John Lewis

The recent near halving of Bitcoin’s price has reignited debate about its true value. As a store of value, net present value asset pricing models suggest it should be worth zero because it pays no dividend. Yet its price remains far above zero, and its total value is still large despite recent turbulence. In this post I explore the question: what’s Bitcoin’s value as a means of exchange? I show that using a simple quantity theory of money framework helps explain its extreme volatility, the powerful influence of sentiment, how prices can surge even when transaction usage is low, and – crucially – why innovations by competitors and limited retail payment adoption pose significant downside price risks.

Economics textbooks present four functions for money: medium of exchange, store of value, unit of account and a standard of deferred payment. In this post I focus on solely on the first. The original white paper, presents Bitcoin exclusively in ‘medium of exchange’ terms, as a ‘peer-to-peer version of electronic cash’ allowing payments ‘without going through a financial institution’. The words ‘asset’ or ‘investment’ are entirely absent.

Just like fiat, Bitcoin pays no dividend and has no intrinsic value (you can’t eat it, smoke it or make jewellery out of it). Fiat nevertheless has value because people are willing to accept it as payment for real stuff (ie labour, goods, services). If Bitcoin did become a medium of exchange could it, by the same logic, have value too?

Elsewhere, I and many others have argued that keeping accounts and/or managing payments in cryptocurrency is not viable because of the day-to-day volatility in its price and lack of singularity. But setting those issues and interactions aside here, I run a ‘what if you’re wrong’ type thought experiment.

The quantity theory of Bitcoin

I approach this through the lens of the quantity theory of money which can represent vastly different views about the value of Bitcoin within a common framework.

Let’s begin with the textbook equation:

MV=PT

This says that the supply of money, M, times the velocity, V (how often each unit changes hands) is equal to the price level times the total transaction value T (sometimes replaced by real GDP, Y). P here is expressed as price of goods in currency, whereas we normally think about Bitcoin prices the other way round (ie how much stuff do you need to buy one Bitcoin). It’s easier to work with if we rearrange it a little:

US$ price of Bitcoin = T/MV

The price of Bitcoin equals the real value of transactions it’s used for, all divided by supply (M) times velocity (V). Quantity is fixed at 21 million Bitcoin, so its price is determined by the value of transactions it services and how fast it whizzes round. The bullish case is that transaction use will grow, so T gets bigger; and so, for a given velocity, the price has to rise.

How much will Bitcoin be worth?

It all depends on your long-run view on T and V. Let’s start with T – currently 2025 payments on the lightning network, are estimated to be $14 billion and the latest estimate of Bitcoin use for transactions under $10,000 (a plausible retail cutoff) is $146 billion annually. What about some other benchmarks? Bitcoin is currently used for some illicit payments, so another thought experiment is to assume Bitcoin takes on all of them: then adding drugs ($800 billion), money laundering ($800 billion) and tax evasion ($171 billion) gets you about $2 trillion. If it becomes visa-sized payment medium then T is $17 trillion. If it takes over all digital transactions it’s $26 trillion. Or if, as Bitcoin maximalists argue, it becomes the world’s money, then T is world GDP: $155 trillion. 

What about V? At the higher end, if someone loads up a payment card each and spends the balance down to zero each month, velocity is 24. For illicit transactions, studies suggest a velocity of about five. For broad money pre-GFC this was around two. Or if you are looking at GDP, then velocity can be as low as one. The table shows what these imply for the price:

In short, you can get wildly different valuations depending on what you plug in.

No coiners think it’s largely useless for real world payments and so T is zero, rendering Bitcoin worthless, regardless of velocity. The upper grey panel shows that that current T implies prices a fraction the current $70,000 or so.

The lower panels show the hypothetical scenarios. If use is confined to illicit payments, and velocity is five the price settles at $19,000. Visa-style volumes with payment card type velocity, the price is around $34,000. If takes over all electronic payments and has an M2 like velocity you are at $619,000. Or if takes over as the world’s currency your valuation could surpass £5 million. 

