Why am I writing this?

On September 12th of 2017, Jamie Dimon, Chairman and CEO of JP Morgan criticized Bitcoin as a fraud.

“It's just not a real thing, eventually it will be closed.”

The market was feeling cold already due to China’s consecutive strikes at cryptocurrency of banning the ICO (initial coin offering) and tighter regulation of exchanges, and his remarks was like pouring colder water.

Proponents of cryptocurrency sparked strong opposition to his argument, but they did not have a clear explanation about the value or price or Bitcoin.

Right or wrong, we have a standard way to value a business. It is the present value of future cash flow. Based on that, investors judge that a company’s share is expensive or cheap, and accordingly sell or buy the shares.

To speak as a disclaimer as well, I have some cryptocurrencies myself. So I was not just intellectually but practically interested in valuing them. But I could not find any reasonable and practical valuation to refer to.

We seem to have only prophetic answers without a reason, or hardly logical arguments like “based on the trend line, momentum will continue.” So I decided to do a valuation of Bitcoin myself.

I plan to write in the following order.

1. Is Bitcoin a fraud? (This post)
   1. If Bitcoin is a fraud, dollar is, too.
   2. Does a non-redeemable currency have no intrinsic value?
   3. How much value does currency have for us?
   4. Is cryptocurrency competitive against fiat currency?
2. What is the fair price of Bitcoin?
   1. How can you value the fair price of Bitcoin?
   2. What will be the price of Bitcoin?
3. Risks and strategy for cryptocurrency (To be written)
   1. What is the biggest risk of cryptocurrency?
   2. Strategy for cryptocurrency to survive

•  Toolkit: Excel spreadsheet for Bitcoin and cryptocurrency valuation 

This article is based on facts and logic, but the conclusions, the answers to the questions in the table of contents above, are my thoughts. I believe they are justified, but they may have errors.

I make it clear that this is not an investment advice. I will share my thoughts on valuation methodology and price level, but I am not telling you to buy or sell cryptocurrencies. You should act by your own judgment and responsibility.

If Bitcoin is a fraud, dollar is, too

There are many debates around whether Apple’s share price will go up or down, but one thing everyone agrees is that the price is not zero.

But when it comes to cryptocurrencies, many people suspect if they have any value at all even before discussing a proper price. They are just codes made on computer, and you can buy foods and electronic products with them?

Not just Jamie Dimon but many people said such questions.

"The question is I do not understand where the backing of bitcoin is coming from. You have to really stretch your imagination to infer what the intrinsic value of bitcoin is. I haven’t been able to do it."
(Alan Greenspan, former chairman of the Federal Reserve)

“when I try to get them to explain to me why Bitcoin is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem.”
(Paul Krugman, economist)

Their arguments can be translated roughly like this. “Currency should act as medium of exchange and storage of value. To do so, currency should be an actual commodity currency like gold coin or needs guarantee of government that it is redeemable for actual commodity.”

But if you look at the history of currency, it is not certain if such an argument is accurate.

Currency has evolved through these stages.

1. Commodity currency (ex: gold coin)
2. Representative money (ex: paper money that is redeemable for gold)
3. Fiat money (ex: currency that is not redeemable for gold or another commodity)

Ancient people began using commodities such as gold and cloth, which may people wanted, as a medium of exchange. Standardizing and formalizing them started the commodity money.

The number on the face of a dollar coin meant, in addition to units of currency, a certain amount of gold. People believed in a gold coin as a storage of value, because even if the government or the central bank that issued one vanished the gold would remain.

But gold coins were heavy to carry. So came a much lighter paper bill. A paper bill, also called a bank note, did not contain any gold in itself, but banks promised to exchange your paper bill to equivalent gold. But a problem arose. Banks often issued more bank notes than they had gold or gold coins, knowing it was highly unlikely that many customers would claim redemption at once. But the banks learned that such an unlikely event could happen. Sometimes people seemed to value the gold more than the dollar.

Thus, the fiat money was created. It was a nonredeemable currency, which meant the issuing bank would not give you gold in return to your dollar bill. During 20th century, most countries converted to fiat money.

They say fiat money is backed by the full faith and credit of the government. But what exactly does it mean? What do they give you, when you bring your dollars to the FED?

The answer is “nothing.” The Fed clearly states this.

“Federal Reserve notes are not redeemable in gold, silver, or any other commodity.”
(Federal Reserve System Website)

Like we are debating about cryptocurrency, people debated if fiat money had any intrinsic value during the transition to fiat money.

In short, cryptocurrency’s alleged problem of ‘not being backed by valuable commodity’ is also a problem with fiat currency.

Then we should ask, does nonredeemable currency have no intrinsic value?

Does nonredeemable currency have no intrinsic value?

A small note. Even though I said nonredeemable, the question is applied to all currency including redeemable and commodity currencies. We can ask if they have only the value of commodity they represent or have additional value due to their function as a medium of exchange. So, I am going to use ‘currency’ rather than (or interchangeably with) fiat currency.

This is my answer.

Even nonredeemable currency has intrinsic value. Currency’s intrinsic value comes from the function of making exchanges easy.

An intuitive way that I use to assess if something has value is to think if people will miss it when it is gone.

What if currency disappears?

