What Gives Bitcoin Its Value? An Objective Explanation

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Bitcoin has evolved from a concept in 2008 to a functioning system in 2009, to its first real-world use in 2010 when it was worth less than a dollar, to exceeding $8,000 per coin and a total market capitalization of over $150 billion by May 2020.

While empirically one of the best performing assets of the past decade, it remains highly controversial. Is it a new form of money? An investment bubble? Or perhaps a bit of both?

Investors have mature frameworks for evaluating assets like equities, credit, and real estate. But for novel monetary assets like Bitcoin, the right tools are less obvious. This article outlines a simple, intuitive framework for assessing Bitcoin’s value as a new monetary asset.

Why Discuss This Now?

In our work, we often explain Bitcoin to investors and institutions encountering it for the first time. Right now, investor interest in Bitcoin and its potential as a form of digital gold is unprecedented.

Financial crises highlight the limitations of existing systems and underscore the need for new ones. This was certainly true during the 2008 financial crisis from which Bitcoin emerged, and it may be even more true today given the unprecedented monetary and fiscal stimulus measures from governments worldwide.

Over the past 11 years, volumes have been written about Bitcoin. This article offers no novel angles but is simply a summary of the conversations we frequently have with those new to the space.

Understanding Money

Money is an ancient and complex idea. It has taken many forms throughout history: from stone axes to shells to precious metals, and then to paper notes. The last major shift in money arguably occurred in the early 1970s with the end of the Bretton Woods system and the gold standard, marking the start of the modern fiat currency regime.

We can think of the market for money as a competitive market, just like other goods. For centuries, gold dominated this market. This didn't happen by accident but because gold possessed important characteristics like scarcity and unforgeability. Today, fiat currencies dominate primarily through national monopoly power, but all monetary assets still compete globally, with gold, the US dollar, and the Euro being favored reserve assets.

Like a written language, money is a protocol standard with powerful network effects. A new monetary asset can only rise to prominence if it better serves the core functions of money and overcomes the adoption hurdles new currencies face. We believe Bitcoin addresses both issues well.

The Store of Value Function

A primary function of money is to act as a store of value: a mechanism to transfer purchasing power across time and geography.

All successful monies have served this function well. If a monetary asset is no longer trusted as a store of value, savings rapidly flee from it, as seen in hyperinflationary economies like Venezuela.

Gold as a Benchmark

Gold has been trusted as a store of value for millennia. Critically, the supply of gold in the earth is known to be scarce. Trust in gold's scarcity is based on an understanding of nature: gold cannot be synthetically produced cheaply—despite the best efforts of alchemists throughout history.

Gold also scores well on many other perfect asset attributes: it is recognizable (does not tarnish), divisible, measurable (by weight), and verifiable (via assay). It is no surprise, then, that gold became the global monetary standard, replacing previous forms of money.

Fiat Money and the US Dollar

Paper money emerged to simplify the daily use of precious metals as a medium of exchange (another core function of money). Although paper money was initially backed by precious metals, most of it today is free-floating in value and established by government fiat.

The US dollar is currently the world's most important fiat currency, having held the status of the global reserve currency for much of the past 100 years (replacing the British pound). Beyond being a trusted store of value, the dollar is the primary medium of exchange and unit of account. A significant portion of global trade is priced and settled in US dollars, regardless of whether the US is directly involved.

Trust in the dollar depends on trust in its government (e.g., to manage its monetary policy wisely). Placing this trust in a single institution is efficient but also carries risks. A fiat currency can lose credibility and be devalued through government actions. In times of crisis, governments may face short-term pressures that far outweigh concerns about long-term credibility. Venezuela is an extreme example of what can happen when that trust erodes: the currency becomes worthless.

Many investors, including central banks, hold both gold and dollars (or dollar-denominated assets) because they offer complementary hedges. We can think of the dollar as a centralized monetary asset that can be devalued by a single point of failure. We can think of gold as a decentralized monetary asset that cannot be devalued by any single entity.

Bitcoin's Monetary Properties

Bitcoin is a new, decentralized monetary asset, similar to gold. It combines gold's scarcity and monetary nature with the digital transferability of modern money. Although still relatively young, Bitcoin has outstanding potential to grow into a future store of value based on its inherent properties.

As a monetary asset, Bitcoin must be scarce, portable, fungible, divisible, durable, and widely accepted. Bitcoin scores well on most of these dimensions, with widespread acceptance being its primary shortcoming:

Beyond these classic monetary properties, Bitcoin also boasts:

An asset with these properties that is widely accepted would represent a significant improvement over gold. However, Bitcoin currently lacks that widespread acceptance and is still in its infancy as a store of value compared to gold's millennia of history and trust. Being a better product is not enough; Bitcoin must have a stellar go-to-market strategy to achieve widespread adoption.

