Bitcoin fever gripping the world, part 1: What gives Bitcoins value?

Imagine a thing that is durable, uniform, divisible and easily deliverable/transferable. My readers, who are doubtless well versed in financial matters, will point out that such a thing could be used as money. However, at least two more conditions need to be met:

1. A suitable quantity of it must exist

2. There must be trust in it

Suitable quantity means several things. First, there shouldn’t be too little of it, i.e. there should be enough of it to go around. Second, there shouldn’t be too much of it, so that the value of a manageable unit is not too small. Third, the quantity available should not vary too much over time to prevent sudden changes to the price level, which could be extremely damaging to the economy.

The other important condition is trust. People have to believe that they can happily accept it as payment because it preserves its value and will be accepted if they in turn wish to buy something. Today it is typical for trust to be provided by the guarantee given by a central authority. The guarantee consists of the rule set down in law by the central authority that the given tender must be accepted as a means of payment. The special banknotes issued by the Hungarian National Bank, on which numbers, swirls and the portraits of historical figures are printed, are an example of such a legal tender.

However, trust can also develop gradually, without central intervention, simply because the tender stands the test of time. A society or community can decide over time which available tender has the best ability to function as money. That tender will gradually become familiar and widely accepted in the community. Cigarettes, for instance, were used as money in prison camps.

However, a new competitor is gaining in recognition; it’s waiting in the wings for the world to discover that it has all the necessary properties of money and to accept it as a means of payment. The Bitcoin (BTC) is a fairly intangible thing. It exists on the web in virtual form only and is stored in virtual wallets. In itself it is an entirely useless mass of data.

A clever program began generating Bitcoins in 2009. Anyone can download the program and try generating Bitcoins for themselves by running it. However, what makes Bitcoin a unique innovation of global relevance is the fact that the rate at which Bitcoins are generated is pre-determined by an equation known to everyone, without any central authority or a program running on a designated serving monitoring compliance. The computers running the Bitcoin-generating program (known as the miner program) have equal status; they are connected online through a P2P network and constantly inspect one another. Trying to cheat is entirely superfluous – it just won’t work. There’s one exception: if more than half of the many tens of thousands of members of the Bitcoin miner community, spread across the globe, were to conspire and try to cheat at the very same time, then they would succeed. That, however, seems highly unlikely. Moreover, there would be no point in it, because the fraudsters would gain nothing. The honest members of the community would immediately catch wind, and Bitcoin would be devalued within seconds. It seems far more likely that the number of Bitcoins prescribed by the program will remain constant, i.e. an average of 25 BTC every ten minutes will be created (the rate will slow later).

Bitcoins derive their value to a significant degree from the belief that a finite number of them can be generated. The Bitcoin-generating program is written so that there will ultimately be a total of 21 million BTCs in the world (currently there are around 11 million). That can easily be checked, since the program has an open source code. If trust in that is shaken, it will spell the end of Bitcoin. Still, it would only be possible to cheat and, say, recode the program to generate more or fewer Bitcoins, if more than half the Bitcoin community tried to cheat at exactly the same time. That sounds just as unlikely as the previous scenario.

Bitcoin’s finite total quantity is an important feature, but it’s not the only thing necessary for Bitcoin to work like money. Bitcoin boasts the various properties listed at the top of my post – it’s durable, it can be divided into small units (0.00000001 BTC is the smallest unit), it’s easily transferable because it’s cheap and extremely simple to transfer Bitcoins between virtual wallets, and it’s uniform by definition.

Yet one item from the list is still lacking for Bitcoin to function effectively as money: trust. Since Bitcoin has no guarantee from a central authority behind it and there cannot be such a guarantee, trust in it can only develop gradually. The figure below suggests that the Bitcoin has firmly begun to stand the test of time. It’s possible to pay by Bitcoin in an increasing number of online stores. Why wouldn’t traders accept Bitcoin in exchange for their goods if they can see that lots of places accept Bitcoin as payment, even if we’re talking about a mass of data, generated by a complicated algorithm, that is worthless in itself? If it has all the necessary properties of money, then this fact alone can give it value. More and more people are becoming familiar with Bitcoin and have trust in it – and that increase in trust also means an increase in Bitcoin’s value. The process visibly reached a critical point, after which events sped up.

So is it worth getting in on the feverish Bitcoin rally? I can’t answer that question for you, but I’ll give you my opinion in this post.

This article reflects the personal views of the author, who does not assume any liability for how the Bitcoin price develops, and who is himself the owner of some Bitcoins.

Next in the series: Anonymous money

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Bitcoin 2.0 – Ethereum

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