Monday, January 8, 2018

Bitcoins and Gold


Before I begin, let me disclose that I am not an expert on economics, investing or pretty much anything else. These are just some of my random observations.

Of late, everyone is talking about Bitcoins. Some swear by it, some think it is the Tulip Bulb Phenomenon of the 21st century. Frankly, I am finding it rather difficult to make any sense of whether investing in Bitcoins is a good idea, or if the current price of Bitcoins is justified. But bubble or not, there is something about Bitcoins that I feel makes them very similar to gold. And so I suspect it might not be a complete sham after all.




Bitcoin as a Store of Value

Don't think of Bitcoin as an investment, don't even think of it as a currency. Think of it as a store of value. Something like Gold. But why is Gold a good store of value? Because there are a few properties of Gold that make it ideal for this purpose. From what I understand about Bitcoins, they too have these same properties and so I suspect Bitcoin (or for that matter any other cryptocurrency) will be used as the store of value of the future. Let me discuss those properties: 

Rarity

Any store of value must be rare. This ensures that the price of the commodity does not go down drastically because someone unearths a large supply. So we can't use something like marbles as a store of value, simply because there is plenty of it. Gold is rare, not just on earth, but probably in the entire universe. Bitcoins by design have this property, since there can be only a total of 21 Million bitcoins, there is no possibility of a sudden surge in supply.


Durability 

Store of value should be very durable, almost indestructible. You don't want to put all your life savings in something that might get rusted, burnt, broken, corroded and so on. Gold is wonderful in this aspect as well. Bitcoins may not be as indestructible as Gold, but they have fault tolerance built into their underlying technology. Blockchain is fault tolerant because of inbuilt redundancy and distributed nature. If you think about it, there are very few things in the world that satisfy these two properties of rarity and indestructibility. But there is one more property we still need.





Fungibility and Divisibility

Fungible simply means mutually exchangeable, like currency notes. A $1 currency bill is replaceable by any other $1 bill. Diamonds are rare (somewhat!) and indestructible but are not exactly fungible. Each diamond is unique with its composition and cut. Gold meets this requirement too. Since 1g of Gold is equal to any other 1g of Gold and doesn't matter where it comes from. Since Bitcoins are digital currency, they meet this requirement trivially.

Gold is also very divisible and it is very easy to make small coins or jewellery items easily (1 grain = 0.0648 grams). Bitcoins take this to another level as you can trade a 0.00000001 fraction (hundredth of a millionth). So even if the Bitcoin price goes up to 100 Million, you can still in theory make $1 purchases. 


But what about Intrinsic Value

One might argue that Bitcoin only exists logically and is not something physical. As such, it has no intrinsic value. Plus, once you have a lot of Bitcoins, what can you do with them apart from trading them further? Does this mean that they are useless? But remember, Gold too does not have any intrinsic value either. And other then jewellery, Gold too has no productive use. So even Gold is only as valuable as the price someone is willing to pay for it. 

If you think about it, Bitcoin meets all the criterions of a store of value. So, in reality, its the other way round - Bitcoin are precious because it is rare, divisible and can be easily traded. It is not being traded because it is precious. Kind of like Gold.