What Determines The Value Of Bitcoin?
Bitcoin is both a network and a new type of digital asset. The value of Bitcoin has been highly debated, with some claiming that it is completely worthless and others claiming that a Bitcoin could be worth a lot at scale. One of the most common questions in these discussions is “What determines the value of Bitcoin?”
During the gold standard, currencies such as the United States Dollar or the British Pound were directly linked to the value of gold. This meant that people could trade in their currency for a set amount of the precious metal. In the case of Bitcoin, instead, expectations about the future utility of the Bitcoin network defines the value of each bitcoin. As a result, Bitcoin does not have a fixed exchange rate against a commodity such as gold or a currency such as the US dollar but fluctuates in value as market expectations change.
Inherent vs. Derived Value
Currency and other assets can have either inherent value or derived value. An example of a currency with inherent value is a gold coin, which is made out of a metal that has other uses. For example, a gold coin could be melted down and used to make jewelry, computer parts, or other things. While the exact value of an ounce of gold may be debatable and vary over time, it has a residual value because of these use cases.
Fiat money — like U.S. dollars and many currencies in active use today — has a derived value. A dollar bill is a piece of paper that has limited utility. However, it has value because people believe that it has value and because it is backed by “the full faith and credit” of the U.S. government. As long as you can exchange that special piece of paper for a certain amount of goods or services, then it has a particular value.
Being backed by the U.S. government does give the dollar weight and trustworthiness. The U.S. government is reliable for paying its debts, as demonstrated by the fact that the U.S. Treasury bond market is the backbone of the modern financial system.
Why Bitcoin is Trusted
As a digital currency, Bitcoin works very differently than traditional fiat currencies. Trust in most currencies and their value boils down to trust in the organization backing them. With Bitcoin, value is derived from properties and incentives built into the protocol.
Under the laws of supply and demand, the value of an asset increases as demand increases and/or supply decreases. For most fiat currencies - such as the U.S. dollar - scarcity is created by the organization in charge of that asset. The U.S. government is the only party that can change the monetary base and supply of dollars. However, if they expand the monetary base too aggressively, it can lead to inflation.
Bitcoin’s scarcity is built into the protocol itself. The total supply is capped at 21 million Bitcoin, each of which can be divided into 100 million Satoshis.
In the traditional financial system, most transactions require trust in centralized institutions. A bank balance is just a number stored on a computer that a bank promises will not be changed without authorization. If that promise is broken, the bank might face an investigation by the government backing it, but investors could lose everything. These organizations can also reverse transactions at will based on reports of fraud and consumers’ requests.
All Bitcoin transactions are recorded on Bitcoin’s immutable digital ledger. The immutability of this ledger is guaranteed via a combination of cryptography and game theory. Rewriting the digital ledger's history requires control of the majority of the network’s hash power. While a 51% attack has happened to smaller cryptocurrencies, it has never happened to Bitcoin.
Bitcoin has a pretty solid track record for security. The biggest successful Bitcoin hack to date occurred on August 15, 2010, about a year and a half after the blockchain launched. This attack exploited a programming error and allowed the attacker to create 184 billion Bitcoin out of thin air. At the time, a Bitcoin was worth only a few cents, and the Bitcoin developers were able to quickly perform a hard fork that rolled back the attack and erased it from history.
Does Bitcoin Need Backing?
Bitcoin and other cryptocurrencies aren’t “backed” in the traditional sense of the term. The lack of a centralized authority (i.e. a “backer”) is one of the primary selling points of cryptocurrencies. Instead, Bitcoin relies on cryptography, game theory, and incentives to induce a network of independent miners and validators to play fair and maintain an accurate copy of the digital ledger. Bitcoin’s lack of a backer doesn’t mean that it isn’t a currency or lacks value. On the contrary, as long as people are willing to accept Bitcoin in exchange for goods or services, the currency has value whether or not its detractors believe it does.