What Backs The Value Of Bitcoin?
Key Takeaways
- Bitcoin’s value is derived from its protocol, which is built on a scarcity principle, secure nature, and stakeholder interest as a savings technology.
- Bitcoin serves as digital gold, offering an inflation hedge and currency debasement protection.
- Market cycles and liquidity shifts drive Bitcoin’s price volatility.
- Bitcoin security is reinforced because of its high computational power and energy, which protects against potential attacks and bad actors.
When considering the skepticism surrounding the value of cryptocurrencies like Bitcoin, compared to traditional, government-backed fiat currencies, it is essential to understand that there are fundamental differences in how Bitcoin finds its values and how it is determined.
What Is Bitcoin’s Underlying Asset?
In 2009, Bitcoin became the world’s first cryptocurrency with a value of one Bitcoin equivalent to the cost of the energy required to produce it at roughly 0.05 cents. Over the last decade and a half Bitcoin has increased in value to as high as $75K because of its inherent value as the world’s first digital monetary protocol.
The security of the Bitcoin network is underpinned by the substantial amount of electricity pledged by miners, making sure that the monetary protocol is robust against attacks from bad actors. This requires immense computational power and energy expenditure to maintain and validate the blockchain.
Blockchain Technology
Bitcoin’s foundational asset is not a physical commodity but the blockchain technology that underpins it. This technology operates as a decentralized ledger that meticulously records all Bitcoin transactions in a secure, immutable, and transparent manner.
The blockchain’s integrity and reliability are central to Bitcoin’s value, providing a robust framework that ensures each transaction is permanently and publicly verifiable.
Decentralization And Consensus Mechanism
The strength of Bitcoin lies in its decentralized nature, achieved through a network of nodes spread across the globe. These nodes are essential in validating and confirming transactions using a consensus mechanism known as proof-of-work (PoW).
This method requires nodes to solve complex mathematical problems, ensuring the network’s security and eliminating the need for a central governing authority.
This decentralized approach enhances security and fosters a trustless environment in which transactions are verified by collective agreement rather than by a singular, potentially biased entity.
Bitcoin Energy Consumption
The hash rate of Bitcoin in 2024 stands at 600 million terahashes per second (TH/s) representing the immense computational power involved in mining and maintaining the Bitcoin network. Understanding this metric is useful to understand how the security and functionality of Bitcoin is sustained and is ultimately backing the hardest money known to humanity.
When trying to contextualize the magnitude of 600 million TH/s in the chart above and to try and put it into perspective, an individual may refer to the capabilities of modern mining hardware.
Here, a high-end Bitcoin mining rig, such as the Bitmain Antminer S19 Pro, can produce about 110 TH/s. To achieve a combined output of 600 million TH/s, the Bitcoin network would need approximately 5.45 million Antminer S19 Pros operating simultaneously.
This level of power is huge, reflecting a vast amount of energy consumption and physical commitment of tangible hardware to sustain an intangible form of money.
The annual energy consumption of the Bitcoin network is often compared to that of entire countries. For example, at certain times, Bitcoin’s energy usage has been comparable to that of nations like Sweden or Malaysia, underscoring the significant resources devoted by humans and capital required to secure the network.
Why Do Bitcoins Have Value?
Understanding why Bitcoin holds value can be understood via following explanation:
Scarcity And Demand
One of the primary reasons Bitcoin holds value is its scarcity. Bitcoin’s protocol dictates that there will only ever be 21 million Bitcoin in existence. This limit is hardcoded into the Bitcoin network, which contrasts sharply with traditional fiat currencies, which central banks can print in unlimited quantities.
The demand for Bitcoin and its limited supply, helps drive its value as more people and institutions recognize its potential as a store of value and a hedge against inflation.
Network Effects
The Bitcoin network grows as the number of its users increases. As more individuals and businesses adopt Bitcoin for various uses, such as remittances, investment, and as a means of transaction, the more ingrained and valuable the network becomes. Similar to how social media platforms or telecommunications networks have become more valuable as more people use them.
Bitcoin offers itself as a banking option across global borders without the need for intermediaries like banks or payment processors.
