If a bitcoin isn’t backed by a government and doesn’t exist in the “real world”, how is it worth anything?
And if it only exists behind a computer screen, how is its value determined? In this article, I’ll answer both of these questions and more. So, read on if you want the definitive answer on where cryptocurrencies get their value.
First, we need to quickly define exactly what a currency is…
What is a currency?
For something to be considered a currency, it needs to fulfill these five criteria:
For a currency to be fungible, each of its units must be completely identical and interchangeable. For example, if you swap one US dollar for another, they’re worth exactly the same amount of money.
The same applies to Bitcoin, making it a fungible currency.
For something to be considered a currency, there needs to be a limited supply of it. Otherwise it wouldn’t have value.
For example, there is a finite amount of gold in the world, which gives it a value as a currency. Similarly, only 21 million bitcoins will ever be released, which gives Bitcoin its value. If anything, fiat currencies like the US dollar have the weakest amount of scarcity, because central banks can simply print more money when they see fit. The reason the US dollar still has value is because the Federal Reserve controls its scarcity at all times.
Gold would make a terrible currency if it dissolved in the rain.
Because it can withstand harsh weather conditions and centuries of wear and tear, we can rely on it to outlive us, which gives it its value. If we couldn’t be sure whether our gold would still be around tomorrow, it wouldn’t have any value as a currency. Cryptocurrencies are arguably the most durable currency of all. As long as the network they exist on survives, they’ll retain 100% of their value.
Given that the networks cryptocurrencies are stored on are decentralized, it would be almost impossible to destroy them, meaning their durability is essentially guaranteed.
The purpose of a currency is to enable trade between people and the transfer of wealth from one entity to another.
For something to be considered a currency, you need to be able to easily transfer units of it to another person. Cryptocurrencies definitely tick this box, as they can be transferred from one individual to another regardless of geographic location (not to mention with relatively low transaction fees compared to fiat currencies).
Finally, a currency needs to be able to be broken down into smaller fractions or units.
One of the main reasons humanity moved away from trade and onto currencies is because it’s impossible to trade half a cow (especially if you want it to live!). However, if you only want half a dollar’s worth of something, you can just pay 50 cents for it. This is divisibility. Cryptocurrencies are divisible too. In fact, Bitcoin’s current lowest denomination is a satoshi, which is equivalent to 0.00000001 bitcoins.
In theory, a simple change in Bitcoin’s code can create infinitely smaller denominations, making it more divisible than fiat currencies.
Defining a currency: USD vs Bitcoin
|Taxed as a currency?
Determining value: Bitcoin vs Gold
As you can see, it’s clear that cryptocurrencies meet all the criteria of a currency. However, it’s important to understand that the way their price is determined is slightly different to that of fiat currencies like the US dollar.
In fact, the value of a cryptocurrency is determined more like the price of gold. The value of gold is largely determined by how much investors are willing to pay for it. This changes based on how much investors speculate it’s going to be worth in the future. However, investors can almost guarantee that gold will always have some value because of its scarcity. This makes it inherently more valuable than fiat currencies like the US dollar, which could theoretically lose their value altogether at some point.
While this seems unimaginable, you only need to look back at Germany in 1922-3 for an example of a currency that was literally “worth less than dirt”. Because there is a fixed number of bitcoins that will ever be in circulation (21 million), Bitcoin’s value works more like gold’s than the US dollar’s.
Much like gold, Bitcoin’s value goes up during stable political and economic times and down during periods of instability. For example, in September 2017 China announced it will be banning ICOs. Off the back of this news, Bitcoin’s price dropped a few hundred dollars. However, a few weeks later the cryptocurrency’s value was back to where it was before the news.
More than anything, it’s important to recognize that like any currency, Bitcoin is prone to fluctuations off the back of market pressure.
Disclaimer: The contents of this article should not be taken as direct investment advice. Please do your own independent due diligence before making any investments, whether this is cryptocurrency or otherwise.