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Bitcoin’s rehab will ultimately determine its true value

Not your pirate currency any more: as traditional institutions embrace Bitcoins, the price will only increase. Flickr/Zach Copley

As Bitcoin’s backers push for it to become acceptable mainstream currency, its value has become increasingly tied to attempts to break the public image that it’s just a currency for cyber criminals.

It’s for this reason that every suggestion the currency is gaining acceptance by governments sends its price soaring. In November, US Federal Reserve Chairman Ben Bernanke released a letter stating there was no need to regulate Bitcoin and that virtual currencies like Bitcoin held promise as a more efficient and more secure payment system.

This morning Glenn Stevens, Reserve Bank of Australia governor, told the Australian Financial Review virtual currencies like Bitcoin have long-term promise, “particularly if the technology leads to a faster, more secure and more efficient payments system”.

This shop in Korea accepts Bitcoins as payment alongside EFTPOS and cash. As Bitcoin loses its shady image, its price climbs. EPA/Yonhap

Bernanke’s oblique endorsement of Bitcoin helped lift its price to about US$1200 per Bitcoin. Conversely, negative statements like that made by China’s Central Bank that Chinese financial institutions should not accept Bitcoin sent its value plummeting by over 30% to a low of $814.

Fair value of $1300?

At the same time, analysts at Merrill Lynch have released a report stating Bitcoin has the potential to become a major means of electronic payment for e-commerce. The analysts put an estimate of its fair value at $1,300.

The basis of the report is the argument that Bitcoin provides a number of key attributes making it ideal as a means of electronic payment.

The first of these attributes is that Bitcoin offers lower transaction costs than normal credit card payment because it’s possible to exchange the currency directly between the buyer and seller without an intervening agency.

Secondly, Bitcoin is relatively secure and the public ledger that records transactions provides an audit trail making it easy to track potential illicit activity.

But this is somewhat mitigated by the fact that Bitcoin transactions are largely anonymous. So although you know that a transaction has taken place, in the absence of other identifying information, it is not possible to say who that transaction was with simply by viewing the ledger.

What is true is that it is not really possible to forge Bitcoins. New Bitcoins can only be created through so-called “Bitcoin mining”, using special software to solve math problems in exchange for a certain number of Bitcoins.

Merrill Lynch listed several disadvantages of Bitcoin as an electronic payment currency, including the volatility of its value and the fact that it takes 50 minutes for a Bitcoin transaction to be verified by the distributed checking system. Of course, as Bitcoin becomes more accepted as a means of payment, its volatility may ease and so the first disadvantage may become less of a problem.

Merrill Lynch’s valuation of Bitcoin at US$1,300 relies on the assumption that it will become a ubiquitous means of electronic payment and come to account for 10% of all electronic transactions conducted online.

And it assumes that a component of Bitcoins’ overall value comes from the fact that it is treated as an investment instrument rather than as a means of exchange. Taken together, the analysts calculated a total market capitalisation of $15 billion giving a maximum fair value of Bitcoin of US$1,300.

It is not clear how valid the calculation is or how relevant it is going to be to the actual price of Bitcoin, which is being driven largely by the Chinese market for Bitcoins that has overtaken the existing leading exchanges used by the rest of the world based in Japan and Europe.

The driver for Bitcoin in China is the belief that it is a safer currency than the national Renminbi because it is largely free of government oversight. Whether this is the case or not is another question. Governments can crack down on Bitcoin or decide to regulate it like any other currency, which would negate this particular advantage.

It seems likely that Merrill Lynch is correct in the view that Bitcoin will increasingly become a popular means of electronic payment once its price starts to stabilise and as it becomes simpler and more seamless to buy and sell.

What its price will be at that point is yet to be seen, but it likely to be significantly more than Merrill Lynch’s prediction of $1,300.

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