Why Do Bitcoins Have Value?

Bitcoin (BTCUSD) is often referred to as digital currency and as an alternative to central bank-controlled fiat money. However, the latter is valuable because it is issued by a monetary authority and is widely used in an economy. Bitcoin’s network is decentralized, and the cryptocurrency is not used much in retail transactions.

One can argue that Bitcoin’s value is similar to that of precious metals. Both are limited in quantity and have select use cases. Precious metals like gold are used in industrial applications, while Bitcoin’s underlying technology, the blockchain, has some applications across the financial services industries. Bitcoin’s digital provenance means that it might even serve as a medium for retail transactions one day.

Key Takeaways

• Currencies have value because they can function as a store of value and a unit of exchange. They also demonstrate six key attributes to enable their use in an economy.
• The definition of value in a currency has changed over centuries from physical attributes to the velocity of its use in an economy.
• Bitcoin demonstrates some attributes for a currency, but its main source of value lies in its restricted supply and increasing demand.
• If the price of one bitcoin were to reach $514,000, Bitcoin’s market capitalization would reach approximately 15% of the global currency market.

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Why Traditional Currencies Have Value

There are six key attributes to a useful currency: scarcity, divisibility, acceptability, portability, durability, and resistance to counterfeiting (uniformity). These qualities allow a currency to find widespread use in an economy. They also limit monetary inflation and ensure that the currencies are secure and safe to use.

Currency is useful if it works as a store of value or, to put it differently, if it can reliably maintain its relative value over time. Throughout history, many societies used commodities or precious metals as methods of payment because they were considered to have a relatively stable value.

Rather than carry around cumbersome quantities of cocoa beans, gold, or other early forms of money, societies eventually turned to minted currency as an alternative. The first such currencies used metals like gold, silver, and bronze, which had long shelf lives and little risk of depreciation.

Assigning value to currencies is a matter of debate. Initially, their value came from intrinsic physical properties. For example, gold’s value comes from the costs of extraction and certain qualitative factors, such as luster and purity content.

In the modern age, government-issued currencies often take the form of paper money, which does not have the same intrinsic scarcity as precious metals. For a long time, the value of paper money was determined by the amount of gold backing it. Even today, some currencies are “representative,” meaning that each coin or note can be directly exchanged for a specified amount of a commodity.

The idea of a currency’s value began changing in the 17th century. Prominent Scottish economist John Law wrote that money—currency issued by a government or monarch—”is not the value for which goods are exchanged, but the value by which they are exchanged.” In other words, the value of a currency is a measure of its demand and its ability to stimulate trade and business within and outside an economy.

This thinking hews closely to the modern credit theory for monetary systems. In this theory, commercial banks create money (and value for currencies) by lending to borrowers, who use the money to purchase goods and cause currency to circulate in an economy.

After countries abandoned the gold standard in an effort to curb concerns about gold supplies, many global currencies are now classified as fiat. Fiat currency is issued by a government and not backed by any commodity, but rather by the faith that individuals and governments have that others will accept that currency.

Today, most major global currencies are fiat. Many governments and societies have found that fiat currency is the most durable and least susceptible to loss of value over time. The value of fiat currencies is a function of their demand and supply. The U.S. dollar is considered valuable because the world’s biggest economy uses it and it dominates the flow of payments in international trade.

The Value of Digital Currencies

Any discussion about the value of Bitcoin must address the nature of currency. Gold was useful as currency due to its inherent physical attributes, but it was also cumbersome. Paper money was an improvement, but it requires manufacturing and storage and lacks the mobility of digital currencies. The digital evolution of money has moved away from physical attributes, and towards more functional characteristics.

Here’s an example. During the financial crisis, Ben Bernanke, who was then the governor of the Federal Reserve, appeared on CBS’ 60 Minutes and explained how the agency “rescued” insurance giant American International Group (AIG) and other financial institutions from bankruptcy by lending money to them. Puzzled, the interviewer asked whether the Fed had manufactured billions of dollars. That wasn’t quite the case.

“So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed,” explained Bernanke. In other words, the Fed “manufactured” U.S. dollars through entries in its ledger. This ability to “mark up” an account exemplifies the nature of currencies in their digital form. It has implications for the velocity and use of currencies because it simplifies and streamlines transactions involving them.

Why Does Bitcoin Have Value?

Bitcoin does not have the backing of government authorities, nor does it have a system of intermediary banks to propagate its use. A decentralized network consisting of independent nodes is responsible for approving consensus-based transactions in the Bitcoin network. There is no fiat authority in the form of a government or other monetary authority to act as a counterparty to risk and make lenders whole, so to speak, if a transaction goes awry.

The cryptocurrency does display some attributes of a fiat currency system, however. It is scarce, and it cannot be counterfeited. The only way that one would be able to create a counterfeit bitcoin would be by executing what is known as a double-spend. This refers to a situation in which a user “spends” or transfers the same bitcoin in two or more separate settings, effectively creating a duplicate record.

