Here Is How Bitcoin Obtains Value as Currency

Apr 6, 2021 06:02 PM ET
Here Is How Bitcoin Obtains Value as Currency

Bitcoin has delivered the biggest shock this year since it became public. Between January and the time of writing, the digital currency was up 100.89% to $58,929.72. According to Glassnode, a blockchain-focused data, and intelligence provider, Bitcoin price is likely to soar even higher in the coming months because the market is accumulating a new crop of HODLers.

Bitcoin price year-to-date

Figure 1: Bitcoin price year-to-date 

Even as the cryptocurrency makes international headlines almost daily, few people clearly understand what Bitcoin is and its origins. Fewer people know why digital currency based on blockchain technology has value and how it obtains it. In this article, we will walk you through a discussion in which we will explain how to obtain value and why that is possible in the first place.

How currencies obtain value

Wait, is the Bitcoin currency? Not everyone agrees, mainly because digital currency has yet to earn mass usage, among other things. However, we shall set aside this debate for a moment and assume that Bitcoin satisfies all the currency criteria. Then, we shall proceed to discuss how currencies obtain value.

Currency, like any other commodity, obtains its value from demand. The more people want to have a certain currency, the higher its value gets. When fewer people want to have the currency, large amounts of it remain floating around in the market. The result of this glut is a lower value. In other words, a currency’s value is obtained at the point of equilibrium between supply and demand.

In other words, a currency’s value is obtained at the point of equilibrium between supply and demand.

Any factor that can lead to a change or shift in either demand or supply of a currency can affect a currency's value. For example, inflation discourages the domestic currency demand, which leads to a dip in the currency's value in the foreign currency marketplaces.

Can Bitcoin be said to have value as a currency?

We promised to return to the question of whether Bitcoin is a currency at some other time, so here we are. So far, we have noted that the demand and supply of a currency determine its value. We should add that a commodity has to satisfy certain preconditions to assume the currency status. Let us iterate through these features and see if Bitcoin passes muster.

Scarcity

As we have already seen, the supply and demand forces determine the direction of a currency's value. A strong and reliable currency maintains liquidity just enough to facilitate the smooth transfer of value. Hyperinflation could happen in the event of a supply glut. Conversely, there is a risk of deflation if the money supply is too thin. How does bitcoin measure up? Satoshi Nakamoto, the creator of Bitcoin, set the supply limit of the coins as 21 million. At the time of writing, the coins in circulation were about 18.7 million BTC. The idea that BTC has a limit to the circulating coins inspires confidence in the market. In terms of scarcity, Bitcoin passes muster.

Transferability

If you are going to trust a commodity to help you move value from one point to another, then it must be easily portable. This means you must have access to reliable, safe, and secure means of storage. Also, mechanisms must be in place to facilitate the movement of the currency. Bitcoin satisfies this requirement through the availability of payment service providers who support or process Bitcoin transactions. Additionally, several Bitcoin wallet providers offer storage services to help store the coins during transit or at rest.

Utility 

A useful currency that serves its purposes whenever you need it. For example, you should be able to pay for a service/product when you need it using your currency of choice. Initially, Bitcoin’s utility was scarce, but increased adoption globally is changing the situation. Recently, PayPal launched a service that would allow users to checkout using Bitcoin and other major cryptocurrencies. This shows Bitcoin’s relevance in everyday commerce is growing. 

Divisibility

You may not always need large sums of currency. As such, a great currency must be successfully used in smaller dimensions. A major problem with commodity money like gold was divisibility because one could not divide it sufficiently. Conversely, Bitcoin is merely a string of characters on a computer screen, which one can divide into as many small units as possible. This makes Bitcoin one of the best currency choices available at the moment.

What challenges does Bitcoin face as a currency?

This study identifies adoption as Bitcoin’s largest area of concern. According to the author, Bitcoin might have become a household name, but few transactions use the coin as a payment method. Another challenge identified in the study is wild price fluctuations. The research concludes that Bitcoin’s price volatility is "greatly higher than the volatilities of widely used currencies," making the coin less than ideal as a bona fide currency. 

3-month and 6-month realized volatilities for Bitcoin (% volume in annualized terms)

Figure 2: 3-month and 6-month realized volatilities for Bitcoin (% volume in annualized terms) 

Additionally, the cryptocurrency's daily exchange rates hardly correlate with common fiat currencies such as the US dollar or with commodity money such as gold. Therefore, Bitcoin is not an ideal currency for risk management, meaning you do not have viable options for hedging against risk in the cryptocurrency market. 

Finally, the blockchain ecosystem that underlies cryptocurrencies is not yet safe enough for mass adoption. Hacking cases as rife, and the existing security measures still suffer leakages. For this reason, some players in the legacy banking system have hesitated to integrate with the cryptocurrency ecosystem. As such, the ecosystem seems a little disconcerting to retail market participants – who make up the bulk of participants in any market.  

Conclusion

The world might be slow in adopting cryptocurrency as a mainstream means for settling transactions, but Bitcoin is not letting up. In ten short years, the digital currency has undergone major transformations to rival many assets with record-breaking returns on investment. Yet, the currency faces substantial challenges that need addressing.

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