Friday, February 14, 2014

The Price of Bitcoins is Irrelevant

Much of the press coverage and discussion of Bitcoin has focused on the price of a Bitcoin, which has fluctuated greatly. It was $15 when I first started getting interested in Bitcoins. I had previously done some mining when Bitcoins are worth about $0.01 each, but I found the whole user experience at the time to be unusable. The $15 price point was when I discovered Coinbase and determined that maybe one day it would be feasible to actually exchange Bitcoins for good and services. Since then, the price has gone up exponentially and this has caused a lot of emotion: excitement from speculators, bitterness from people that missed out, disdain from people calling Bitcoins beany babies for nerds, even outright hatred from Charles Stross. Suddenly everyone is asking me about Bitcoins. My aunt even asked me about them at Thanksgiving. Now that the price has gone down somewhat from it's high at around $1000 per Bitcoin, people are proclaiming that this heralds the end of Bitcoins, that they knew all along it was a fad, and that they were smart for not investing. Every fluctuation in the exchange rate is viewed as a portent which confirms the feelings of the commentator.

I can see why people like to talk about the price of Bitcoins, especially the press. It's a very easy to track and easy to visualize indicator. The swooping curves, either upwards or downwards, are visually engaging. It fun to talk about Bitcoin millionaires, and it fun to talk in a schadenfreude sense about people losing their life savings in foolish Bitcoin investments. It's all very exciting and makes for good entertainment news.

I have a different perspective, and it is that the price of bitcoins is irrelevant. The focus on price is due to a misunderstanding of what Bitcoins are, what they're good for, and why they're interesting. Let me break it down for you.

What is money?

Money is a:
  1. unit of measurement
  2. store of value
  3. vehicle for speculation
  4. means of exchange
A given type of money can be any or all of these. People think Bitcoin is all of them and this is the root of the confusion as Bitcoin is bad at 1&2 while being good at 3&4. Therefore some people think Bitcoin is "good money" and some people think it's "bad money". It's both!

Unit of Measurement
We use money as a unit of measurement every day. When you say things like "$X is too much for a cup of coffee" or "My time is worth $X an hour", you are measuring the value of things in terms of dollars. A common misconception people have about Bitcoin is that Bitcoin is a unit of measurement and that something would cost, for instance, 1 Bitcoin. In actuality, when you see a price in Bitcoins it is calculated dynamically from a price in $. Some Bitcoin payment processing services like Bitpay will do this for you automatically based on the current exchange rate. Otherwise the vendor can calculate prices daily based on the current exchange rate. So prices are actually measured in dollars and just displayed in Bitcoins. The reason is that vendors have to spend dollars to acquire the products they sell you. Having a fixed cost in dollars to acquire goods and then selling them at a fixed price in Bitcoins while the dollar-Bitcoin exchange rate fluctuates is a nonsensical situation for vendors. You can hypothesize about a world in which vendors buy their stock of products with Bitcoins and then sell them for Bitcoins, but this is an imaginary world and not the one we are currently operating in. We do not live in a Bitcoin-based economy. We live in a dollar-based economy where Bitcoin only fills a small link in that chain between the customer and the vendor. Therefore, at the present time, Bitcoin is not a good unit of measurement. Most prices in Bitcoin is just a marketing tactic to let people know you accept Bitcoins.

Store of Value
Bitcoin is simple put a terrible store of value because the value is measured in dollars (see above). Obviously if the dollar value decreases then thats bad, but a store of value which increases in value is also not a very good store of value. A good store of value maintains its value (in dollars) consistently over time. Since the price of Bitcoins in dollars is determined by a market-based exchange rate, it is a poor store of value. Of course dollars aren't a particularly good store of value, even when they are stored in banks, due to inflation. Some national currencies might be an even worse store of value than Bitcoins if they are undergoing hyperinflation. However, if the choice is between Bitcoins and dollars, dollars are a superior store of value with significantly less fluctuation in value in the short term and a good track record for holding their value in the long term. The best store of value is a diversified investment portfolio. If you want to put some Bitcoins in the mix that's fine, but often when people buy Bitcoins they buy too many Bitcoins and are not sufficiently diversified. Consider mutual funds, real estate, and small business investments along with high-risk speculative investments such as Bitcoins and Internet startup stock options.

Vehicle for Speculation
When discussing what money is good for, people sometimes forget to include that it is a vehicle for speculation. This is true of all currencies, including dollars, because of currency exchange markets. Bitcoins are an excellent vehicle for speculation. Unlike the currency exchange markets, the Bitcoin-dollar exchange has a low barrier to entry and low overhead. You can start your exchange rate speculation today with only $1 of starting capital. The high volatility of the exchange rate offers many opportunities to buy low and sell high. With the multiple exchange markets there are also ample opportunities for arbitrage. It's a day trader's dream. Of course I'm not saying that Bitcoin is a good speculative investment or that you will make money playing the market. Successful speculation involves guessing when the prices are going to up and when they are going to go down, which is where the fun and the risk come in. So while Bitcoin is a fun and easy way to speculate on currency exchange markets, the actual price of Bitcoin is unimportant to speculation. All that matters is that the price keeps going up and down with sufficient frequency that you have opportunities to place bets on which direction it's going to go.