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Utility

What makes double-spending unlikely, though, is the size of the Bitcoin network. A so-called 51% attack, in which a group of miners theoretically control more than half of all network power, would be necessary. By controlling a majority of all network power, this group could dominate the remainder of the network to falsify records. However, such an attack on Bitcoin would require an overwhelming amount of effort, money, and computing power, thereby rendering the possibility extremely unlikely.

But Bitcoin often fails the utility test because people rarely use it for retail transactions. The main source of value for Bitcoin is its scarcity. The argument for Bitcoin’s value is similar to that of gold—a commodity that shares characteristics with the cryptocurrency. The cryptocurrency is limited to a quantity of 21 million.

Bitcoin is much more divisible than fiat currencies. One bitcoin can be divided into up to eight decimal places, with constituent units called satoshis. Most fiat currencies can only be divided into two decimal places for everyday use.

If Bitcoin’s price continues to rise over time, users with a tiny fraction of a bitcoin will still be able to make transactions with the cryptocurrency. The development of side channels, such as the Lightning Network, may further boost the value of Bitcoin’s economy.

Scarcity

Bitcoin’s value is a function of this scarcity. As the supply diminishes, demand for cryptocurrency has increased. Investors are clamoring for a slice of the ever-increasing profit pie that results from trading its limited supply.

Bitcoin also has limited utility like gold, the applications for which are mainly industrial. Bitcoin’s underlying technology, called blockchain, is tested and used as a payment system. One of its most effective use cases is in remittances across borders to bump up speed and drive down costs. Some countries, like El Salvador, are betting that Bitcoin’s technology will evolve sufficiently to become a medium for daily transactions.

Marginal Cost of Production

Another theory is that Bitcoin does have intrinsic value based on the marginal cost of producing one bitcoin. Mining for bitcoins involves a great deal of electricity, and this imposes a real cost on miners. According to economic theory, in a competitive market among producers all making the same product, the selling price of that product will tend towards its marginal cost of production. Empirical evidence has shown that the price of a bitcoin tends to follow the cost of production.

Monetarist Theories

Monetarists try to value bitcoin as they would money, using the supply of money, its velocity, and the value of goods produced in an economy. The simplest way to this approach would be to look at the current worldwide value of all mediums of exchange and of all stores of value comparable to Bitcoin and then calculate the value of Bitcoin’s projected percentage. The predominant medium of exchange is government-backed money, and for our model, we will focus solely on that. Roughly speaking, the money supply (M1) in the U.S. was worth more than $20 trillion as of the end of 2021.

Assuming this total remains stable, if Bitcoin were to achieve 15% of this valuation, its market capitalization in today’s money would be approximately $3 trillion. With all 21 million bitcoins in circulation, that would put the price of 1 bitcoin at roughly $143,000.

El Salvador became the first country to make Bitcoin legal tender on Sept 7, 2021. The cryptocurrency can be used for any transaction where the business can accept it. The U.S. dollar continues to be El Salvador’s primary currency.

The Challenges of Valuing Bitcoin

One of the biggest issues is Bitcoin’s status as a store of value. Bitcoin’s utility as a store of value depends on how well it works as a medium of exchange. If Bitcoin does not achieve success as a medium of exchange, it will not be useful as a store of value.

Throughout much of its history, speculative interest has been the primary driver of Bitcoin’s value. Bitcoin has exhibited the characteristics of a bubble with drastic price run-ups and a craze of media attention. This is likely to decline as Bitcoin continues to see greater mainstream adoption, but the future is uncertain.

Difficulties surrounding cryptocurrency storage and exchange spaces also challenge Bitcoin’s utility and transferability. In recent years, hacks, thefts, and fraud have plagued digital currency.

Why Do Some People Believe Bitcoins Are Worthless?

Like any asset or thing of value, the price that people are willing to pay for Bitcoins is a socially-agreed upon level that is also based on supply and demand. Because Bitcoins are virtual, only existing within computer networks, some people have a hard time grasping that Bitcoins are scarce and that they have a cost of production. Because of this unwillingness to accept that digital traces can hold value in this way, they remain convinced that Bitcoins are worthless. Others who understand the Bitcoin system agree it is valuable.

Are Bitcoins Fairly Valued?

The market price of Bitcoin is highly volatile and subject to large price swings. As a result, the market price at any given time may vary wildly from its fair or intrinsic value. Still, over time, oversold markets tend to rebound and overbought markets cool off. Thus, it is impossible to say at any given moment whether Bitcoins are fairly valued without the benefit of hindsight.

Is Bitcoin Money?

While Bitcoin has several money-like features, economists and regulators remain unconvinced that Bitcoin currently acts as money. This is because relatively few transactions are conducted in Bitcoins and very few things are denominated in Bitcoins. While people may trade Bitcoin in large volume and transfer value across the network, little commercial activity still takes place.

How Much Does it Cost to Produce 1 BTC?

The cost to produce one bitcoin depends on the cost of electricity, the mining difficulty, the block reward, and the energy efficiency of miners. With a block reward of 6.25 BTC, difficulty at 27.5 trillion, $0.15 per kWh, and energy efficiency of 45 joules per terahash, the cost to produce 1 BTC = $35,500.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual’s situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns cryptocurrency.