Only a year has passed since Bitcoin enthusiasts predicted the cryptocurrency would reach a price of $ 1 million.
But that was it then. With the price of Bitcoin BTCUSD + 1.73% down almost 80% from its high and now trading well below the USD 6,000 support level, everyone is wondering where it is going from here.
The answer is a quick and painful drop to zero.
In a MarketWatch column I wrote last April, I explained how Bitcoin can become worthless. Bitcoin is approaching this point. As I said earlier, once the price of Bitcoin falls below the cost of mining, the incentive for Bitcoin will worsen, driving Bitcoin into a death spiral. That is, without the mining activities that back up the ledger, which keeps a record of who owns what – after all, bitcoin is a series of encrypted numbers that cannot establish ownership of anything – bitcoin becomes worthless.
A typical asset has a series of cash flows and its value is determined by what investors expect from those cash flows. Bitcoin has no cash flows. In this regard, it is more similar to gold in that its value depends to some extent on its desirability and potential uses, but most of all on its mining costs. While there are many estimates of the cost of mining Bitcoin, most estimate it to be close to $ 5,000 per coin. Although traditional commodities like gold require significant investments with limited technical knowledge and capital, anyone can mine bitcoins. Therefore, the price of Bitcoin must be close to the full cost of mining (meaning you will only get marginally compensated for your time and capital outlay). So one would expect the price of Bitcoin to fluctuate somewhere around this point.
In addition, there is an additional complication: unlike gold, which is widely accepted as a store of value, likely due to a historical accident, Bitcoin is a digital commodity without such universal acceptance as a store of value. While the original Bitcoin buyers and miners truly believed in the paradigm shift they believed was promised and ready to make the investments necessary for future profits, the younger buyers and miners were common greed. driven investors.
Their greed was further fueled by futures trading, which was introduced when Bitcoin prices were booming and the sun seemed to be rising steadily on the horizon. With bitcoin prices well above the cost of mining, they saw an obvious arbitrage opportunity: mine bitcoin and sell it at a higher price on the futures market for guaranteed arbitrage profits.
It was not surprising that traditional investors were drawing attention, as many were investing in mining operations and the bitcoin, which was likely to be generated by mining, was being sold on the futures market. As more arbitrageurs came into the market to take advantage of this opportunity, Bitcoin prices were pushed close to their mining costs (with a low rate of return) and resulted in a long period (in the Bitcoin world) of stable prices. It has changed the look of miners as well, and a higher percentage of them are now fair-weather miners looking for a quick buck that would quickly fade once the opportunity clears.
However, the cost of mining Bitcoin is not a fixed dollar amount. There is a feedback mechanism in the mining of raw materials that applies to Bitcoin: when the price of Bitcoin rises, new miners enter the market, which increases the cost of mining Bitcoin as the reward is shared among a larger group of miners . Similarly, when the price of Bitcoin falls and miners get out, the cost of mining goes down. The number of miners cannot go below a certain level, however, as the Bitcoin blockchain cannot remain viable without the miners who provide the computing power to keep the ledger.
Mining at a cost greater than what you can sell on the futures market destroys value. Any reasonable investor – even one who firmly believes the price of Bitcoin will recover – has no incentive to mine when the cost of mining is higher than the future price and it is better to buy on the futures market . And unlike gold, which can hold its value even if mining stops, Bitcoin cannot have any value without the mining activity, which keeps the ledger of who it belongs to. Without the mining activity, Bitcoin is just a series of encrypted numbers with no value.
So it seems that Bitcoin is now getting into a death spiral: if the price keeps dropping and the cost of mining doesn’t drop accordingly (the cost of mining will algorithmically drop, but not necessarily to the same extent as the price drop), Bitcoin will go fast go to zero.
Bitcoin proponents will argue that the price of Bitcoin has previously fallen by large percentages. That said, this recent decline differs in three major ways. First, the magnitude of the recent decline dwarfs the magnitude of past declines. Second, the losers in the recent decline are new investors who are likely to back off until there is more clarity on Bitcoin’s use cases. Third, the futures markets have changed the game, allowing miners to estimate their mining losses and profits at the outset. If you can buy on a futures market at a price below my mining cost, why for a certain loss?
History is full of examples of innovative companies that have gone bankrupt and the “me too” companies become the best investments.
Many will argue that it is extreme when Bitcoin becomes really worthless. Sure, if you look at some memorable fads and bubbles, tulips still sell for $ 10 a bunch, and beanie babies are fair priced at $ 5.
And it looks like the blockchain economy will stay here, where many of our transactions are processed on the blockchain, using cryptocurrency for daily transactions. While the world may forever be indebted to Satoshi Nakamoto for giving us a viable cryptocurrency, Bitcoin may no longer exist. An improved coin could evolve or governments could issue cryptocurrencies. History is full of examples of innovative companies that have gone bankrupt and the “me too” companies become the best investments.
And finally I can give my wife a bouquet of tulips and make her happy. And I can still give my grandchildren beanie babies to play with. But what do I do with a series of numbers that I can’t prove will make me the owner of anything?
Atulya Sarin is Professor of Finance at Santa Clara University. He wrote about currencies in his book “Fundamentals of Multinational Financial Management” (sixth edition) and worked extensively as a valuation expert.
Continue reading: Bitcoin is still fooling buyers that those profits of more than 200% are returning