Bitcoin Fever Gripping the World, Part 5: Review

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flag1_bitcoin-1024x576In my opinion, and based on what I wrote in my previous posts, those who dismiss the Bitcoin fever as a typical speculative bubble, as experienced time and time again throughout history, are mistaken. The difference is that Bitcoin is a brilliant invention, the like of which the world hasn’t seen before. It’s a unique thing, which means the outcome cannot be predicted.

Currently Bitcoin demand has three main components. The first is anonymity. Anyone wishing to own assets or trade in products anonymously can turn to Bitcoin. The second is demand for diversification. Bitcoin enables us to avoid the risks inherent in the existing monetary system. The third demand component, which is probably the main one at the moment, is speculation. That is based on the belief that the first two demand factors will increase in the future and general use of Bitcoin as a form of payment will increase, i.e. Bitcoin will be used increasingly widely by traders.

Alongside these advantages, there are serious risks associated with Bitcoin. One of the main risks is the stable functioning of the technology involved. If technological problems are experienced, then the value of BTC will be reduced to zero within seconds. The other main risk factor is the development of the legal environment. Decentralized virtual money is a new invention and it hasn’t been substantially regulated yet. If the regulations are too stringent, then the BTC price could tumble to close to zero.

How high could the value of one Bitcoin be if the risks don’t occur, everything goes well, and Bitcoin spreads throughout the world as a standard means of payment? My accurate answer: I have no idea. It’s not even possible to make a well-founded estimate of the order of magnitude. It would definitely be far greater than at present. If we take the fact that the USA’s M0 monetary supply in January was 2,740 billion USD, and we consider that the maximum number of Bitcoins is 21 million, then that gives 130,000 USD for a single Bitcoin. Now the value is at around 120 and the exchange rate is highly volatile.

Investing in Bitcoins is doubtless something of a lottery – their value will either be zero or very high. The current fair value can be calculated by assigning equilibrium exchange rates to the various outcomes and then weighting those with probabilities assigned to the outcomes. For instance, if we assume that there is a 99% chance of one of the risks occurring and the value of the Bitcoin will ultimately be zero, and there is a 1% chance of the risk not occurring and the value will ultimately be USD 10,000, then the current fair value is 0.99*0+0.01*10,000 = 100 USD. However, if we say that there is only a 98% probability of the risks occurring, then the current fair value is 200 USD.

The market is much worse at estimating probabilities than being able to get it right within a few percent. Sometimes it gets it far more wrong that that. The fair value of Bitcoin is extremely sensitive to the probability of the various outcomes. Moreover, nobody knows what the equilibrium exchange rate would be in the case of a positive outcome. What that means is that the price of the Bitcoin will remain extremely volatile in the future.

It’s very important not to be greedy when it comes to investing in Bitcoins. It’s advisable that people only invest as much as they can afford to lose with a shrug of the shoulders, since Bitcoin is a highly risky asset. If the exchange rate rises, then it’s advisable to cash in some of your Bitcoins from time to time, preparing for the collapse, which could come at any time.

I had two reasons for purchasing some Bitcoins, solely as a private individual. The first is that the Bitcoin price is still not calculated as the fair value derived from the equilibrium prices of the potential outcomes mentioned above and their probabilities. Instead, it also includes the world’s doubts and fears concerning anything that is radically new and unknown. As the world starts to “get used to” Bitcoin and recognizes its right to existence, its price could rise. While I consider it more likely that the risks will occur and Bitcoin may not be able to operate in its current form in the long term, that is clearly not absolutely certain, so the fair value could be higher than at present. The current price may also reflect the fact that it still fairly tricky for people who are not IT savvy to purchase Bitcoins without help. Such people are in the majority. However, improvements might be seen here. That would mean that more and more people will be able to purchase Bitcoins securely and more and more people will take advantage of the opportunity.

The other reason is more of an emotional one. I’m simply really excited by the opportunities presented by Bitcoin and like owning such money. It has incredible prospects. I’ll write about those in a later post.

Original date of Hungarian publication: 22 April 2013 in