Mining Difficulty Adjustment
The mining difficulty adjustment mechanism in Bitcoin is a unique feature designed to maintain a consistent block production rate, regardless of fluctuations in mining power.
This adjustment occurs approximately every two weeks and is based on the total computing power dedicated to mining on the network. The self-regulating mechanism helps stabilize the network and ensures that new Bitcoins are created at a predictable rate, reinforcing its underlying value proposition.
Human Effort And Physical World Interactions
An often overlooked aspect of Bitcoin’s value is the substantial human effort and physical resources committed to maintaining and securing its network. Miners use powerful computers that require significant electrical energy to solve complex mathematical problems, thereby processing transactions and securing the network.
This mining process comes as a sizable investment in physical infrastructure and electricity pledge, tying Bitcoin’s digital presence to substantial physical world activities and costs.
Bitcoin Is Digital Gold
Bitcoin has been recognized as a commodity akin to digital gold by the world. Bitcoin holds value because of its role as a hedge against inflation and currency debasement. Bitcoin’s capacity to maintain purchasing power over time and actually increase in purchasing power over time makes it a modern day savings machine, particularly in economies where fiat currencies are susceptible to devaluation.
The Bitcoin finite supply and resilience to censorship and confiscation are absolutely important to its value proposition as a reliable digital monetary asset in the 21st century.
What Drives The Price Of Bitcoin?
The price of Bitcoin is influenced by a multitude of factors, driven by various stakeholders with differing motivations:
Investors Vs Traders
Investors who view Bitcoin as a long-term store of value, contribute to its price increase by accumulating and holding significant quantities of the cryptocurrency.
On the other hand, traders, who seek short-term gains through market speculation, engage in frequent buying and selling, leading to BTC price volatility.
The Four-Year Bitcoin Cycle
The Bitcoin market typically follows a four-year cycle, characterized by distinct phases and induced because of its 4 year cycle to each halving.
The Bitcoin 4 year cycle begins with a year of price discovery, marked by extreme volatility and ends in euphoria. This is (to-date) followed by a year-long bear market, where prices correct and consolidate leading to a depressed market.
Subsequently, the next two-years are the accumulation phase, during which prices stabilize, and investors gradually accumulate Bitcoin at lower prices. Throughout these phases, market sentiment shifts from depressed to optimism, breathing new life into the Bitcoin market.
Market Sentiment
During periods of market depression or fear, when sentiment is pessimistic, prices may decline as investors panic-sell or adopt a wait-and-see approach.
Conversely, in times of market greed or optimism, driven by positive news or developments, prices tend to surge as investors rush to buy in anticipation of further gains.
Thin Order Books
High spreads and limited liquidity have historically contributed to Bitcoin’s volatility, resulting in fluctuations in its market capitalization over the four-year cycle. As more liquidity enters the market, mainly through vehicles like ETFs (Exchange-Traded Funds), it is anticipated that there will be a reduction in Bitcoin’s volatility.
Increased liquidity typically leads to a more stable market environment, as a larger pool of investors can buy and sell assets with less impact on prices. Consequently, Bitcoin’s market capitalization may become more resilient to rapid fluctuations, reflecting a maturing and potentially less volatile market.
Lack Of Widespread Education
Lack of education about Bitcoin and cryptocurrencies contributes to price volatility, as uninformed investors may react impulsively to market events or misinformation.
This lack of understanding can amplify market movements and increase volatility. Over time as education increases and more people adopt Bitcoin, volatility is beginning to reduce.
What Is A Backed Currency?
Traditionally, a “backed currency” has its value directly tied, or pegged, to a tangible asset such as gold or another stable currency. This pegging ensures that the currency’s value remains stable and predictable, reinforcing user confidence by ensuring that the currency holds intrinsic value. However, Bitcoin and other cryptocurrencies derive their value from different factors.
United States Dollar Background: The 1900-1971 Gold Standard
The United States dollar was officially pegged to gold with the establishment of the Gold Standard Act on March 14, 1900. This legislation defined the dollar’s value in terms of gold, explicitly setting the dollar’s value at 25.8 grains of gold at ninety percent purity, equivalent to $20.67 per ounce of gold.
