth storage: people purchase Bitcoin as a way to store their wealth, as they would with gold today.
What can we tell from these? Let’s go one by one.
1. Bitcoin disappears
There are many ways in which Bitcoin could disappear: the focus should switch to some other cryptocurrency. Regulators could label Bitcoin a security, or otherwise crack down on it. The network could simply disintegrate in internal conflict and forking. In this case, the value of Bitcoin is zero. That was easy.
2. Bitcoin becomes a currency in daily use
It is very hard to imagine Bitcoin becoming a currency, due to the inherent difficulty to scale the infrastructure. Some other cryptocurrency might circumvent this issue, but I have strong doubts about it: if you want to truly forego a trusted third party, the ledger must be distributed, and this limits the bandwidth of the entire system to the bandwidth of one node. You are trading efficiency for safety, and there aren’t many ways around that. The solutions proposed to scale the Bitcoin blockchain are temporary reliefs. In addition, even if Bitcoin could clear as many transactions as Visa or PayPal, there would still be the problem of the processing time: a block is added to the Bitcoin blockchain every 10 minutes, and most recommend waiting several more blocks before considering the transaction settled. Do you feel like waiting for an hour in a store to buy a soda?
3. Bitcoin is used for international wires
Using Bitcoin to wire money from France to the US presents the appearance of a free and relatively quick transfer, but doing so would require you to buy Bitcoin for Euros on one end, and then sell them for US Dollars on the other. That’s two traders who need to participate and who will charge commissions. The only way to avoid this is if Bitcoin were redeemable in the real world without exchange, but that would require it to be a currency. Incidentally, this is why companies like Ripple exist, with blockchain solutions specifically adapted for transfers.
That leaves us with wealth storage. Fortunately, this is one application for which Bitcoin is exceptionally well suited.
What is a store of value?
Where do you store your wealth? If you are like most people, you have some of it in the bank. You may have some stock and bonds. You may have purchased some real estate. And some of it may be stored as gold, as is the case for $8 trillion out of the $256tn or so of global wealth.
Over the ages, wealth has been stored under many forms. Grain, diamonds, artwork, cash, cattle, or the slave girls of medieval Ireland. It’s worth giving some thought about what makes gold so good at its task. An ideal store of value should be:
Liquid: an active market exist to exchange it for currency
Fungible: you can divide it or merge it without losing value
Portable: it should be possible to carry with you as large a value as possible
Durable: it should not decay with time
Independent of society & government: no person or organisation should be able to debase your wealth
Stable in supply: there should be no risk of the supply fluctuating wildly, for instance increasing suddenly and making the value drop
Stable in price: you should have confidence in the fact that you’ll be able to exchange your value for currency at a price similar (in real terms) as your purchase price.
You may think that gold would fail some of these categories, as I did when I started researching this article, but you would be as wrong as I was. Let’s dig in.
Gold as a store of value
The liquidity of gold is fairly obvious. For time immemorial it has been valued for its permanence and unique appearance, and markets have existed to purchase and sell it.
Gold is also evidently fungible. Cutting a bar of gold in half gives you two parts which will have a combined value equal to the initial bar. It does not matter to the buyer what shape the gold comes in as long as it’s pure (we’re talking about bullion, not jewellery, which is obviously a different case).
At around $40k per kg, you can carry a million dollars worth of gold in a backpack. It’s not ideal, but sure beats many other forms of storage in portability.
Gold is durable, more so than other metals such as silver, since it doesn’t readily oxidize.
Independence of government and society are also obvious. Gold is valuable because everyone agrees it is, and no government can quantitatively ease that out of our minds.
Now comes the question of the stability of supply. Gold is a mineral and it is being mined. Surely this would erode its price? It is in theory true, but the mined amount is actually very low. In 2014, 2'860t of gold were mined worldwide, for a total available supply of 187'200t, so the yearly production represents about 1.5% of the total stores. Even with an otherwise perfectly stable price, this would be an acceptable deflation, lower than that of cash in many parts of the world.
Annual gold production, 1900–2014. Chart from https://en.wikipedia.org/wiki/Gold_mining
But the price of gold does not actually decrease by 1.5% per year. Below is the price of gold in real dollars, from the beginning of the 20th century to today, as well as the compound annual growth rate (CAGR) over 10- and 20-year periods. Think of the CAGR as the interest you would have needed to have every year in an bank account which would have given you the same returns as holding gold in the previous period. As it turns out, the price of gold is remarkably stable, maxing at ±8% CAGR on a 20-year period.
