Until around 2012, the benefits of bitcoin were largely theoretical. You could pay anyone in the world almost instantly and almost free. The recipient, however, would have limited uses for the bitcoin he received apart from holding it speculatively or converting it to local currency.
In this article, we’ll begin with unique uses of bitcoin that drive adoption, and the incentive merchants face to accept the currency. Then I’ll discuss the feedback loop between utility and demand, leading to the investment case for bitcoin.
Unique Uses of Bitcoin
The bitcoin ecosystem has grown rapidly in recent years. The currency now enables many unique uses, including:
- Purchasing gift cards to hundreds of retailers – such as Target (NYSE:TGT) and Home Depot (NYSE:HD) – at a 3% discount with no counterparty risk.
- Anonymously purchasing pornography, gambling online, and buying goods and services that do not require shipping, without having to supply any personal information.
- Buying gold online without having to initiate a bank wire or pay a 3% credit card fee.
- Receiving an instant 5% Amazon (NASDAQ:AMZN) discount through Purse, and a 9% Starbucks (NASDAQ:SBUX) discount through Fold.
- Earning a return on coins through lending or bitcoin savings accounts.
- Trading in bitcoin futures and options markets.
One can also use bitcoin to pay an increasing number of online merchants. Such bitcoin-accepting businesses range from well-known companies like Dell, Overstock, Newegg, and Steam, to small businesses that accept and encourage payment in bitcoin.
Relative to credit cards, bitcoin offers sellers many advantages:
No payment processing fees. Credit card payments incur processing fees of approximately 2-4%, depending on factors like industry and transaction volume. By contrast, there are no fees for accepting payment in bitcoin. Services are available to automatically convert bitcoin payments into USD or other currencies. Coinbase offers this service free for the first $1M in transactions; after that, it costs 1% or less.
No chargebacks. Credit card payments may be reversed months after the initial sale, often due to fraud. Each chargeback results in merchant penalties in addition to the loss of revenue. Chargebacks cost US retailers over $10 billion per year. Chargebacks are not possible with bitcoin, however: There is no central authority with power to reverse a charge. (There is a small risk of double-spending with bitcoin, which can be eliminated by waiting for multiple confirmations on larger purchases.)
Accessibility to International Customers. Merchants can accept payments from anywhere in the world, regardless of fraud rates or other barriers to trade.
Attracting Bitcoin Users. The bitcoin community is largely young and tech-savvy. Many will go out of their way to patronize businesses that accept bitcoin.
Eliminating liability and negative PR from hacking. There have been many high-profile credit card breaches, including over 40 million Target customers having their credit and debit card numbers stolen. There is no such risk of compromised financial data with bitcoin payments, as bitcoin addresses can safely be made public.
(Newegg’s initial promotion to attract bitcoin users)
To be clear, the average American online shopper has probably heard of bitcoin, but does not own or use it. Even bitcoin-savvy customers will not always pay with bitcoin. One reason bitcoin users might decline to pay with bitcoin is the same lack of chargebacks, particularly if lacking trust with the merchant. Bitcoin purchases also do not come with the cashback accompanying credit card purchases. As more merchants begin offering discounts for bitcoin payments, more will use this payment method.
While a minority of customers will choose to pay with bitcoin currently, there are few reasons for merchants not to accept it given the lower fees, lack of chargebacks, and other benefits discussed above. Cost of implementation is low. Accepting bitcoin does not require holding it past the point of sale. Merchant adoption has steadily grown in the past few years, and will continue to increase.
In addition, bitcoin and blockchain-related startups have received approximately $1 billion in funding in the past three years, leading to powerful new bitcoin applications. For example, there were approximately 100,000 downloads in the first month of OpenBazaar, a decentralized competitor to eBay (NASDAQ:EBAY) and Amazon with zero fees and no site-wide terms and conditions. The company 21 Inc. manufactures a bitcoin computer enabling a variety of micropayment applications, such as inexpensively selling Wi-Fi minutes.
The Bitcoin Feedback Loop
There is a feedback loop with bitcoin. As merchant acceptance increases, and there are generally more unique and desirable bitcoin applications, legitimacy and demand increase. And as the demand for bitcoin increases and it attracts new users, merchants have greater incentive to accept it, and applications to be built on it.
