Judges can’t make their minds up whether Bitcoin is real money or not

A court in Florida, USA ruled that a prosecution for money laundering cannot go ahead because the money in question was bitcoin.

“This court is not an expert in economics, however, it is very clear, even to someone with limited knowledge in the area, that bitcoin has a long way to go before it is equivalent of money.”

This decision drew criticism, however. Law authorities have been trying to clamp down on bitcoin being used for illegal activities for sometime. The IRS, however, taxes bitcoin as “intangible assets” rather than money.

Across the Atlantic, the European Court of justice has different opinions. It ruled that bitcoin is not an asset but a currency. And consequently it doesn’t attract VAT when it is bought.

It’s a question I have addressed before. Whether it is a currency or an asset is important for legal and tax purposes, but neither of these designations explains why it is actually worth anything at all.

Comparison with legal tender

Let’s compare bitcoin with legal tender, that is to say currency that is accepted by a national government to repay debts and settle tax. No legal system in the world (to my knowledge) recognises bitcoin in this respect, probably because national banks don’t have bitcoin lending and national governments don’t have bitcoin spending.

And therein lies the value in national “fiat” currency. I think of national currency as tax tokens. So long as a government demands payment of tax in a currency, it will always have a value, albeit rampant inflation can rapidly erode that value.

National currency is created as debt. In the UK, most of it is created by banks, usually as mortgages. Indeed some organisations campaign to change this regime. In the UK, as much as 97% of currency in circulation has been created by banks as loans in this way whilst the remaining 3% has been created by the Bank of England. Bitcoin, on the other hand, is created by “mining”, simulating a precious metal. Clearly one cannot physically mine a virtual currency, but the cyber equivalent has been created whereby computers, whole networks of them, solve mathematical tasks, each one of which also facilitates the settlement of a packet of transactions. The reward is a fraction of a bitcoin.

These two completely different process by which the different types of currency come into being inform us that there are likely to be differences in how they are valued. In much the same way that the value of gold fluctuates against currencies, in fact. But even that doesn’t explain why bitcoin has a value. At least gold looks nice and lasts forever. But that isn’t enough for us to ignore bitcoin.

Bitcoin as currency

Imagine bitcoin has just been invented and that some people have some. Let us say that there are systems available to transfer bitcoin, and to settle transactions using them (e.g. buying on Amazon). How do we know how much they are worth? OK, let’s give them an arbitrary value of $100. Then if more people want bitcoin than there are prepared to sell bitcoin, the price goes to $101 then $102, to entice holders to sell, much like forex or stock markets. Where does the demand come from? From people willing to sell goods or currencies for bitcoin. Why might they do that?

Some say that it’s criminal activity that provides demand for bitcoin. Certainly we know the anonymity of bitcoin attracts money launderers, but we can’t be sure that it’s its main driver. After all, if the purpose of criminals using bitcoin is to transfer wealth, then wouldn’t they want to convert it into legal tender or other assets as soon as possible? In which case the round trip has an equal quantity of buying and selling of bitcoin.

If bitcoin is to at least maintain its value against currencies then although a round trip of currency transfer might be market-neutral, the implication is that at any one time, the value of transactions is increasing if the value of bitcoin is to rise. So between the time that someone buys bitcoin then sells it elsewhere, someone else has also bought some. And this also helps the original buyer, who has made a profit on their bitcoin.

Bitcoin as a store of wealth

Although the court ruling in Europe stated that bitcoin wasn’t an asset, there’s no doubt that there is a case for including bitcoin in a diversified portfolio just as one might hold cash.

But bitcoin is only a store of value insomuch that people continue to use it for transactions. As soon as demand dries up, and holders want out, so will its exchange value. But isn’t that the same for any currency?

Yes and no. National currencies will always have a value for settling taxes and debts. Bitcoin doesn’t have that demand to back it up, although bitcoin debts can certainly be created they will necessarily be created from bitcoin already in circulation.

So what is bitcoin really worth?

The more that bitcoin is used for settling transactions, the more its value rises, or at least is maintained. And the more its value is at least maintained, the more it becomes a store of wealth, attracting investors to buy and hold, again putting upward pressure on its value.

It’s a question that has been asked many times. When Business Insider asked Chris Dixon, they still didn’t understand the reason even after three attempts at getting Dixon to explain. The website bitcoin.org provides an explanation similar to mine, that is that its value comes from the growing acceptance of its use to settle transactions, again comparing bitcoin to gold. This BBC article makes a valid point, however. Banks and other financial organisations like Western Union offer services that enable us to send money around the world. But it’s costly and might take days, not to mention the paperwork that might be required. Bitcoin transactions are near-instantaneous, and if the transaction to exchange USD for bitcoin is initiated in the USA now, a transaction to exchange bitcoin into HKD can be initiated a few moments later, probably with little or no movement in the value of bitcoin against either currency in the process.

The only way to really answer the conundrum of: What is bitcoin really worth? is to state that it has value at all because it is widely used and is plentiful enough for large transactions to be completed. And while there is upward pressure on its value as volumes of transactions rise, it becomes attractive as a store of wealth. It’s not so much a question of how much one bitcoin is worth, as how much the value of one bitcoin is likely to change over time. If there are more people wanting to use bitcoin as a store of wealth than there are to liquidate it in favour of other assets, the value of bitcoin relative to fiat currencies will rise.

That doesn’t explain how it became thus, only how it remains thus. It just evolved that way.