Price of gold in real dollars, as well as 10-year and 20-year CAGR, for the past century. Over 10 years, the returns vary between -8% and +24%. Over 20 years, the returns are contained within ±8%. Data from http://www.macrotrends.net/
Sure, losing 8% a year over 20 years sucks: it represents a loss of 81% of your initial wealth. But then again, Citigroup lost 92% of its value, in real terms, since 2000. In addition, these periods of sustained losses for gold were very rare. Have a look at the histogram below: over a 20 year period, in the past century, you had over 70% chance of breaking even or making a small profit, in real terms. You won’t get rich by buying gold, but it does a great job of storing wealth.
Histogram of 10-year and 20-year CAGR for gold investments over the past century. The most probable outcome is a slight increase in value in real terms.
All other stores of value have all obvious flaws in comparison. Grain is not portable. Diamonds aren’t fungible, nor is artwork. Cash depends on government, cattle aren’t durable, and so on. That’s why gold is and has always been… well the gold standard, for wealth storage.
Bitcoin as a store of value
So how does Bitcoin qualify as a store of value? Bitcoin passes the first criteria with flying colors: it is liquid, fungible, much more portable than gold, and totally decentralized and therefore protected from government interference.
Durability may be challenging to accept — how can a non-physical commodity be durable? However, the nature of the blockchain makes that all of the nodes of the network would need to be knocked out for your Bitcoin to disappear. A tall order to say the least³.
You may have heard about mining and think this could undermine the stability of supply criterion. Computers who verify Bitcoin transactions get rewarded in Bitcoin, through a process called “mining”. However, the maximum amount of Bitcoin is capped at 21 million. When this number is reached, “miners” will get paid by charging transaction processing fees instead.
And now comes the matter of stability of price. Surely anyone who thinks Bitcoin has price stability is out of their mind, right? Bitcoin is so famously volatile that it has spawned legions of hilarious visualizations of its evolution, such as the one below.
But the thing is, again, that we still don’t know what Bitcoin is. Bitcoin fluctuates because it is undergoing a process of price discovery. Imagine someone putting a teleporter on the market: it’s easy to assume its price would fluctuate massively before its true market value is identified. The same goes for Bitcoin.
Should Bitcoin become adopted as a store of value, price stability would automatically follow since a massive amount of wealth would be transferred onto the network, and therefore no single transaction could have a great impact.
The cautious reader (which I’m certain you are) will have detected a circular argument here. Bitcoin needs to be first adopted as a store of value before it can claim to have a property any decent store of value should have: stability.
Yes, you are right. You can have a cookie. However, Bitcoin has enough early adopters that it’s not impossible to imagine it easing into such a position, attracting more and more wealth, becoming more and more stable, and therefore appealing to less and less risk-averse investors.
Doesn’t a store of value need to be physical / have a practical use?
I have heard many times the argument that a “good” store of value needs to be physical. I believe this is due to the fact that we have never had a serious contender that wasn’t. The requirement for a store of value to be physical doesn’t hold much water: you want your store of value to be durable before all, and Bitcoin is durable, even if it’s not physical. You will be able to keep it around and exchange it whenever you want for currency. It being physical is actually a hinderance since it limits portability.
Some people also comment on the fact that Bitcoin is “useless” whereas gold has practical uses. This again breaks down under close scrutiny. Gold’s practical uses are industrial applications, where its chemical, electrical and thermal properties are valued, and dentures. Both these didn’t become widely available until well into the 20th century⁴, and still account for only around 10% of consumption in the US. Global data is hard to come by, but it’s safe to assume the vast majority of gold is not used for the metal’s practical benefits.
I would go even one step further, and argue that a relative uselessness is a benefit. Imagine storing your wealth in a useful commodity such as oil, whose price varies in response to demand: if everyone decides to buy Teslas (and Tesla can deliver, of course), oil’s price will sink, and your wealth with it. This cannot happen to gold — or Bitcoin — since their practical uses are marginal at best.
That Bitcoin can act as a store of value is not an original idea, of course. Lots of people have spoken to that effect, including Bill Gurley and Peter Thiel.
