Is Bitcoin a Store of Value or a Payment System

It is a while since I have written about Bitcoin, but I continue to be fascinated by it. In particular, by Bitcoin’s ability to endure and continue serenely on in the face of all manner of controversies and headwinds.

Possible Outcomes

I have a long-held view there are only two possible outcomes for Bitcoin – it will either disappear, or it will become mainstream as a digital asset (a new asset class). There are many who wish it to disappear and write or speak out to promote this view, but in this blog I examine what mainstream Bitcoin might look like.

In this scenario, there are a range of possibilities - at one end Bitcoin is primarily a store-of-value, and at the other end, Bitcoin is a high volume payment system.

Economics

Before explaining these, I will first recap Bitcoin economics with some figures.

Miners are the backbone of the Bitcoin network. They compete to generate Bitcoin blocks and validate transactions, costing them huge sums in computing hardware and electricity costs. They get rewarded in bitcoins for each block they generate, and for each transaction they validate. While the block reward is fixed, currently 12.5 bitcoins per block, transaction fees are set by the sender and need to be sufficient for a miner to make the effort to validate the transaction.

In the 12 months to 10 Nov 2017, miners created about 55,000 blocks and validated about 100 million transactions. This earned them an astonishing $1.8 billion in revenue, of which about 11%, or $205m was in transaction fees, the rest in block rewards.

Two Key Factors

Coming back to the spectrum of possibilities for mainstream Bitcoin, there are two key factors to consider.

One is the block reward which halves approximately every four years, reducing to 6.25 bitcoins per block around mid 2020, then again to 3.125 bitcoins per block around mid-2024 and so on. The other is the current limit on capacity, which the network has already reached, at around 100 million transactions per year.

The block halving means that miners revenue will also halve every four years unless the price of Bitcoin increases to compensate, or unless the capacity limit is increased so that more transactions are processed, generating more transaction fees.

Implications

To examine our two scenarios with these factors in mind, we need to make some assumptions. The current Bitcoin price is around $6,500, which if sustained, would give miners around $5 billion in revenue over the next 12 months, including about $500 million in transaction fees at the current average rate of $5 per transaction.

If we assume that $5 billion (sic – that would be the value of the 695,000 bitcoins to be mined over the next 12 months at $6,500 each, plus transaction fees) is the steady state annual running cost of the network, then for the store-of-value scenario to materialise, the Bitcoin price will have to rise to achieve this with each block-halving, for example I calculate to around $26,000 in 2024, $52,000 in 2028 and so on. Alternatively, if $6,500 becomes the steady price in the payment system scenario and we assume the transaction limit problem is solved with limitless capacity, then block revenue would only be $1 billion from 2024, and transaction revenue would have to rise to around $4 billion, or 80% of revenue. Assuming a transaction fee of 5 cents (the average value in 2015 before the capacity limit was hit), that would equate to around 80 billion transactions per year.

Clearly these assumptions will turn out differently, little is steady in the Bitcoin domain, but they serve to support this illustration for each end of the spectrum of outcomes for Bitcoin, should it become mainstream.

Conclusion

In my view, it is difficult to believe that the store-of-value outcome is sustainable, as the price of Bitcoin will have to keep doubling every four years for the miners to keep the network running, but with no clear reason to do so other than the increasing price, a virtuous circle that surely would have to end at some point. This highlights that for Bitcoin to endure, the capacity problem must be solved, and the network must start to be used for high volume payment transactions. With the Segwit2x capacity improvement cancelled this week, the day when this problem is solved appears to be looking more and more distant.

However, this story will continue to unfold in unforeseen ways, and as ever will be fascinating to watch.