The Nature of Monetary "Bubbles"

Since its inception, many astute investors have observed that Bitcoin looks like a bubble. They are not wrong, but for reasons they may not fully understand.

If we define a bubble asset as one that is valued beyond its intrinsic worth, we could argue that all monetary assets are bubble assets.

By definition, a store of value is an intermediate asset that is desired not for its direct utility but for its future exchange value. This value is reflexive: people believe in the store of value if they believe others will believe in it (who, in turn, expect others to believe in it, and so on).

This phenomenon is distinct from other asset classes, which have utility-based demand with speculation layered on top. For monetary assets, the utility exists within the collective speculation itself.

Nobel laureate economist Robert Shiller observed: "Gold is a bubble, and it has always been a bubble. It has some industrial uses, but it's essentially like a fad that has persisted for millennia."

We can view money as a bubble that never pops (or hasn't popped yet). The value of fiat, gold, or Bitcoin relies on a shared belief. Other factors—like government power, gold's industrial uses, or the robustness of Bitcoin's codebase—can reinforce this belief, but the belief is key.

That such enormous value arises from shared belief can seem circular and non-fundamental. However, the social and economic cooperation facilitated by monetary assets has real value (just as the value of a universal language is real).

Furthermore, this shared belief cannot form around just any asset—successful monetary assets must compete on inherent properties to win this belief. Superior inherent properties explain why gold was a more favored monetary asset than silver or fur, and why Bitcoin is better than any number of its imitators.

The Bubble as a Go-to-Market Strategy

If Bitcoin succeeds in becoming a trusted store of value, its end state is a bubble. The bubble is also the path through which Bitcoin gains wider acceptance.

In its 11-year history, Bitcoin has experienced at least four major bubbles:

Each bubble period shares similar characteristics. When the market is in a trough and ignored, highly convicted investors begin buying. This drives up the price, attracting media attention, which in turn draws in investors (or speculators), many of whom have little faith in Bitcoin itself and short time horizons for returns. More buying drives the price even higher, fueling more attention and greater investor interest. This cycle repeats until demand is exhausted and the bubble pops.

Although investors who experience the bubble are left with painful memories, each bubble brings greater attention to Bitcoin, expands its reach, and grows the community of long-term holders who are convinced of its future as a store of value. The floor price of Bitcoin after each bust has been progressively higher, demonstrating this momentum: $2 in 2011, $200 in 2015, and $3,500 in 2018. 👉 Explore more strategies for understanding market cycles

The Potential Future of Bitcoin

What might the future look like as Bitcoin gains broader acceptance? Some speculate about a future where salaries and daily expenses are denominated in bitcoin. While this may happen to some extent, it seems unlikely that Bitcoin will challenge the dollar's primary role as a medium of exchange and unit of account, at least not anytime soon. Instead, Bitcoin is more likely to earn a place alongside gold as a very sensible component of many investment portfolios.

Early adopters and technology leaders will be the first to embrace it. Over time, we hope this camp will expand to include more investors and institutions. Eventually, central banks may come to see bitcoin as a complement to their existing gold reserves.

Finally, the rise and fall of monetary assets occur over cycles longer than a human lifespan, making them difficult to predict. Before the dollar became the world's primary reserve currency, that role was held by the currencies of Britain, France, Holland, and even ancient Greece and Rome. Similarly, before the adoption of gold, more primitive forms of money dominated. The idea of decoupling fiat (like the dollar) from gold itself is a recent phenomenon that would have seemed unthinkable half a century ago. It seems likely that the global monetary order may change in ways we cannot imagine today, with digital currencies like Bitcoin playing a major role.

Assessing the Market Size

As a decentralized store of value, it is natural to consider Bitcoin's potential market size relative to gold. The total value of gold is estimated at roughly $9 trillion (as of May 2020), held as central bank reserves (17%), private investment (22%), jewelry (47%), and other various forms (14%). Bitcoin could capture some, but not all, of this value.

Over time, market demand for assets like gold and Bitcoin could expand beyond $9 trillion, especially considering the dominant trend of global monetary easing. According to the IMF, total international reserves reached approximately $13 trillion in 2019, comprising gold (11%), foreign exchange reserves (86%), and IMF-related assets (3%). If governments outside the US—some of which are already wary of their dependence on the dollar for reserves—begin to adopt Bitcoin as a complement to their existing gold holdings, the potential market size could expand dramatically.

Beyond supplementing investment demand for gold, Bitcoin could indirectly capture a broader store-of-value market. Consider individuals holding depreciating fiat currencies (e.g., the Argentine peso or Turkish lira) who may have difficulty accessing dollars or gold. Or consider various collectibles like art or gems, some of which are held primarily as stores of value. Or empty apartments in New York owned by individuals seeking to store assets outside their home country. Bitcoin could more efficiently and sensibly capture a subset of these behaviors.

