One of the things that Ive found challenging to explain to people who are new to Bitcoin is what drives the seemingly astronomical and volatile price. Ive been asked numerous times to explain why Bitcoin is worth hundreds or potentially thousands of dollars. Heres an attempt at an explanation, though for something we use so automatically on a daily basis, money turns out to be a surprisingly complex, abstract and difficult-to-explain concept.
The somewhat unsatisfying answer Ive heard people give in response to the more common question of why the U.S. dollar has value post-gold standard goes something along the lines of the dollar is worth what other people are willing to give you for it. That seems to me to beg the question and while true, it doesnt explain why someone would exchange a particular good or service for a certain number of currency units (its price).
To explain the concept, I think it makes sense to think of currency as a standardized way to issue IOUs. Like a typical person-to-person written IOU, a currency IOU entitles its recipient to redeem a piece of paper for a good or service at a later time. However, unlike regular IOUs, the standardization of currency units enables acceptance by a much larger network of people for a wider range of goods and services.
The standardization of currency IOUs provides the benefit of wider applicability, but it also requires a different form of trust. If you receive a paper IOU from a friend, for say a free dinner, that IOU has value because you trust its issuer (your friend) to make good on it. A currency is also valuable because of trust, but that trust is much more abstract and more widely distributed.
At the most basic level, a currency user must trust that if she provides a good or service and receives an IOU in return (in the form of currency units), shell later be able to turn the IOU in for something roughly equivalent in value. It turns out that some currencies can be trusted to perform this function very well, and some currencies cant. This trustworthiness can be considered the currencys integrity, or soundness. The 2008 Zimbabwean Dollar, the current Argentinian peso, and the U.S. dollar during the inflation of the 1970s are examples of times when currencies lacked soundness.
When IOUs are passed between friends, their integrity is usually not at issue. Usually, a friend wont create more IOUs than he has the ability to pay back, though it does happen. Its also unlikely that an IOU recipient will try to forge more copies of IOUs than he was given, since its fairly easy to detect cheating among friends. In the case of currencies that depend on distributed trust, however, these situations (inflation and counterfeiting), are challenging to prevent, and there have been many historical attempts to find robust systems that could represent distributed IOUs that were resistant to inflation and counterfeiting. Seashells, clay tablets, salt, precious metals, and paper notes are a few of the many forms of money that have been used, each with their own pros and cons.1
One distinction to note about inflation in the analogy between IOUs and currencies is that when an IOU is created, its issuer becomes liable for supplying a specific good or service upon redemption. In the case of currency, that is not the case. Because the relationship between currency issuers and consumers is indirect and abstract, an issuer of new units of currency IOUs does not itself need to produce anything, but puts the burden of production on all of the users of that currency. Each new unit of currency slightly devalues every other unit of currency, which doesnt happen in the IOU case. The fact that there is no specific liability incurred when producing currency has at times tempted governments to compromise their currencys soundness in order to pay debts or stimulate economic activity.
If Bitcoins predictable approach is eventually proven to result in a more dependable and useful currency, more goods and services will likely be traded for Bitcoin-based IOUs (bitcoins). In addition, if bitcoins are thought to more dependably maintain their value than other currencies, they would likely be held longer by those saving for the future. Both greater usage and longer holding times would gradually increase the demand and the price premium for the limited quantity of bitcoins available.
An important thing to note, and something thats confusing to many people, is that IOUs, paper currencies or electronic currencies are not valuable in and of themselves. The pieces of paper or electronic records serve only a symbolic purpose. Its unintuitive to think that a symbolic token of distributed trust can have a (sometimes high) price, but the use of tokens without practical value is what distinguishes money transactions from barter.2
Another misconception is that the Bitcoin price is primarily based on the value of the Bitcoin payment network and its ability to execute fast, cheap transactions. Many believe that the price of Bitcoin is dependent on increasing transaction volume. The Bitcoin payment network is incredible, but even if it were slow and cumbersome with a low transaction volume, the price of bitcoins could still be very high as long as Bitcoin was seen as a more durable and sound recordkeeping system than other forms of currency. By analogy, the value of the Visa payment network has little impact on the exchange rate of the U.S. dollar, and the total market value of gold is higher (~$10 trillion) than the total outstanding U.S. dollars ($2-3 trillion), though gold is slow, cumbersome and has a much lower transaction volume.
As for questions about the volatility of the Bitcoin price, Bitcoin is still very early in the technology adoption cycle. As it hasnt yet reached the mass market, theres a great deal of uncertainty about how many people will eventually use Bitcoin and how much those users will use it vs. other currencies. With a relatively tiny total market price (around $5 billion, vs. something like $2-3 trillion for the U.S. dollar and $9-12 trillion for gold), any small change in the market perception of future demand for Bitcoin has a large impact on that present price. As such, theres a large component of Bitcoins market value that reflects speculation about the possibility that Bitcoin usage could achieve exponential growth and eventually be traded for tens or hundreds of billions of dollars in goods and services. This speculation about Bitcoins future drives the volatility in its price today.
Over the course of the coming years, Bitcoins place in the market for currency will become more clear. It could be a small niche currency, it could grow to rival national currencies and precious metals, or it could fail altogether. As the Bitcoin technology and ecosystem mature and its outcome becomes better known, the speculative component of its price will decrease, and its volatility will decrease as well. As that happens, Bitcoin could become even more useful as both a transactional currency and as a store of value.
To conclude this fairly long discussion, the fundamental determinant of Bitcoins total market price is market perception of the value of goods or services that will be represented by bitcoins. This can be thought of being composed of three parts. 1) the value of goods and services that were supplied in return for the bitcoins outstanding today. 2) a premium based on market speculation about the future value of goods and services that will eventually be supplied in return for bitcoins (probably the largest component of the price at this point). 3) a discount based on the potential that Bitcoin might fail.
1. For an explanation of how currencies come into being in the first place, see Nick Szabos Shelling Out – The Origins of Money. 2. Note that gold does have non-monetary uses such as for electronics. However, the price of gold is largely driven by its monetary properties, and its other uses contribute a negligible amount to its price. The other primary use of gold is as jewelry, but its desirability as jewelry is also due to its monetary properties. Equally shiny metallic jewelry can be had at a fraction of the price of gold jewelry.