Thursday, January 8, 2015

Bitcoin is inherently worthless. So why is it valuable?

Bitcoin (BTC) is inherently worthless. Despite that, it retains value. Why?

What do we know about BTC?
1. It's convenient for buyers and sellers to transact in BTC, for goods and services
2. It's convenient for people who want to exchange currency to use BTCas a intermediate step between currencies.
3. You can easily store it, for long or short term.
4. It doesn't require a central authority.
5. There is a limited amount of it, and its hard to get more via mining, which is a function of computing power.
6. The harder people work to crate bitcoin (measured in total computing power devoted to creating it), the harder it becomes to create a bitcoin (measured in computing power)

To try to answer this question, lets look at a riddle

Since its convenient to sell goods and services in BTC, we know that people also sell computing power (as a service) and physical hardware which can be used to mine BTC, priced in BTC.

People are devoting exponentially more and more computing resources to creating Bitcoin

The mining hardware that is sold in BTC cannot be priced at lower than the USD cost required to create the hardware (Fabrication cost, materials cost, etc.)

The mining hardware that is sold in BTC cannot be priced HIGHER than the estimated projection of how many BTC it can reasonably be used to create.

Therefore, there is a minimum  USD cost, and a maximum BTC cost of mining hardware.

Lets say one chip (or computer), as of the time its sold, can mine 100 BTCs in its projected lifespan. In that case, the maximum cost is 100BTC. The chip costs $100 to create (in USD). Therefore, the minimum cost is $100.

If that hardware, therefore, is sold for its maximum price of 100BTC, that means the minimum value of a BTC mus be $1.00. If it is sold for less BTCs, then BTC must be worth more than $1.00.

The harder mining becomes, the more expensive BTC must become, because the price of mining hardware must increase: 

So you can see, that the price of BTC is implied by the desire people have to create it, because the more desire (computing power devoted to creating it) there is to create BTC, the harder it becomes to create.

The answer

The reason Bitcoin retains value, is because computers work HARD to create it (and consume energy to do so), and have been working increasingly harder to do so over time. Those computing cycles have a clearly defined value (in USD and other currencies), and a clearly defined replacement cost (The cost of new hardware).

Therefore, the more computing resources devoted to creating it, the more expensive it should become, over the long term.

In other words, just how USD is a currency backed by Debt (dedicated human power).

United States productive  power has increased exponentially, which is why the value of USD (as a total currency, not each individual dollar) has increase radically. However, the USD money supply has grown dramatically/exponentially., reducing its value (as a single USD)

Bitcoin, is a currency backed by Hash Rate (dedicated computing power), which is increasing exponentially. However, BTC is not growing exponentially.

A currency backed by Debt is worth only as much as the indebted population is valuable (and the natural resources they have access to)
A currency backed by Hash Rate is worth only as much as it's computing population is valuable (and the energy resources it has access to)

Why cant the price crash?

As long as the hash rate stays up, the price of bitcoin will not drop, because there is a mathematical floor implied by the relationship between the replacement cost to compute a bitcoin, the demand/desire to create bitcoins implied by total hash rate, and the price of bitcoin.

Unless/until hash rate crashes, the price of BTC will not crash.