While precise market size estimates are challenging, we believe it is clear that Bitcoin has significant room to grow if it continues to gain broader acceptance.

Acknowledging the Risks

Although Bitcoin is now over a decade old, significant risks remain:

The Adoption Chasm
Bitcoin has gained credibility among early adopters, including some large institutional investors, but it remains a niche asset compared to established monetary assets like gold. Bitcoin might never cross the chasm to widespread adoption, disappointing its proponents. Of course, this is also the opportunity. If Bitcoin were already a widely accepted store of value, its value would be orders of magnitude higher, and the upside would be relatively smaller.

Price Volatility
Relative to the dollar, Bitcoin's price has been (and will likely continue to be) highly volatile. This volatility can be a barrier to adoption, preventing investors from viewing it as a reliable store of value. For better or worse, this volatility may be inherent to its adoption process, as natural fluctuations in investor confidence (as with any early-stage disruptor) are reflected in its price. Bitcoin's bubble-like adoption path exacerbates this volatility effect. As Bitcoin matures and is more widely accepted as a monetary asset akin to gold, investor confidence and Bitcoin's price should stabilize.

Regulatory Uncertainty
Bitcoin is a new form of money and payment rail that exists outside the traditional financial system, posing a potential challenge to existing regulatory frameworks. Similar to the early internet, governments could pursue thoughtful regulation that allows innovative use cases to flourish. However, there is a risk that regulation becomes overly burdensome and ultimately hinders Bitcoin's broader adoption. A mitigating factor is that Bitcoin is a global, decentralized network, making it difficult for any single government to control completely, though governments could potentially restrict access to the network in various ways.

Technical Risks
The Bitcoin codebase and network have been battle-tested for over a decade, but it is still evolving, and some open questions remain about the system's long-term operation. For example, as the Bitcoin supply curve flattens, miners must be compensated primarily through transaction fees rather than block rewards.

Competitive Risks
Other cryptocurrencies could compete with Bitcoin, as could government-sponsored central bank digital currencies (CBDCs). Compared to other cryptocurrencies, Bitcoin has a powerful first-mover advantage in acceptance, security, and credibility that will be difficult for competitors to overcome. Compared to CBDCs, Bitcoin is unique in its scarcity and gold-like nature. A digital dollar or digital yuan would have the benefit of being a unit of account people already know and use, but they would still be subject to their respective national monetary policies.

The Unknown
We must acknowledge that digital monetary assets like Bitcoin are without historical precedent. We are entering uncharted territory, which carries more uncertainty than conventional assets.

Frequently Asked Questions

Is Bitcoin a good investment?
Bitcoin has historically been a high-risk, high-reward investment. Its potential for significant returns is counterbalanced by substantial price volatility and uncertainty regarding its long-term adoption and role in the global economy. It should be considered a speculative asset within a diversified portfolio.

How does Bitcoin differ from traditional money?
Unlike traditional fiat money issued by governments, Bitcoin is decentralized, has a fixed and predictable supply cap, operates on a global peer-to-peer network without a central authority, and offers properties like censorship-resistant transactions and digital portability that traditional money lacks.

Can Bitcoin be used for everyday purchases?
While technically possible, Bitcoin's primary use case is currently evolving as a store of value rather than a medium of exchange for daily transactions. Its price volatility and sometimes slower settlement times compared to traditional payment systems can make it less practical for small, everyday purchases at present.

What are the biggest threats to Bitcoin?
Key threats include persistent regulatory crackdowns in major economies, a failure to achieve broader adoption beyond its current user base, potential technical flaws or security vulnerabilities, competition from other cryptocurrencies or government digital currencies, and the inherent risks associated with a still-nascent asset class.

How can I securely store Bitcoin?
Bitcoin can be stored securely using various methods. These include hardware wallets (dedicated physical devices), software wallets (applications on your computer or phone), and for larger amounts, institutional-grade custodial services. Security best practices involve safeguarding private keys, using strong passwords, and enabling two-factor authentication where available.

Conclusion

Bitcoin is a new monetary asset on a rising adoption curve. Although not yet widely accepted, Bitcoin has significant potential to serve as a future store of value based on its inherent features.

Because the emergence of a new monetary asset is not a common event, Bitcoin is likely to challenge our conventional intuition, provoking (understandable) controversy in the investment world.

This controversy, of course, also represents opportunity. We believe Bitcoin offers attractive returns for patient, long-term investors willing to spend the time to truly understand it, albeit with considerable risk. We hope this article provides a good starting point for that journey.