For the first year or so after bitcoin was created, extremely few people used it, and correspondingly there were few available uses. (Merchants couldn’t accept bitcoin, as there was essentially no exchange rate. The first bitcoin purchase may not have occurred until the $5 million pizza in 2010.)
On the other hand, suppose that everyone held and used bitcoin. If all your customers actively use a certain payment method, and you can accept it with no fees and chargebacks, you will almost certainly offer it as a payment option. Funding for bitcoin applications would be high. Increased use leads to increased merchant acceptance and entrepreneurial attention.
Similarly, suppose bitcoin was a universally accepted payment option. No matter where you went, every business accepted it – restaurants, clothing stores, landlords. The number of bitcoin users would be high in this case. Such universal acceptance would make it a legitimate and highly useful currency with little chance of a major price collapse. Coupled with the other benefits to holders discussed below, bitcoin would be very widely held.
There are other catalysts for bitcoin demand to increase rapidly, such as a country with strict capital controls or economic turmoil moving substantial wealth into it. Such an event isn’t necessary, however. The natural process is for merchant acceptance and application development to increase due to bitcoin’s benefits, leading to increased legitimacy, new users, and higher demand.
In the past 7 years, bitcoin has gone from an obscure currency/commodity with no market value or practical use cases, to a multibillion-dollar network with millions of users, over 100,000 businesses accepting it, and around 200,000 network transactions per day.
The Investment Case for Bitcoin
One reason that many investors decline to invest in bitcoin, particularly value investors, is that the normal investment process is not readily applicable to bitcoin.
In part, until the launch of the Winklevoss ETF (Pending:COIN) or a competitor, the only option for buying bitcoin with a brokerage account is the illiquid Bitcoin Investment Trust (OTCQX:GBTC), which trades at a high premium to NAV. (The future availability of a bitcoin ETF could function as another catalyst.)
(GBTC trading at a premium of over 50% prior to the recent price increase; image credit to Tradeblock)
Another way in which bitcoin investment differs from conventional investment is the process for deciding if it merits purchase at a particular price. With stocks, an investor can use standard valuation methods to determine if the company is trading sufficiently far below intrinsic value to justify purchase. While there have been many attempts to produce bitcoin price targets, it is difficult or impossible to quantify the value of a bitcoin.
An investment in bitcoin is also a strong candidate to violate Buffett’s first rule of investing: “Don’t lose money.” There is a significant chance that the price per coin will fall to $0 within the next decade. Such a price collapse could occur due to a fundamental flaw with the bitcoin protocol, adverse legislation, or a competing cryptocurrency becoming dominant. Buffett has, in fact, explicitly said regarding bitcoin: “Stay away from it. It’s a mirage, basically.”
So why would an investor purchase an asset with no quantifiable intrinsic value, and a substantial risk of losing the full investment?
The answer is risk-reward. Bitcoin is competing against currencies and gold, and despite its often-volatile exchange rate, has properties that make it superior to both from an investor’s perspective in many aspects.
(Comparison of Bitcoin to Gold and Currencies; Image Credit to Dugcampbell.com)
Bitcoin’s fixed supply makes it a strong hedge against inflation; there will never be more than 21 million coins in existence. There is no counterparty risk to holding bitcoin in a wallet where you control the private keys. There is no possibility of seizure by banks or governments, no capital controls, and no withdrawal limits. There is no burden of transporting or storing physical assets. You can encrypt and make multiple backups of your bitcoin wallet. It is easy to liquidate or transfer value anywhere in the world.
If a non-negligible fraction of global gold and currency demand does move into bitcoin, the current market cap of $8B would necessarily increase by orders of magnitude. An investment that has the potential to increase significantly can fail the majority of the time, and still have a positive expected value.
To turn this argument into a sound investment case, one would need to determine the probabilities, USD/BTC exchange rates, and time frames associated with all possible outcomes for bitcoin. If there is interest, I will roughly quantify these assumptions in a future article.
Apart from using bitcoin, I own it as an investment with a simple thesis: There is a non-negligible probability that the bitcoin price will increase by a factor of 100 or more in the next decade, and for me that is sufficient compensation to invest in an asset that may fall to $0.
Disclosure: I am/we are long BITCOIN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.