Futures trading in bitcoin opened the door for naysayers to participate in the trading market, which had previously been largely dominated by true believers. Now the naysayers have pushed bitcoin’s price down sharply. Since closing at a peak above $19,000 on December 18 — on the first day of futures trading — bitcoin has lost almost half of its value.
Where will the price go from here? Now arbitrageurs can mine bitcoin BTCUSD, -3.78% and sell in the futures market BTCG8, +2.28% XBTG8, -0.18% Bitcoin mining is a competitive business requiring no specialized knowledge or intellectual property.
Accordingly, in the long run, bitcoin miners (like other commodity miners) will earn only enough returns to compensate them for their cost of capital. Unlike with technology companies thta possess trade secrets or market power, bitcoin miners cannot earn large excess returns in the long run — ensuring bitcoin’s equilibrium price will be only modestly higher than the cost of mining. Any higher, as it is currently, and arbitrageurs will start mining because there are no barriers to entry and they can make riskless returns by mining bitcoin and selling it in the futures market.
The prospect of earning a riskless return will attract other arbitrageurs and drive down profits until bitcoin’s price approaches its fundamental value — in this case, the cost of mining.
If the price falls below the cost of mining, the miners will not be able to earn their cost of capital, and it will not be in their economic interest to participate and provide the infrastructure for the bitcoin blockchain. Without the computing power provided by the miners, the system would eventually collapse, rendering bitcoin worthless. However, with a valuable bitcoin network currently in place and many enthusiasts who strongly believe in its prospects, this scenario is highly unlikely in the short run.
Thus, the floor on the price of bitcoin is around $5,000 to compensate for the cost of mining and a modest profit. The equilibrium price will increase as the mining costs increase. Once there are no more bitcoins to mine, its value will be driven by the role it will play in the blockchain economy.
One possible way bitcoin’s value could fall below the mining cost is through regulatory interference. After the start of futures trading in the CBOE and CME was announced, the price of bitcoin skyrocketed almost three fold from the announcement until the first day of trading on the CME. The prevailing view within the crypto community was that trading in mainstream exchanges imparted legitimacy, thereby attracting institutional money.
Not unexpectedly, this activity also heightened attention from regulators, who are rightfully concerned about nefarious uses for bitcoin, including money laundering, fraud, and tax evasion. For example, South Korea and China, where a large part of the trading was occurring, have threatened a hard stance against owning and trading cryptocurrencies. Even U.S. Treasury Secretary Steve Mnuchin has suggested he will work with G20 nations to prevent bitcoin from becoming the digital equivalent of an anonymous Swiss bank account.
Forcing bitcoin into oblivion would likely require a concerted and coordinated regulatory effort, however, because its global nature allows it to operate quite effectively as long as there are a few countries with a permissive regulatory regime, such as Japan. Nevertheless, bitcoin faces regulatory risk, which is yet another potential contributing factor in bitcoin’s price decline.
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Right now, however, bitcoin’s price decline is mostly a reflection of the current uncertainties surrounding a technology in its infancy. It is just as true today as it was a month ago, before futures trading began, that blockchain technology has the potential to be a disruptive technology which can increase the speed, efficiency, cost, and transparency of many transactions, and that bitcoin could play a pivotal role in those transactions. It is also just as true that bitcoin has the potential to bank the unbanked, allowing many without access to a credit card or bank to conduct digital transactions with their smartphones.
In fact, this correlated decline in all cryptocurrencies makes a case for bitcoin as digital gold — in a world in which the majority of transactions use utility tokens and bitcoin is the dominant cryptocurrency that can be readily converted into other tokens, bitcoin holdings could maintain their purchasing power by hedging against cryptocurrency price increases.
So, over time, if blockchain technologies are extensively deployed, with bitcoin playing a pivotal role, and there are no more bitcoins to mine, then bitcoin’s price could appreciate. However, the equilibrium price, at least in the intermediate term, simply reflects that its value can be no more than the cost of mining it.
Thus, even though violent swings in bitcoin prices may create doubt about its future, this volatility is just the first important step in the price-stabilization process. Eventually, bitcoin prices will move closer to fundamental value (the cost of mining bitcoin) with lower volatility, which may actually help blockchain technology (and related cryptocurrencies) to deliver on its promise as a disruptive blockbuster.
Atulya Sarin is a professor of finance at Santa Clara University. He has written on currencies in his book Foundations of Multinational Financial Management (sixth edition), and has worked extensively as a valuation expert.