What advisors need to know about bitcoin

December 1, 2017 by Kyle Johnson

A woman researches bitcoin.

about the author:

Kyle Johnson

Revenue operations lead

Kyle provides revenue and sales analysis for all Advicent go-to-market teams. These analytics optimize Advicent pipeline forecasting, marketing strategies, and leveraged media channels to improve efficiency of sales operations. Kyle is interested in combining his three passions: tech, data analytics, and marketing, to drive success.

Bitcoin has made waves in the news recently due to the extremely high price it is fetching and the wild price swings it is going through. It is very possible that your clients are wondering how bitcoin functions and what exactly drives its price.

There seems to be nothing tangible backing the cryptocurrency, so how can something without a tangible asset behind it have a price? What drives that price so high? Bitcoin is a currency just like the American dollar, or any fiat currency, because it exhibits the same values as a currency and the price is controlled in the same manner. What is currency? Here is some information about bitcoin in the event that your clients have a few questions about it.

Defining "currency"

According to The Ascent of Money: A Financial History of the World, by Niall Ferguson, currency has value as:

  • A medium of exchange
  • A unit of account
  • A store of value

It is important for a currency to be a medium of exchange because it has the advantage of eliminating the inefficiencies of barter, where two individuals have two different values for the same item. A currency must be a unit of account to facilitate valuations and calculations. Lastly, a currency must be a store of value to allow economic transactions to be conducted of long periods of time or distance. Bitcoin also exhibits all three of these traits for a currency. As well, notice that intrinsic value is not a requirement for a currency.

The fallacy of absolute value

In the 1500s, the Spanish were one of the most dominant empires in the world. They looked to fund the expansion of their empire, through wars, with the acquisition of rare metals in the Americas. The Spanish believed that the more rare metals they acquired, the richer they would be.

The Spanish, however, fell into the trap of believing that the value of their metal currency is absolute. When in fact, an increase in the amount of currency in the economy will not make the economy richer because people understand that the metal is not nearly as scarce now that more metal is floating around the marketplace. Put differently, money or currency is only worth what the other individual in a transaction is willing to give you for it.

Determining the value of currency

The dollar has no real intrinsic value, except that the individual or company on the other end of transaction has a similar valuation of the dollar as you do. Thus, bitcoin does not need to have intrinsic value in order to be used.

While it is perfectly fine to believe that one bitcoin is not worth $10,000, one should comprehend that money and currency is primarily used as a medium for exchange. Bitcoin certainly satisfies this requirement with more and more people using it. So what determines the price of a bitcoin?

Bitcoin prices move up and down with supply and demand. The price at which people are willing to buy and sell bitcoin determines the price of the currency. Much like a stock, the last trade made on the exchange will control the price. Some of the real value in bitcoin comes from its control of the supply of the currency.

Understanding supply and demand

As many people know, there are bitcoin “miners” that solve complex cryptographic-based calculations to obtain a bitcoin. Due to the nature of cryptography and Moore’s law, people are able to understand how long it will take for cutting-edge microprocessor to create a new amount of bitcoin. Thus, people are able to know the exact supply of bitcoin at any given time. This steady increase in the supply of bitcoin helps people involved in the market know how the supply and demand curves are shifting to garner what they believe to be an accurate price.

As opposed to a currency governed by a central bank, where the central bank has a large amount of control over the money supply and thus the agreed upon price for exchange of the currency. Thus, regardless of a rise in the price of bitcoin, bitcoin offers a unique way for investors to shield against inflation.

Holding the relative price of bitcoin equal and the commonalty of bitcoin as a medium of currency, investors in bitcoin can better comprehend the inflation of the bitcoin supply while investors that keep their dollars in the bank run the risk of an increase in the money supply by a central bank eroding their buying power.

The relevance of bitcoin

This was meant to inform you about how bitcoin is used in our modern economy. Bitcoin is a viable currency, as it is able to be a medium for transaction, a unit of measure, and a store of value. Additionally, bitcoin’s supply and demand controls the price and one of the biggest benefits to bitcoin is the standardized and controlled supply of the currency.

While it remains to be seen how the value of bitcoin will change in the future, it appears that bitcoin is not going away any time soon.

To learn how to remain relevant to your clients in a rapidly changing industry, click here.