A bubble? We don’t even know how to value Bitcoin

Bitcoin is a “speculative mania” in line with the governor of the Reserve Bank of Australia. But it’s not very easy to mention that Bitcoin may be a bubble - we don’t skills to value it.

Recent price rises (close to A$18,000 in the past three months) may be too great and can’t continue. But the Bitcoin market is simply just maturing as an investment and as a currency, then it should still have room to grow. A bubble is when the value of an asset diverges from its “fundamentals” - the aspects of an asset that investors use to value it. These could be the income that can be earned from a stock over time, a company’s cash flow, the state of a country’s economy, or even the rent from the property.

But Bitcoin does not pay out profits (like shares) or rent (like property) and is not attached to a national economy (like fiat currencies). This is a part of the reason why it's hard to inform what the underlying value of Bitcoin is or should be.

In the search for fundamentals, some have suggested we should look at the supply of Bitcoins in the market (which is regulated by the technology itself), the number of Bitcoin transactions through the market, or maybe the energy consumed by Bitcoin miners (the computers that validate transactions and are rewarded with Bitcoins).

Diverging from fundamentals

If we take a detailed look, we are able to see how the worth of Bitcoin could also be diverging from these fundamentals. For instance, it's becoming less profitable to be a miner, especially because the energy required increases. At some stage the cost may exceed the price of Bitcoin, making the network less worthwhile to both mine and invest.

Bitcoin could also be the best-known cryptocurrency but it's also losing market share to other cryptocurrencies, like Ethereum and Litecoin. Bitcoin currently accounts for 59.4% of the entire global cryptocurrency market, but at the start of 2016, it was 91.3%. Many of those other cryptocurrencies have more functionality than Bitcoin (such as Ethereum’s ability to execute smart contracts), or are more efficient and use less energy (such as Litecoin).

Government policy, such as taxation or the establishment of national digital currencies, may also make it riskier or less worthwhile to mine, transact or hold the cryptocurrency. China’s ban on Initial Coin Offerings earlier this year reduced the value of Bitcoin by 20% in 24 hours.

Without these fundamentals, the price of Bitcoin largely reflects speculation. And there is some evidence that people are simply buying and holding Bitcoin in the hope it will keep rising in value (also known as Greater Fool investing). Certainly, the cap on the entire number (21 million) of Bitcoins which will exist, makes the currency inherently deflationary - the worth of the currency relative to goods and services will keep increasing even without speculation then there's a disincentive to spend it.

Bitcoin still has room to grow

Many big investors - including banks and hedge funds - haven't yet entered into the market. The volatility and lack of regulation around Bitcoin are two reasons for stopping these investors from jumping in. There are new financial products being developed, such as futures contracts, which will reduce the danger of holding Bitcoin and permit these institutional investors to induce in.

But Bitcoin futures contracts - where people can place bets on the future price of stocks or markets - can also work against the worth of Bitcoin. Just like gamblers place bets on horse races instead of buying a horse, investors may simply buy and sell the futures contracts instead of Bitcoin itself (some contracts are even settled in cash, rather than Bitcoin). All of this might cause less actual Bitcoin changing hands, resulting in less demand.

Although the push to require a position is seemingly encouraging some people to take out mortgages to shop for Bitcoin, traditional banks won’t lend specifically for that purpose because the market is just too volatile.

But it’s not just on the finance side that the Bitcoin market is about to expand. More infrastructure to support Bitcoin within the broader economy is rolling out, which should spur demand. Bitcoin ATMs are being installed in many countries, including Australia. Bitcoin lending is emerging on peer-to-peer platforms, and new and more regulated marketplaces are being created.

Many companies are accepting Bitcoin as payment. That means that even though the speculation dies down, Bitcoin can still be traded for a few goods and services. And finally, although the basics of Bitcoin are still up for debate, when it involves transaction volume through the network there appears to be loads of room for growth.

It’s good to remember that people have been calling Bitcoin a bubble for a long time, even when the price was just US$35 in 2013. In the end, this is uncharted territory. We don’t have the knowledge to value Bitcoin, or what's going to happen. Historical examples may or may not apply.

What we do know is that the technology behind most cryptocurrencies is enabling new models of value transfer through secure global consensus networks, which is causing excitement and nervousness. Investors should beware.