Imagine you need some eggs. You know that any grocery has eggs. Money being nonexistent, however, you need to exchange some of your goods with eggs. You need to find out which item that you have a store wants. Until you find such a store, you should keep looking.

Let’s say you found a store which wanted one of your shirts, and you face another problem. You believe your shirt is worth 100 eggs, but want only 10 eggs. What do you do? You need to exchange your shirt with something else you need first, perhaps peanuts, and then exchange some of the peanuts with eggs. You will take the rest of peanuts home as well as 10 eggs. (We can see peanuts emerged as a medium of exchange here.)

Currency makes a complex set of transactions like this very simple. And we live a much easier life with currency than without. Even if the currency is not gold or backed by gold, its value is not 0 when people use the currency as a medium of exchange.

One more thing. An exchange needs two or more people. Showing 10 dollars or 100 dollars on the face, a paper fiat money is nothing but a piece of paper if no one accepts the money. But the more people uses it, the more useful it becomes. It shows network externality, a concept in economics.

Network externality means that my demand of something is affected by others’ demand of it. The reason why I use Whatsapp is that many other people use it. Even if there is a better messaging application, it is useless if no one is on it.

How much value does currency have for us?

So far, we discussed that currency does have intrinsic value that is bigger than 0. Now let’s think about how large it may be.

We can ask a question like this. How much different will the wealth of a country be, with and without currency. In other words, if we do away with currency (that is, we need to barter), how much GDP will decrease? (As wealth can be viewed as the present value of all future incomes, these two are closely related questions.)

It is a hard question. But we can foresee productivity decline and costs increase. Overall wouldn’t this result in tens of % decline of GDP?

To create phenomenal prosperity of the modern world, division of labor played a key role. Division of labor is giving and receiving helps by doing what each individual or company does best. A large part of division of labor happens through transactions in a market. And those transactions are done via currency as the medium. Currency is the key enabler for complex yet efficient division of labor in the modern society.

Another way to see this is from a viewpoint of an individual not a country. Imagine only I am excluded from currency-based economy. Everyone uses money, but I may not give or receive money. I have no way but to barter.

Let’s say I want to sell a camera and buy a guitar. While I am researching and planning how to do this, a government official comes to me and says this. “If you pledge to sell the camera at a lower price, we will let you use money for this time.” How much discount am I willing to give?

It will differ by person, but as far as I am concerned, I am willing to give at least 20% discount. Rather than visiting this and that websites, calling and emailing back and forth, and perhaps exchanging the camera with peanuts and then peanuts with a guitar, I would simply give 20% discount away and take money and buy a guitar with the money.

That discount is how much I feel is the loss of wealth by not being able to use currency. Or in the other way around, the additional value created by being able to use currency.

In summary, I think currency has a large weight in the wealth of an economy. My intuition says at least 20%.

Does cryptocurrency have competitive advantage over fiat currency?

If a currency that is neither a commodity nor redeemable for a commodity has value, cryptocurrency must have value, too. It does not become a lasting currency just because its intrinsic value is bigger than 0. The world is full of wonderful things that disappeared into oblivion. For cryptocurrency to be used in some if not all markets, it needs have some advantages over existing currencies.

Let’s state the conclusion first. Cryptocurrency has clear advantages over fiat currencies.

• It does not need intermediaries.
• It has low transaction fees.
• It has shorter time to complete a transaction.
• It is much harder to make a counterfeit money.

Not requiring an intermediary is probably the most important property. Under current financial environments, there is no practical way I can send money to my brother overseas by myself. I could board a plane and carry the cash myself, but it takes many hours and especially costs that could be even larger than the money sent. Practically, it is necessary to get help from at least one and usually two banks, one for me and another for my brother.

But with Bitcoin, I can just send money that I have in my computer wallet to my brother’s. Just like sending an email.

Low transaction fee is also an advantage. Cryptocurrency transaction fees are usually low compared to banking fees. Some cryptocurrencies even have zero fees. Some people ask, “I have zero banking fees now. What’s the difference?” But that’s because you are an important customer for the bank or the bank is running a marketing campaign. Financial services just cannot sustain itself with zero fees, as they have expensive people and systems working for them. To be fair, Bitcoin also needs efforts of people called miners, the whole process is more efficient than existing financial ecosystem, which makes transaction costs lower.

Consumers may not feel firsthand the difference in transaction time. With existing Internet banking, you can send money almost instantly to another person’s account. But that’s what appears to you at the front end, and the final settlement behind the scene between banks takes longer time. Eventually, this involves paper money as well.

It is easiest to feel the speed with international money transfer. If you send money to another country using a bank, it takes days. But it does not matter if you send your Bitcoin to a person next to you or across the ocean. It takes the same time, usually 1 to 2 hours.

(Yes, transaction with cryptocurrencies takes much longer than instant right now. However, technologies to solve this issue are emerging, and some cryptocurrencies are already using them. In principle, cryptocurrency, as a digital native, will have higher transaction speed than fiat currency does.)

The difficulty of counterfeiting money is not apparent either to consumers who use less and less cash, but it’s important for the overall financial service system. Even now counterfeiting does exist.

Cryptocurrency has evident advantages over paper bills and coins in the Internet age. Therefore, it will survive.

Now let’s talk about the question that we are most curious about, the price of Bitcoin.