This gold standard system ensured that each unit of currency issued had a direct equivalent value in gold reserves. This legislation enabled Individuals and foreign governments to exchange dollars for gold at this rate, anchoring the dollar’s value and maintaining global trust in its stability.
Beyond Traditional Currency Backing
The terms “money” and “currency” refer to different concepts. Below are their definitions:
What Is Money?
Money is a medium of exchange, a unit of account, and a store of value. It facilitates transactions between parties and can manifest in various forms, including gold and silver coins, paper bills, rai stones and Bitcoin.
The best forms of money in history are durable, divisible, portable, recognizable, and scarce. These characteristics help retain value over time and maintain confidence among its users.
What Is Currency?
Currency, refers to money that is officially issued by governments or central authorities. This type of money, especially in the form of fiat currency is declared as legal tender and must be accepted in the fulfillment of debts.
Fiat currencies are typically not backed by physical commodities, like gold or silver but are backed by the government’s promise for the fiat currency to maintain order in the country’s economic system. Fiat currency lacks intrinsic scarcity, which can lead to devaluation in purchasing power by its users over time due to inflation or excessive issuance by government.
Transition from Money to Fiat Currency
From 1900 to 2024, as economies evolved, many countries moved away from the gold standard to adopt fiat currency systems.
This chart above illustrates the start and decline in purchasing power of the U.S. dollar over the last century, highlighting historical events and monetary policies that influenced its value.
Following the abandonment of the gold standard in 1971, after which the dollar officially became a fiat currency.
Adoption Of Bitcoin As A Currency
Michael Saylor, CEO of MicroStrategy, and Bitcoin bull, characterizes Bitcoin as a “monetary energy network,” efficient in storing and transmitting value over time and space. Saylor notes that Bitcoin is highly efficient as an energy network, maintaining its integrity across distances without the energy loss typical of traditional systems.
Why Are Currencies Backed?
Currencies are backed to ensure stability, trust, and value retention over time. The benefits associated with backed currencies include:
Stability and Trust
Stability is required to foster a society built on trust and confidence. When people believe that a currency is stable and valuable over time, they are more likely to hold and use it, increasing its functionality as a reliable medium of exchange.
Intrinsic Value
Modern fiat currencies, such as the U.S. dollar, Euro, or Yen, are not backed by physical commodities but derive value from the economic stability and governance frameworks of the issuing countries.
Fiscal and monetary policies, rather than military might, are central to maintaining each currency’s value, influencing national economic health and ensuring stability through government regulation and central bank actions.
Protection Against Inflation
By tying the currency’s value to a physical commodity that is less likely to depreciate rapidly, central authorities can maintain the currency’s purchasing power. The preservation is vital for long-term economic stability, as it ensures that the currency remains a viable store of value.
International Trade Facilitation
Backed currencies are often favored due to the fact that they are perceived as secure and stable. The confidence that these currencies instill in global trading partners facilitates smoother and more reliable international transactions, aiding in economic globalization.
Central Bank Control And Crisis Resilience
When currencies are backed by central banks or government reserves, it gives these institutions greater control over monetary policy. This control can be useful in times of economic uncertainty, as backed currencies tend to be more resilient during financial crises.
Conclusion
Bitcoin derives its value from a combination of factors being scarcity, its decentralized network secured by energy-intensive hardware, and widespread adoption by stakeholders.
As a digital asset with properties akin to gold, Bitcoin serves as a hedge against inflation and currency debasement, embodying the evolution of money in the digital age.
FAQs
Bitcoin mining increasingly utilizes surplus and renewable energy sources, transforming potentially wasted energy into a valuable and secure, global digital currency network. Regulatory announcements can induce volatility, influencing Bitcoin’s market as stakeholders adjust to compliance and restrictions. Technological improvements enhance Bitcoin’s network security and efficiency, crucial for its adoption and trustworthiness.What are the environmental impacts of Bitcoin mining?
How do regulatory changes affect Bitcoin's value?
What role do technological advancements play in Bitcoin's security?
