At the time of writing, you can buy a bitcoin for about 3600 United States Dollars (USD). Since it reached its all-time high of 19380 USD on 11 December 2017, bitcoin has lost more than 80% of its value (data taken from Coinbase). This notwithstanding, bitcoin is making progress…

Even after a significant decrease in purchasing power over the last 12 months, there are more people using bitcoin today than there were 3 years ago. An illustration of this can be found in the data from Google Trends which indicates that there are 2,5-times the amount of people searching for ways to “buy bitcoin” now as compared to early 2016.

Source: Google Trends Search Tool

Bitcoin is still very much alive. However, after the significant loss in purchasing power over the last 12 months, probably the most asked question is: “If bitcoin is not performing the functions of a money today, why would it perform them in the future?”

In this series of articles, I will discuss two critical issues: (i) the monetization path for bitcoin as it makes sense to me; and (ii) what large-scale shifts could happen over the next 3–5 years that would assist bitcoin along this monetization path.

Important Principles

First and foremost, bitcoin is money. If you own bitcoin, you only receive something in return for it if others accept it from you in exchange for their goods, services or another money that they are holding. A bitcoin (or a part of a bitcoin) is not a share in a company that provides recourse to cash flow; preferential rights; a dividend stream; or a pro rata share of the liquidation value of the company. It is also not something like oil that can be used up in production.

While this may seem like a very simple or innocuous distinction, it is actually incredibly important because to understand the subtleties of bitcoin you must analyse it with a monetary lens.

Further, the reality is that the invention of bitcoin created a free market in money. The effect is that supply and demand rather than regulation will dictate what money is held, spent and accepted. This is significant because a free market in money has not existed since the 1800’s.

Money’s Primary Function — Medium of Exchange

Once we accept that bitcoin is money, we can move onto thinking about the functions that a money performs.

Life is made better when we are able to exchange value between one another. To conduct this exchange of value we could barter with one another (exchange goods or services for other goods or services). However, bartering isn’t often an option because inevitably there will be a lack of coincidence of the exchanging parties’ wants, scales, time frames or locations.

To solve the shortcomings of the barter system, we use an intermediary good that is money. In this way, money’s primary function is to facilitate exchange between people. However, just because it is easy or convenient to exchange a particular good does not mean that it will be used by society as the medium of exchange. Rather, the particular good must first have the ability to store value.

Store Of Value Before Medium Of Exchange

People only accept a money in exchange for their goods or services if that money has the ability to store value — i.e. it is a store of value. By definition, something is a store of value if the holder can sell it on the market at any time and recover the same — or inconsequentially similar — value that the good had when the holder received or acquired it.

The store of value requirement is illustrated by the events that played out in Zimbabwe in 2008 and 2009. At a certain point in time, Zimbabweans stopped accepting the Zimbabwe Dollar in exchange for their goods or services because they no longer thought that the currency had the ability to store value. At that point, Zimbabweans only accepted the USD in exchange because the USD was a superior store of value. This is still the case today in Zimbabwe. Similar events have happened in Argentina in the late 1980’s, in Venezuela from 2016 to date and in many other countries.

A money’s ability to store value is determined by supply and demand. Central authorities have a few tricks up their sleeve to ensure that there is sufficient demand for the money that they create. In particular, they stipulate that taxes can only be paid in the government money and that the banking system can only open accounts and transact in government-sanctioned money. Further, countries have legal tender laws that force people to accept the local currency for goods and services.

The result is that there is a constant demand for government money and for so long as the available supply of the money does not get out of hand, the money will hold value for sufficient periods of time (i.e. be a store of value) and people will not deviate from using it as the medium of exchange in society.

Bitcoin As A Store Of Value

I think it is safe to say that over at least the next 10–15 years, it is highly unlikely that a constant demand for bitcoin will be created by governments mandating that society must use bitcoin as money. Therefore, bitcoin does not and will not have the tail-wind that government money has. Rather, a constant demand for bitcoin will need to develop organically.

Can bitcoin become a store of value? My article “Bitcoin Is Like Gold, But It’s Superior” contains an explanation of gold as a store of value, the attributes that allow gold to function as a store of value, as well as the attributes that bitcoin has that should enable it to function as a store of value. In short, bitcoin’s supply cap and deflationary monetary policy mean that it has similar attributes to gold. Bitcoin is therefore well placed to be able to function as a store of value in the future, much like gold functions as a store of value today.

However, bitcoin will not become a store of value simply because it is like gold but superior. Rather, the strict supply will need to be accompanied by a lot more people wanting to store wealth in bitcoin.

Next week I will be writing about the main themes that I think will result in increased demand for bitcoin over the coming 3–5 years, and therefore help bitcoin along its path towards functioning as a store of value.

Disclaimer: The comments, views, opinions and any forecasts of future events reflect the opinion of the quoted author, do not necessarily reflect the views of Switch or other professionals at Switch, are not guarantees of future events or results and are not intended to provide financial planning or investment advice.