What does this say about price dynamics?

To justify current valuations from such a model, the story must be of (beliefs about) the *future* rather than current scale of transactions, which are far too low to support current prices. And the vast range of potential prices creates highly volatile expectations.

Even small changes in the perceived probability of a future scenario can generate sizeable swings in prices.

The model also implies a paradox about hoarding: the less holders use their Bitcoin for real transactions, the lower velocity is, and the higher the price. There is ample evidence that a large chunk of Bitcoin is not actively circulating but rather lies idle in wallets. 

Hoarding can amplify price swings. If you think Bitcoin will surge in price, you won’t spend it today, instead you’ll hoard it. But if sentiment swings and you think Bitcoin will lose value, then you want to spend it, or sell it for dollars, further depressing the price.

For more optimistic valuations to be validated in this framework, Bitcoin must at some point start to move towards those bullish long run usage levels. How have things progressed on that front over the past few years?

The recent history of Bitcoin and payment systems

In the late 2010s sceptics argued the argued the triad of scalability, delays and cost would prevent Bitcoin’s widespread adoption as a payment medium. But bulls countered that takeoff was imminent, with comparisons to internet adoption, and some even suggesting Bitcoin might become the world’s primary means of payment sometime in the 2020s.

That disagreement was less about the technical limits of Bitcoin *at the time* and more about whether/how/how fast the system could develop to overcome them *in the future*. Central to the optimistic case was confidence in an emerging ‘second layer’ of infrastructure, led by the Lightning Network to enable Bitcoin to scale-up. Simply put, the idea was apparatus sitting below (and crucially off) the main protocol to handle most transactions. Freed from the technical limitations of the main blockchain, advocates argued this could deliver faster settlement, lower fees and – crucially – a much higher transactions volume.

Evidently, that higher volume hasn’t come to pass. Bitcoin has seen little to no growth as a payment medium since the late 2010s as adoption flatlined. And it is increasingly hoarded – around 60% of Bitcoin supply has not changed hands in the past year. Even in El Salvador, where it became legal tender, it was used for less than 5% of transactions and accepted by less than fifth of firms. And, like in 2018, Bitcoin conferences still aren’t taking crypto. 

Lightning was too expensive because opening and closing a bilateral ‘payment channel’ between two parties still requires an on-chain Bitcoin transaction which creates a high fixed cost, with rising Bitcoin transaction fees passed on to lightning fees. Not to mention problems with liquidity and network reliability. 

Many of the most far-reaching innovations in payments technology over the past two decades have actually come from Bitcoin’s competitors in digital payments, providing challenges. Gone are the days when cheques were a key payment tool, or bank transfers needed several days to clear. In most jurisdictions, fast payments now offers free and near instantaneous domestic payments between accounts. On cross border payments, Swift Go introduced near instant settlement of transfers for small-value high-volume transactions, and multiple rails have been developed for transfers outside of SWIFT. Since the late 2010s, stablecoins have grown dramatically, especially for cross-border payments, taking on many of the purported advantages of Bitcoin: ‘open all hours’, quick online payments, and even programmability, but without Bitcoin’s price gyrations.

What next?

Current valuations of Bitcoin as a payment medium are incompatible with current low usage levels. And the experience since the late 2010s is that progress towards adoption stalled. Perhaps the most high-valuation yet plausible scenario for the price of Bitcoin is that Bitcoin retreats to illicit payments where its anonymity and secrecy are particularly advantageous. But then authorities would surely take a more hostile approach. And with fewer legitimate, users it’s harder to disguise transactions, especially moving funds between Bitcoin and the regular system. Is that a viable longer-run business model? Without a compelling and sizeable use case I see little value in Bitcoin as a means of payment.

John Lewis works in the Bank’s Centre for Central Banking Studies Division.

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