What determines and influences bitcoins value?

Introduction

As the first truly successful digital currency, bitcoin has quite a fascinating price history, characterized by steep increases in value and long periods of high volatility. The current value of 1 BTC is roughly $27.000,00 (31-08-2023), but all the way back in 2009, when the New Liberty Standard Exchange noted the first exchange of bitcoin for dollars, 1 BTC was worth only $0,00099. Given its all time high in 2021, when 1 BTC cost $64.800,00, there is no doubt that bitcoin had an incredible rise in value. 

When Satoshi Nakamoto first launched bitcoin in 2008, very little could be bought with this new form of currency. So how did bitcoin gain its value? And how did it rise so fast to thousands of dollars? 

In this article, we aim to answer the questions surrounding the origin of bitcoin’s value, including a dive into the many factors influencing value, and how bitcoin’s value differs from the mechanism through which fiat currencies acquire their value. This article will take you along on a brief journey through monetary theory, behavioral economics, and network effects in order to unravel the process behind bitcoin’s price development.

A brief introduction to value

Value of historical currencies

In the past, the definition of value of currencies was not the same as it is today. Long ago, the value of a product was dependent on its use. The physical attributes of an object played an important role in determining its price. Today, however, the physical attributes of a currency have very little influence on the price.

Value tied to gold

For a long time in history, people used precious metals, such as silver and gold, as a currency. Precious metals had a scarcity that ensured a certain extent of resistance against high inflation, and they had a long shelf live. Rarity, durability, and utility were the key characteristics that made gold such a popular form of currency. In this regard, gold stands as an important example for the origins of value, having played a pivotal role in shaping economic systems and underpinning monetary value for millennia. 

In economic terms, gold has historically served as a store of value and a medium of exchange, forming the foundation for many early monetary systems. Its tangible nature and established historical track record imbued it with a level of trust that facilitated cross-border trade and mitigated the uncertainties inherent in fiat-based systems. Moreover, the limited supply of gold prevented arbitrary inflation, thereby maintaining the stability of its value over time.

However, precious metals as a form of currency also had disadvantages. Because of the difficult extraction process of gold, the supply could not always match the growing economy’s command, therefore potentially hindering economic growth. In addition to this, as economies expanded and international trade increased, the limitations of commodity-backed systems became more apparent. Shipping large amounts of precious metals from one country to another could be a very costly endeavor. Gold also limited the freedom central banks and governments had in implementing monetary tools to steer the economy more effectively. 

Ultimately, these drawbacks lead to the rise of many of the fiat currencies that we know today.

The value behind fiat currencies

The scarcity of gold made it a very effective currency. Fiat currencies, like the euro and the US dollar, do not have the same inherent scarcity that gold has. For a while, the value of fiat currencies was still backed by gold, providing a level of stability and predictability to monetary systems. 

The gold standard’s appeal lay in its ability to limit government discretion in printing money, thereby curbing inflationary pressures. However, this fixed linkage between currency and gold also constrained the flexibility needed for economies to respond to changing economic conditions. The rigid adherence to the gold standard could exacerbate economic downturns, as the inability to increase the money supply in times of crisis could lead to deflation and reduced economic activity.

Eventually, many countries let go of the gold standard in the previous century. The demise of the gold standard marked a pivotal shift towards fiat currencies, where the value of money is not tied to physical assets but rather relies on the trust and confidence of the issuing government and the broader economic ecosystem. In contemporary economies, fiat currencies derive their value from a combination of factors:

• Legal Tender: Governments declare fiat currencies as legal tender for settling debts and transactions within their jurisdictions. This legal backing establishes the mandatory acceptance of the currency, bolstering its utility.

• Economic Productivity: The value of fiat currencies is closely tied to the overall economic productivity of a country. A strong and vibrant economy enhances the perceived value of the currency.

• Trust and Confidence: Public trust in the stability of a nation’s economy and its government institutions plays a significant role in determining the value of fiat currency. Confidence in the currency’s purchasing power and stability is crucial.

• Global Reserve Currency: Some fiat currencies, like the US dollar (USD), have become global reserve currencies due to their widespread use in international trade and finance. This status enhances their value and demand.

Bitcoin compared to fiat currencies

Many of the factors mentioned above in relation to the value of fiat currencies, do not directly apply to bitcoin. In many cases, bitcoin is not recognized as an official currency, therefore lacking the legal tender aspect. Because bitcoin is not tied to a single country as a national currency, its value is also not that closely linked with the economic productivity of a single country. Rather, its value would be influenced by the condition of the global economy.

