How Is The Value Of Bitcoin Determined?

As I’ve already explained, Bitcoin has been getting a huge amount of hype recently. It’s one of the many digital currencies in existence today which acts and functions like regular money but exists entirely electronically—like data inside computers.

And that can be kind of confusing, because if there is no actual physical bitcoin:

  • How can it have value?
  • How can you use digital currency in a physical world?

Well actually, the question of how bitcoin has any value at all isn’t so far off from the question of how most real-world money has value.

First off, Bitcoin has no actual intrinsic value, which means that it has little to no use to us outside of its economic context. But the same can be said for most real-world currencies: money only has value because the government that issues it says it does.

This is called ‘fiat currency,’ because its value is not tied to any physical commodity and relies on the backing of a government.

But unlike fiat currency, Bitcoin does not have an issuing authority that gives it value. Bitcoin is a decentralized currency, meaning there is no governing body that regulates its production and transactions.

It doesn’t answer to any government or organization, so there isn’t really a reason why it should have value, yet it does – and it can all be boiled down to utility, scarcity, and supply and demand.

Bitcoin’s Value Lies In Its Utility

Before we discuss the utility of Bitcoin, first you must understand the basics of how it works. You are connected to the community of Bitcoin users through a computer network, and the ledgers that Bitcoin uses is called a blockchain: transactions are compiled into blocks, which in turn are connected in a chain-like manner, hence the name.  The ledger keepers are called miners, because what they are doing, essentially, sounds very much like gold miners who work hard to find gold: they are working for the reward in the form of bitcoins, which, like gold, are limited in supply.  So now you know how Bitcoin works. What does that have to do with its value? Everything, actually. Bitcoin’s value is in its utility: its decentralization, security, and ease of transaction.

First, let’s look at Bitcoin’s decentralized system. Bitcoin is designed such that there is no need for any governing authority to control it. It operates through a peer-to-peer network where all transactions are recorded in the blockchain.  On the most basic level, this would mean that it is not tied to any state and therefore is the only truly borderless currency. What this means is that you can conduct transactions with people from different countries easily because you’re using the same currency.  On a deeper, much more complicated level, the decentralization of Bitcoin’s system creates the possibility of transforming the finance industry.

The finance industry offers multiple ways to simplify transactions for ease of convenience. There are credit and debit cards, money transferring systems, electronic bank transfers, etc. But all of these systems need to have a middleman to function—they need a company or authority to facilitate the exchange.  So what you’re doing whenever you make a transaction is that you’re putting your trust on the middleman—that they will get your money through or keep your money safe among other things. There is also the matter of transaction fees, which, considered per transaction, is not too much, but can easily pile up over time. What Bitcoin does is it eliminates the need for these middlemen.

As mentioned above, all transactions in the Bitcoin network are recorded in the blockchain by miners. While the blockchain and miner network has the semblance of a governing body in the sense that it keeps track of all bitcoins in existence, it’s still in the public domain and therefore cannot be monopolized.

This means that no single person or group of persons has a hold on the network—which, in turn, means that bitcoins can remain fully transparent and neutral in its transactions.

But if there is no official body acting as a regulator, who can you trust to make sure that transactions do go through? The answer: no one. And it sounds bad, but it’s actually a good thing.  The Bitcoin system is designed to operate without the need for trust. See, it’s not simply a digital currency, it’s a cryptocurrency, which means that it is heavily based on encryption techniques to keep it safe.  Instead of operating based on customer trust, Bitcoin operates using tried and tested mathematics (more on that later). Cheating the network is impossible due to its public environment.  Not only that, but the system is encrypted so that trying to commit fraud would require an extremely large amount of computing power, which would by then have been more useful if you just used it to mine more bitcoins.

The security system, aside from ensuring the reliability of Bitcoin transactions, also ensures that the identity of the Bitcoin users can be protected. Unlike in credit cards, your account number does not have any value in your transactions, which are ultimately verified using a private and public key.  It works like this: you put a digital signature to your transactions using your private key which can be verified by the users of the network using your public key. The keys are encrypted so that the public key can only ever work if you had used the correct private key in the first place.

This means that:

  1. Your identity can’t be stolen by criminals to make fraudulent transactions in your name.
  2. You can choose to remain completely anonymous in the Bitcoin network, which may prove useful for some.

Lastly, bitcoins have the possibility of providing an ease of convenience that surpasses the traditional paying methods that we already have now. According to the Bitcoin site, using bitcoins allow you “to send and receive bitcoins anywhere in the world at any time.  No bank holidays. No borders. No bureaucracy. Bitcoin allows its users to be in full control of their money.

Moving on, we look at Bitcoin : Supply and Demand