“I think of it as an incredible store of value in the rest of the world, I don’t think it’s irrational.” — Bill Gurley, interviewed on CNBC.
“It’s like gold, and it’s just a store of value. You don’t need to use it to make payments.” — Peter Thiel, speaking at the Future Investment Initiative, Riyadh, Saudi Arabia
What does it mean for Bitcoin’s price?
If Bitcoin starts taking gold’s place, we can calculate the price it should have. There are 187’200 tons of gold in circulation (that’s a cube with a 21m side, if you’re wondering. All the world’s gold would fit in a 7-story building, or on a tennis court stacked 37m high). At a price of around $42k per kg, this represents 8 trillions of dollars.
Bitcoin, as mentioned before, is capped at 21 million units. Therefore, should half the wealth currently stored in gold migrate to Bitcoin, this would bring its price to $188k⁵.
If half the wealth stored in gold migrated to Bitcoin, one coin’s value would be of $188k
Wait a minute! you may think. That’s a number you just pulled out or your ass! Why half? There are hundreds of hypotheses underpinning this number!
Yes there are, and yes I did — I’m happy you noticed. But look at it. This may be the first valuation of Bitcoin you’ve seen that was built from first principles. If you don’t agree with me, please do your own analysis and ping me: I’d love to read it.
I cannot justify the 50% figure quantitatively, but qualitative reasons exist to believe it is reachable. First of all, Bitcoin will have a bigger mindshare by the new generation than gold does. Digital natives may be less bothered by its lack of physical embodiment. Most importantly, in periods of extreme stock market volatility, zero-interest-rate-with-no-inflation, political tensions, and so on, it’s very easy to imagine a higher share of the world’s wealth migrating to “safe havens”, thus potentially increasing the $8tn value stored in such a way.
So should I buy?
Should you? In short:
First of all, you shouldn’t invest anywhere because some dude on the Interwebs said so. If you think otherwise, please reach out to me: I have a business proposal.
Then there’s the question of what Bitcoin will be. I believe that a store of value is its most likely future, but it could very well sink and vanish. You have to factor that into your expected value.
But even if my assumptions are true and Bitcoin’s price rises to $200k, it may not make it an interesting investment. Migrating $4tn will take a long time; exactly how long will have a great impact on your returns, as is shown in the below graph.
If it takes 50 years, you stand to make an annual return of 6.4% — nothing extraordinary. In addition, there may be large fluctuations along the way which would result in doubt, grey hair, and tweets suggesting to #hodl. You don’t want any of that.
All of these risks may very well be priced into the $10k BTC.
Now, if you do need investment advice (which, again, you should not), you may want to look towards gold. If $4tn moves from gold to Bitcoin the price of gold will be slashed by two. Shorting gold wouldn’t be better than buying Bitcoin: the price of gold will take the same time to fall as that of Bitcoin to rise. However, the situation may be much different for gold miners. In 2015, the cost of production for the two biggest producers, Barrick Gold Corporation and Newmont Mining, was of $1'115 per ounce, for a gold price (at the time) of $1'160. If the two biggest players are hardly making any profit, we can reasonably assume that the situation is worse for the smaller companies.
Gold mining companies could go under even with a small decrease in price. Shorting them may be a better idea than buying Bitcoin. But again, an idea you should not follow.
¹ I’m intentionally not including here the concepts of commodity, security and speculative asset. If Bitcoin is deemed a security it would disappear — as simple as that — but that’s unlikely². If it is a commodity, it doesn’t tell us anything as to its value. Likewise, anything with a price can be a speculative asset, and it is equally unhelpful in establishing the price.
² Here is a comprehensive study about whether Bitcoin should be considered a security: https://www.bu.edu/jostl/files/2016/01/21.1_Alberts_Final_web.pdf
³ Head here for a primer on blockchain technology: https://www.cbinsights.com/research/what-is-blockchain-technology/
⁴ There are numerous examples of antique dentistry using gold, but find it very hard to imagine it being more than a marginal usage. I don’t have data though, so if you do please send it my way.
⁵ One interesting consequence is that, since Satoshi Nakamoto is reputed to own 980'000 BTC, that would make him or her the richest person in the world by far, with a fortune of $185bn. That is, if Satoshi Nakamoto is one person and is still around, of course.
