Understanding the Bitcoin surge

Bitcoin has been making waves recently, with the price of the crypto-currency rising rapidly. 1 bitcoin is above Rs. 8,00,000 rising an astonishing 68% in this month alone. The rise in bitcoin has resulted in people rushing to buy bitcoins. But what are bitcoins and how do they work? What is the likely future for Bitcoin price? All of these questions are valid and need to be understood.

What is a bitcoin?

Bitcoin is a cryptocurrency, or a digital currency, that uses cryptography for generation and regulation of units of the currency. The units are generated by complicated mathematical operations and governed by millions of computer users called ‘miners’. It has no physical existence and its value is set by trading activities by a distributed network of millions of users via their personal computers daily, unregulated by the govt.

Each Bitcoin holds a  data ledger file called a blockchain. Each blockchain is unique to each individual user and his/her personal bitcoin wallet where the bitcoin is stored. All bitcoin transactions are available in a public ledger, verified by the distributed network helping ensure their authenticity and preventing fraud. This also helps to prevent duplication of transactions and people from copying bitcoins. Thus the basis of bitcoins and other cryptocurrencies is the blockchain technology, which is basically a distributed ledger system that helps to maintain integrity and robustness of the system.

Blockchain technology characteristics make it extremely relevant to the financial sector, which is why we see an increasing trend of banks beginning to use blockchain in their operations.

Read: How blockchain technology is being adopted by State Bank of India

What determines Bitcoin price?

From the outside, the rise of bitcoin appears tempting yet fragile as you have no reliable metric to understand how its price works as it is not governed at all and depends on the collective outcome of disparate transactions being made all over. This is where an interesting theory is gaining ground.

This theory attempts to explain bitcoin price function in terms of Metcalfe’s Network law which states that a network’s value is proportional to the square of the number of users. putting it simply, a single mobile phone has no intrinsic value. However, adding another mobile phone gives it some value. Add a million mobile phones and suddenly, the whole mobile phone network becomes very valuable.

This relationship has been observed in many industries where increased adoption boosts the network’s overall usefulness, such as European internet usage, Facebook’s value, and more recently Tencent’s value according to Stephen Powaga of ETF Momentum Investing

So, now extending this analogy, we can say that as the adoption of Bitcoin increases, it is likely to increase in value as the number of people to potentially exchange it with for goods and services increases over time, which mirrors Metcalfe’s law.

Frank Holmes, CEO of US Global Investors speaking at the LBMA/LPPM Precious Metals conference in Barcelona, observed that

“Metcalfe’s law states that the bigger the network of users, the greater that network’s value becomes. Robert Metcalfe, distinguished electrical engineer, was speaking specifically about Ethernet, but it also applies to cryptos. Bitcoin might look like a bubble on a simple price chart, but when we place it on a logarithmic scale, we see that a peak has not been reached yet.

 

 

 

Given its distributed nature, it is very difficult to to accurately predict the rise and fall of Bitcoin prices. But it appears to follow the tenets of Metcalfe’s law which sows us that the peak of Bitcoin has probably not reached yet. As more and more people join Bitcoin, the intrinsic value of the Bitcoin will only rise further and while this is no guarantee of future price of Bitcoin, it is a useful indicator to keep an eye on.

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