The digital payment system Bitcoin has seen massive price swings in the past few days as the Senate homeland security and banking committees have held hearings to examine its rise.
Given that the price of one Bitcoin late Tuesday afternoon is six times higher than it was at the beginning of the month, it’s worth asking if Bitcoin is in a bubble.
A bubble is when the price of an asset rises beyond its fundamental value.
Since Bitcoin has no intrinsic value beyond its owners’ belief that other users will accept the currency as payment for a good or service, at first glance it appears that a price above $600 for one Bitcoin is out of line with reality.
Yet there are other reasons to believe that Bitcoin’s value could easily be as high or well above what speculators are currently paying for it.
Bitcoin’s value largely depends on how widely it is accepted as payment.
That is also true of dollars. Like Bitcoins, dollars cannot be traded in for gold or any objectively valuable physical item.
Unlike dollars, however, Bitcoins are not promoted by the government as legal tender for all debts throughout the country, and are not already widely in circulation.
That means Bitcoin’s viability as a currency hinges on its ability to gain traction among a wide base of users.
Since its introduction in 2009, Bitcoin's usefulness has mostly been limited to its role in anonymous illegal activity online. Some retailers accept it, but Bitcoin’s dollar value rose into the triple digits even when its commercial viability was mostly limited to online drug markets like the Silk Road.
But advocates hope that as more people learn about the system and trust it, store owners will accept it as payment and more consumers will adopt it, leading to it become more like a real currency.
This week's high-profile Senate hearings have boosted Bitcoin's visibility. Mentions of Bitcoin have spiked in recent days, according to Google trends, as prominent newspapers like the Wall Street Journal have dedicated front-page stories to the phenomenon. In the past, Bitcoin has surged anytime it has been in the news.
And regulators' and law enforcement officers' relatively warm embrace of the digital currency at both hearings has lent it some credibility and doubtlessly increased users' willingness to embrace it.
As Bitcoin gains notice and trust, each unit of the currency should appreciate in price.
Part of the system is the artificial scarcity of Bitcoins. The system's open-source code is written in such a way that only 21 million Bitcoins will ever be produced (12 million are currently outstanding).
If Bitcoin becomes a mature currency, it will ultimately trade at relatively stable exchange rate with the dollar, just like any other currency.
Because the overall level of Bitcoins is capped, that exchange rate could be high — likely far higher than it is today.
So the run-up in Bitcoins over the past few days may be a speculative bubble. But it also could be Bitcoin users pricing in the increased probability that it could become a legitimate currency thanks to this week’s media coverarage and acceptance by regulators.