Bitcoin as the new gold?

Within the realm of bitcoin, numerous enthusiasts and experts hold the prevalent sentiment that bitcoin exhibits a greater semblance to gold than to conventional fiat currencies. 

The lessons drawn from gold’s role as a historical anchor of value have direct implications for the evaluation of cryptocurrencies, particularly Bitcoin. As Bitcoin is often likened to “digital gold,” the parallels between the two assets offer insights into the potential sources of value in the cryptocurrency realm. Similar to gold, Bitcoin’s scarcity, reinforced by its fixed supply algorithm, contributes to its appeal as a potential store of value. Furthermore, the decentralized and cryptographic nature of Bitcoin introduces an innovative layer of security and transparency that aligns with some of the attributes that underpinned gold’s value in the past. 

Now that we have briefly looked at the recent history of value, let’s dive into the question this article is all about: Where does bitcoin get its value from?

Scarcity and utility

Scarcity of bitcoin

Delving into the fundamental economic principles that underlie Bitcoin’s value reveals two key aspects: scarcity and utility. Scarcity refers to the finite supply of Bitcoin, with a predetermined cap of 21 million coins. This scarcity is programmed into the technology, mirroring the constraints of precious resources like gold. For example, a relatively small amount of gold is added to the total amount of gold in circulation each year, because it is so costly and difficult to mine. Similarly, the bitcoin algorithm releases a small amount of new bitcoins each year, in the form of a bonus for the miners. This total bonus each year is only a fraction of the total circulation, and due to the halvings, the added supply decreases each year too. As a result, this artificial scarcity can imbue Bitcoin with a perception of rarity and potentially contribute to its desirability as a store of value. This perceived scarcity is an important aspect in determining the value of bitcoin.

Utility

In addition to scarcity, the utility of Bitcoin as a decentralized digital currency for peer-to-peer transactions and its potential to facilitate borderless and frictionless transfers provide it with practical value. Especially with regulation paving the way for more applications and a broader use of bitcoin, the utility of bitcoin is expected to increase.

The economic interplay of scarcity and utility forms a foundational basis for the valuation of Bitcoin in contemporary financial landscapes.

The role of bitcoin’s technological foundations

Security and value

An important aspect of the value of both fiat currencies and gold is security. Both gold and fiat currencies are difficult to counterfeit, and it is not easy to drastically change its value. Similarly, bitcoin’s value is linked to the utilization of cryptographic protocols and other technologies that provide it not only with a secure network in which transactions can take place, but also fosters trust and transparency within its decentralized network. Cryptographic techniques, such as public-key cryptography and hashing, ensure that transactions are authentic and that the same bitcoin cannot be spent twice, therefore maintaining the integrity of the blockchain ledger. Such a high level of security stimulates confidence in the use of bitcoin, as well as trust in the system. As a result of this, part of bitcoin’s value stems from it being a reliable and tamper-resistant digital currency.

Socio-political context

Bitcoin’s value cannot be seen separately from the socio-political context in which it was developed. Many of such factors contribute to its value by influencing the demand side of bitcoin’s price mechanisms. In this section, we will briefly highlight each of these factors before diving a little deeper into the narrative that sees bitcoin as a hedge against traditional financial systems.

Decentralization and trust

Bitcoin’s decentralized nature reduces reliance on centralized intermediaries, such as banks or governments. This decentralization fosters a level of trust and autonomy, making it appealing to those skeptical of centralized authorities and potential financial manipulation. This characteristic is unique to bitcoin and other cryptocurrencies, since fiat currencies are controlled by governments and central banks.

Economic uncertainty

In times of economic instability or hyperinflation, Bitcoin can serve as a hedge against traditional assets. Its finite supply and scarcity-driven value mechanism make it an attractive store of value for those seeking to preserve wealth during turbulent economic periods.

Geopolitical advantages

Because bitcoin is not linked to a single country and its spending can be easily done online, it is a great currency for international transactions. In addition to this, the fact that it is censorship-resistant also makes it a great means of payment between people in countries with strict governments. In regions facing geopolitical conflicts or economic sanctions, Bitcoin can facilitate cross-border transactions without relying on traditional banking channels.

Financial inclusion

Another element influencing the value of bitcoin through the demand side is its easy accessibility. Because everyone can access bitcoin through the internet, this currency allows individuals without access to traditional banking systems to participate in the global economy. This inclusivity resonates with the unbanked and underbanked populations, potentially empowering them financially and increasing demand for bitcoins.

