As a analyst following Bitcoin full-time for several months, I have been keeping up with developments in the cryptocurrency, attending Bitcoin meetups in Silicon Valley, and talking to Bitcoin startup founders. One key question that keeps coming up is — what is the intrinsic value of Bitcoin? Bitcoin proponents have made several arguments for it and I soon became an evangelist. The detachment of Silicon Valley from the rest of the world probably contributed to my conversion. But deep down, I have always had a nagging feeling that something was ‘off’. I could not find an argument that convinced me one-hundred-percent that Bitcoin had intrinsic value — until today.
One common argument supporting Bitcoin is that, Bitcoin has intrinsic value because there are people that believe Bitcoin has value and are willing to accept it. Fine, the history of the Iraqi Dinar proves that money does not need the backing of a government to function as currency and that the network effects of money can be powerful in maintaining its intrinsic value. But that argument does not answer the question of why people are ultimately willing to accept Bitcoin? Why not use gold? If people use Bitcoin because they believe other people will accept it, is it not just a self-fulfilling prophecy?
An extension of that argument is that, Bitcoin has intrinsic value because people are willing to use it for its superior characteristics — “Bitcoin is better gold or better money”. Bitcoin is not as unwieldy as gold. Bitcoin is better for payments and remittances because it has near-zero transaction fees (compared to 2.5% credit card transaction fees and Western Union’s “mind-boggling” >10% commissions). Since Bitcoin is better, people would prefer to use and accept it, thereby giving it value. But is Bitcoin really better money? If you break down the value-chain of the credit card transaction process, around 1% of the 2.5% in fees are returned to the consumer in the form of credit card rewards. In the case of remittances, it is more naunced than people think. Companies like Xoom allow foreign Filipino workers to remit up to $3,000 for a $5 (a fee of 0.16%); the money would usually be available instantly across 13,000 locations in the Philippines. I had a call with an executive that used to work at Western Union, and he shared that the commissions for the more established corridors only range from 2-3%. That said, Bitcoin can still add value, especially in the area of international payments and micropayments, but it appears that the benefits are only marginal and the Bitcoin’s potential may be smaller than originally thought. It would be difficult to justify a high valuation (then again, how does one define ‘high’?).
I do, however, believe that if Bitcoin — or some other cryptocurrency — evolves to be more functional (i.e. a strong use case), it could be worth its weight in gold (pun intended). Opponents of Bitcoin like to argue that, unlike the US Dollar, Bitcoin has no intrinsic value because it has no government backing. I think that is only partially correct. Going back to the example of the Iraqi Dinar, it is not the backing of a government that gives money value — it is the backing of a functional government that does so; a functional government that provides public services, such as roads, the police, and military defence. The government is the only entity that is able to provide these public goods. In exchange for these essential services, the government only accepts the legal tender as payment in the form of taxes.
What if a cryptocurrency network could behave in a similar way? People are only starting to imagine the possible applications of an infungible global public ledger that can exist forever (e.g. smart contracts, smart escrow). If a network only accepts its own cryptocurrency as payment in exchange for these important services, the cryptocurrency-denominated “miner fees” would be the equivalent of taxes that businesses and individuals will have to pay. This would drive true demand for the cryptocurrency and form a stable foundation for its intrinsic value, which can then be used to support the functions like payments and remittances that everyone is trying to do today. Today, startups like Counterparty are already embedding data on the Bitcoin blockchain, and the ‘free-rider problem’ is already starting to surface. The key assumption above is that the use case has to be strong enough to be considered essential, not just a marginal improvement. For example, email is a strong use case of the Internet, not services that digitize your snail mail.
So what can we do now? I would watch out for changes to the Bitcoin protocol that take advantage of features unique to cryptocurrencies, alternative protocol innovations, and start-ups that make use of these a cryptocurrency protocol’s special functions. For example, here in Silicon Valley, there has been a lot excitement among the developer community around Ethereum, which is an alternative protocol that allows scripts to be run when a transaction is sent. I would also start to think about how protocol-based applications and services, like “smart-contracts”, would be evolve and whether it would eventually be an integral part of our society.