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Bitcoin exchange rate as a prediction

November 11th, 2013
bitcoin, money  [html]
Bitcoin has a small chance of becoming a major way people handle money. There are 1.2 trillion dollars in circulation, so if bitcoin seriously succeeded the value of all coins might total around a trillion dollars. The long-term maximum number of bitcoins is 21 million, so each coin would be worth about $50K.

If we naively think of bitcoin as an all-or-nothing thing where it's only worth it if it gets huge, then we can interpret the current exchange rate of $360 as a prediction that bitcoin has around a 1% chance of making it. To figure out if this is a good way to think of it, let's consider the other likely outcomes for bitcoin.

Governments could pass laws or apply existing ones in ways that make bitcoin impractical to use or fully illegal. There is lots of interest, speculation, and growing experience with the legal aspects of a decentralized currency, and it's not at all clear yet how it will turn out. It might end up as just another currency, but it also might end up unusable.

There are also technological issues. So far the bitcoin cryptography and protocol seem solid, but occasionally things have gone wrong and there may be some incentive issues. If there's a deeper protocol flaw, or if the math behind the cryptography turns out to be more tractable than believed, we could end up in a case where bitcoins lose all their value. For example, if you could construct a private key for an address from its public key then there's no longer a way to tell whose money is whose and the whole thing would collapse.

Finally, governments could allow bitcoin on similar terms to cash, the technology could stand up to the challenge, but people still might not switch to it. Perhaps the volitility never gets low enough for people to be comfortable, it can't lose its associations of drugs and money laundering, or people really like being protected from fraud via chargebacks. It could fade away or end up with long term niche use by hobbyists and people with transactions too shady to use standard currency.

In each of these alternative outcomes bitcoin is either worthless or very small on a global scale. Most of the expected value of bitcoin does seem to come from this small chance that it will be very large, so I think the original naive calculation is about right. The market is estimating that bitcoin's probability of making it big is around the current price divided by $50,000, which is currently 0.7%. If you think this is too low or too high, you could make some expected money by correcting it.

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