It's important to understand the difference between speculation and other types of investment. Long-term investments are like farming. With farming, seeds cost less than crops, so you invest in buying the seeds with the belief that if you wait a while the seeds will grow into crops and you can sell them for more than you put in. Value is created with time and effort. Businesses do this as well, so when you invest in a business you are buying a share of the larger value that's going to be created in the future. Speculative investment is more like betting on the result of a coin flips. You buy at a certain price hoping that the price will go up rather than down. Unlike the crops produced by farming or the value produced by businesses, Bitcoins do not naturally become more valuable over time. The rise in the price of Bitcoins has been based entirely on fluctuations in demand, which makes Bitcoins a specultive investment. So when people compare Bitcoins to beanie babies or tulip bulbs, there is a meaningful parallel there when speaking of Bitcoins as an investment. People are going to get rich and people are going to lose their shirts. That's how gambling works. While fun and perhaps the most discussed monetary feature of Bitcoin, I consider speculation to be the least interesting aspect of Bitcoin. The real value of Bitcoins is as a means of exchange.

Means of Exchange
Where Bitcoin really shines is as a means of exchange, even though for some reason the press never seems to cover this aspect of Bitcoin. The great feature of Bitcoin is that you can buy things with it! Also, you can sell things in exchange for Bitcoins! Buying and selling things is perhaps the oldest feature associated with money and a very handy feature indeed. Cash is a form of money that provides this feature but also has some downsides, particularly for Internet sales. Credit and debit cards work for Internet sales, but also have some undesirable features which are actually pretty weird if you think about them. Bitcoin offers an improvement over credit and debit cards for buying and selling goods and services, both in person and over the Internet.

Here are some great features of Bitcoin as compared to credit and debit cards:

  • Security - The customer only authorizes a specific transaction with the merchant, so the merchant can't steal from the customer or leak information that would allow hackers to steal from the customer.
  • Privacy - The customer doesn't provide any private information to the merchant such as their home address. Due to the increased security, this private information is not necessary to verify transactions.
  • Cost - Credit cards processing is expensive for the merchant and this is reflected in higher prices for the customers. All transactions carry what is essentially a sales tax but instead of being used to build schools and roads it just adds to the profit of the banks. Merchants have to pay swipe fees, a percentages of the sale, monthly fees, setup fees, and they have monthly minimums they must pay for even if they end up making no sales. Bitcoin is much cheaper for the merchant as there are only per-transaction fees and they are comparatively very low. Think about this: why do credit card transactions have percentage-based fees when a digital currency transaction requires the same amount of work for the processor whether it's for $1 or $1000?
  • Ease of use - Bitcoin is the easiest way to accept money on the Internet. No special equipment is required and you don't need a credit card processor or even a bank account. You can start accepting Bitcoins as payment right now for no cost. The easiest way is to set up a Coinbase account. It takes a couple of minutes and it will provide you with some HTML code you can put on your website to start accepting payments. It's really that easy!
So Bitcoin is a terrible form of money for all uses except for buying and selling things. For buying and selling things it's great and really quite revolutionary. Here's the thing about using Bitcoins for buying and selling goods and services: the price of Bitcoins is irrelevant. There is no reason to hold onto Bitcoins because they are a terrible store of value and they're a terrible investment unless you just like to gamble. Vendors do not price in Bitcoins (although they may display prices in Bitcoins) because we do not live in a Bitcoin-based economy. So if you want to buy something with Bitcoins, you purchase just the exact number of Bitcoins you need to match the price in dollars at the current exchange rate and send them to the merchant. The merchant then converts those Bitcoins immediately into dollars and deposits them in a bank account. The Bitcoin-dollars exchange rate only matters for the duration of the transaction, a short enough time period that the price is stable. Services for merchants like Coinbase and Bitpay automate this whole process for you so that you can use Bitcoin as a medium of exchange but only ever deal with dollars on either side.

So if the price of Bitcoins is irrelevant, how can we track the rise of Bitcoin and tell how adoption is going? The real measure of value is in the amount of goods and services being transacted using Bitcoins. Every time a new vendor starts accepting Bitcoins, that's when the real value of Bitcoins goes up. Unfortunately, there's not a handy chart of this, so it will probably never being reported on by the press. However, if you're in Austin for SXSW, hit me up and I'll show you where you can buy tacos with your Bitcoins.