Since Bitcoin is the first of its kind as the first scarce digital object in the world that can be sent over the internet, it’s very difficult to assess where exactly its value comes from and how valuable it actually is.
Although there are multiple different ways of assessing BTC's worth, in this article we are going to focus on Bitcoin's scarcity aspect and what role it plays in relation to its inherent value. As far as we are aware, this approach was first introduced in an article published on Medium, which generated a fair bit of interest in the community.
What pretty much all commodities share in common is that, at least in some capacity, their value is derived from a combination of their scarcity, rarity, costs associated with their production, and the volume of production.
Scarcity in numbers
In dictionaries, scarcity is defined as limited availability of a commodity due to market demand. Traditional commodities, such as gold and silver, have low levels of yearly production in comparison to their supply, while enjoying relatively stable market demand. The consistently low rate of supply is the fundamental reason why precious metals have maintained their monetary role throughout human history.
For reference, yearly production (also referred to as flow) of gold amounts to 1.6% of its existing stockpiles (also referred to as stock). This leads to gold’s relatively low price volatility as yearly production is not nearly big enough to impact the price in a significant way. For this reason, silver and especially gold, belong to the so-called monetary goods category of commodities as their stack-to-flow ratio (STF) is very high.
Gold stockpiles amount to 185,000 tonnes, while yearly production, or flow, amounts to 3,000 tonnes. Dividing gold's stock with its flow yields a 62 STF ratio. In other words, it would take 62 years to produce the current gold stock if the production volume would remain constant.
Bitcoin's stock-to-flow ratio
Now, let’s take a look at how BTC fares when observed through the lens of the STF ratio. BTC currently has a stock of 17.7m coins and a flow of approximately 0.7 million new coins per year, which leads to an STF ratio of 25. This puts BTC in the same category as gold, at least in terms of its STF ratio. Its production costs are predominantly associated with the cost of electricity, which is needed to run the energy-intensive PoW algorithm when creating new coins.
"The existing stockpiles of Bitcoin in 2017 were around 25 times larger than the new coins produced in 2017. This is still less than half of the ratio for gold, but around the year 2022, Bitcoin's stock-to-flow ratio will overtake that of gold" — Ammous
The reason why BTC will overtake gold's SF ratio in 2021 or 2022 is the upcoming halving, which is scheduled for May 2020. With every passing year until 2140, when the last BTC will be produced, the volume of newly created coins will represent an ever decreasing portion of all existing BTC. Because of this ongoing dynamic, the STF ratio will continue to increase.
Since its inception, BTC’s value is heavily correlated with its scarcity, just as the hypothesis laid out in the Medium article states. As long as the same nine-year-old trend remains unchanged, the STF ratio will increase to 50 shortly after the next halving. As a result, BTC’s market value is predicted to reach $1 trillion, sometime between 2020 and 2023, while the price of a single coin will supposedly reach $55,000 (if the model proves to be correct).
“Bitcoin’s market value is predicted to reach $1 trillion, sometime between 2020 and 2023, while the price of a single coin will reach $55,000.”
Power law relationship
Another piece of data that gives credence to the proposed STF/scarcity hypothesis is the so-called power law relationship. In general, power laws reveal underlying properties between phenomena independent of scale. A good example of applying power laws to crypto is analyzing three BTC crashes that took place in 2011, 2014 and 2018. Although the price fluctuations were massively different in dollar amounts, the relative change was pretty much the same as the value of BTC dipped for approximately 80% during every crash.
A similar power law relationship seems to be in effect when comparing BTC’s STF ratio and market value. Although the market value has risen over several magnitudes since the first BTC trade has been made, the relation between STF and market value remains constant throughout the years.
Critique of the Model and Final Thoughts
The main critique of the proposed model is its inability to predict what impact will the future BTC halvings have on the price. After next couple of halvings, BTC is about to reach STF ratios before unexperienced by any commodity in history, so predicting the future market value based on these parameters seems to be, more or less, a guessing game.
On the other hand, the relationship between STF ratio and market value is too closely related to be dismissed as a lucky coincidence. Furthermore, the value of precious metals like gold and silver, which are subject to completely different market dynamics than cryptocurrencies, also show a very similar relationship between stack-to-flow, scarcity, and their respective market value.
The digital scarcity of BTC combined with its ability to transfer value over the internet securely and without third-party interference certainly has value. The question remains, how much?