Innovation and technological empowerment

Bitcoin’s emergence symbolizes innovation in financial technology. Its open-source nature encourages collaboration and experimentation, making it attractive to tech-savvy individuals and communities seeking to reshape financial paradigms. It is also an interesting option for developers seeking new kinds of payment methods for their applications, games, etc.

Privacy and anonymity

Another characteristic that makes bitcoin attractive and thus stimulates demand is the fact that it offers privacy and anonymity. While Bitcoin transactions are recorded on a public ledger, they do offer a degree of pseudonymity. This appeals to individuals valuing financial privacy and autonomy over their transactional history.

Bitcoin as alternative to traditional finance

One of the main drivers behind the development of bitcoin is the desire for a payment network without a central authority controlling transactions and accounts. In traditional finance, a bank is usually the central organ in a payment network, controlling and recording all transactions. During the financial crisis of 2008, more and more individuals lost trust in these traditional systems that manipulate inflation and deflation through interest rates and other monetary instruments. Furthermore, a central authority overseeing all transactions also increases the chances of censorship and of fraud within that central authority. 

The narrative of bitcoin being a hedge against traditional systems and economic unrest is still a popular one within its user base. This narrative rests on the premise that Bitcoin, as a decentralized and digitally scarce asset, offers a distinct alternative to traditional financial instruments vulnerable to economic volatility and centralized control. Advocates argue that Bitcoin’s fixed supply, immune to arbitrary inflation through centralized decision-making, provides a safeguard against the erosive effects of fiat currency devaluation. Moreover, its borderless nature facilitates movement of value independent of national jurisdictions, enabling individuals to potentially sidestep capital controls and geopolitical uncertainties. This narrative gains traction particularly during periods of economic downturns or fiscal crises, where doubts about the resilience of traditional financial systems emerge. However, it’s important to note that this perception of Bitcoin as a hedge is not universally accepted and remains subject to debate, as the asset’s own price volatility and evolving regulatory landscape introduce their own set of complexities and considerations. 

Still, in the early days of bitcoin, this narrative was an important motivation for many diehard users to stick to this new form of currency.

Behavior and value

Ultimately, the value of bitcoin is not prescribed by a computer or algorithm. At its core, its value depends on supply and demand, which is determined by the behavior of people. This behavior is in turn impacted by factors such as media, sentiment and herd behavior.

The role of media in bitcoin’s price development

In today’s digital age, the media played a big role in the increase in bitcoin’s popularity and, consequently, its price. The role of media in the development of Bitcoin’s price is a classic testament to the intricate interplay between information dissemination and market dynamics. Media outlets wield considerable influence in shaping public perception and investor sentiment towards Bitcoin. Positive coverage, highlighting technological advancements, adoption by prominent companies, or regulatory developments that favor cryptocurrencies, often correlates with price surges as heightened positive sentiment attracts new investors. Conversely, negative news, such as security breaches or regulatory crackdowns, can lead to price declines due to increased uncertainty and cautiousness.

The role of sentiment and herd behavior

Media coverage that is either negative of positive plays into people’s emotions, which can impact investor confidence and decisions. This sentiment-driven dynamic often fosters a collective response, commonly known as herd behavior, wherein individuals tend to mimic the actions of the larger group. Herd behavior can lead to rapid price movements, both upward and downward, as market participants react to prevailing sentiment. During the price surge of 2021, the sentiments about bitcoin were very positive, with the increasing price driving more and more people to jump on board the bitcoin train. However, emotions can be a fickle thing, and sentiment can change from one day to another, which also happened in 2021.

Conclusion

While fiat currencies derive their value from governmental decree, institutional backing, and the trust placed in centralized financial systems, bitcoin’s value is rooted in a decentralized framework and its intrinsic technological attributes. Fiat currencies rely on legal mandates that mandate their acceptance for transactions and payment of debts, backed by the authority and stability of national governments. In contrast, bitcoin’s value emanates from its scarcity, as determined by its algorithmically programmed limited supply. This scarcity engenders a perception of digital rarity, akin to precious metals, while its decentralized architecture leverages cryptographic techniques to ensure security and transparency in transactions, fostering trust independently of central authorities. The value narrative of bitcoin emerges from a complex interplay of technological innovation, economic principles, market dynamics, and evolving socio-political paradigms, distinguishing it from the foundational mechanisms that establish the value of fiat currencies.