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It's only been a year since bitcoin fans predicted that the cryptocurrency would reach $ 1 million.
But that was then. With the price of the bitcoin
BTCUSD, -4.43%
after losing nearly 80% from its peak, and now trading well below the $ 6,000 support level, everyone is wondering where it will go from here.
The answer is, a quick and painful drop to zero.
In a MarketWatch column I wrote last April, I explained what bitcoin would require to become useless. Bitcoin is approaching that point. As I argued, once the price of Bitcoin falls below its cost of extraction, the incentive for mine will deteriorate, pushing bitcoins into a deadly spiral. That is, without the mining activities that support the ledger that keeps records of who owns what – the bitcoin is, after all, a set of encrypted numbers that can not establish ownership of anything – the bitcoin will become useless.
A typical asset has a series of cash flows and its value is determined by investors' expectations on such cash flows. Bitcoin has no cash flows. In this respect, it is more similar to gold, as its value is driven in part by its desirability and its potential uses, but mainly by its cost of extraction. While there are many estimates of the cost of Bitcoin mining, most suggest that it is close to $ 5,000 per currency. Moreover, even if traditional raw materials such as gold require significant investments, with limited technical knowledge and capital, anyone can extract bitcoins. Therefore, the price of the bitcoin must be close to the cost of complete extraction (which means that you are modestly compensated for the time and the outlay of capital). So, one would expect the price of the bitcoin to float somewhere around that point.
Moreover, there is a further complication: unlike gold, which, probably due to a historical incident, is universally accepted as a store of value, bitcoin is a digital commodity without such universal acceptance as a reserve of value. While original bitcoin buyers and miners were true believers in the paradigm shift they thought they had promised, and were willing to make the necessary investments for future gains, the most recent buyers and miners were rude, greedy-invested investors.
Their greed was further fueled by the futures trade, which was introduced when bitcoin prices were exploding and the sun seemed to be constantly on the horizon. With bitcoin prices well above the cost of mining, they saw an obvious opportunity for arbitrage: mine bitcoins and sell them at a higher price in the futures market to obtain guaranteed arbitrage profits.
It is not surprising that traditional investors have noticed this, with many investments in mining activities, and the bitcoins that were thought to have been generated by mining activities were sold in the futures market. With the entry into the market of multiple arbitrators to take advantage of this opportunity, bitcoin prices have been pushed down close to their cost of extraction (with a small return) and have led to a long term (in bitcoin) prices stable. He has also changed the miners' complexion, and a greater proportion of them are now the right time miners looking for a quick pay that will disappear quickly once the opportunity fades.
However, the cost of bitcoin mining is not a fixed dollar amount. There is a feedback mechanism in the extraction of any commodity that applies to bitcoin: to increase the price of bitcoins, new miners enter the market, increasing the effort required to extract a bitcoin, since its reward will be shared between a larger group of miners. Likewise, when the price of the bitcoin falls and the output of the miners, the cost of mining decreases. However, the number of miners can not fall below a certain level, because without the miners providing the computing power to keep the register, the bitcoin blockchain will not remain viable.
The mining at a cost higher than the cost at which it is possible to sell in the futures market destroys the value. So any rational investor – even one who firmly believes in the rebound in bitcoin price – has no incentive for mine if the cost of mining is higher than the future price and it is better to buy futures on the market. And unlike gold, which can retain its value even if mining stops, the bitcoin can not have any value in the absence of mining that keeps the register of who owns it. Absent mining activity, bitcoin is just a set of worthless ciphers.
Spiral of death
So, it seems that the bitcoin is entering a deadly spiral: if the price keeps going down and the cost of mining does not decrease correspondingly (the cost of mining will decrease in an algorithmic way, but not necessarily to the same extent as the fall in prices) , bitcoin will quickly go to zero.
Bitcoin supporters will argue that the price of bitcoin has declined by large percentages before. Except that the most recent decline is different in three significant ways. Firstly, the magnitude of the recent decline diminishes the magnitudes of past declines. Secondly, the losers in the recent decline are new investors who will probably retire until there is more clarity about the use of bitcoins. Thirdly, futures markets have changed the game, allowing miners to estimate losses and mining profits from the start – if it is possible to buy in a futures market at a price lower than mine costs, because mine for a certain loss?
History is full of examples of innovative companies that have gone bankrupt and "me-too" companies have become the best investments.
Many argue that the bitcoin become really useless is extreme. Of course, looking at some fashions and memorable bubbles, the tulips are still trading for $ 10 per deck and Beanie Babies are reasonably priced at $ 5.
And it seems that the Blockchain economy is here to stay, where many of our transactions will be processed on the blockchain and use cryptocurrency for daily transactions. In fact, while the world may be in debt forever with Satoshi Nakamoto for giving us a vital cryptocurrency, the bitcoin may cease to exist. An improved currency could evolve, or governments could start issuing cryptocurrencies. History is full of examples of innovative companies that have gone bankrupt and "me-too" companies have become the best investments.
And after all, I can still give my wife a bunch of tulips and make her happy. And I can still give Beanie Babies to my nephews to play with. But what will I do with a series of numbers that I can not prove makes me the owner of something?
Atulya Sarin is a finance professor at the University of Santa Clara. He wrote about currencies in his book "Fundamentals of Multinational Financial Management" (sixth edition) and worked extensively as an evaluation expert.
