Just a few years ago, most of us had never heard of digital currencies like bitcoin. Now, discussion of bitcoin and other digital currencies dominate the financial landscape.
I'm not here to offer an opinion as to whether or not you should purchase bitcoin, but to hopefully shed light on an area where, for some, emotion has taken hold. Here are three simple concepts about bitcoin that could clear up a few misunderstandings:
1) Comparisons to Stocks are Flawed
In recent weeks, as bitcoin scaled new heights, we've heard countless comparisons of the digital currency to stocks. "The market cap of bitcoin has exceeded company XYZ", has become a familiar phrase on financial television.
The combined value of all the bitcoins in the world currently in circulation is approximately $250 billion (this figure fluctuates). If bitcoin was a company, it would be among the 20 largest in the S&P 500.
However, these comparisons are flawed; why would anyone compare a currency with a stock? Bitcoin is a currency, and it should be compared to other currencies.
According to the St. Louis Federal Reserve, the U.S. M3 money supply stands at $13.7 trillion. That gives the U.S. dollar a market cap of $13.7 trillion, which dwarfs bitcoin's $250 billion market cap.
2) Scarcity Drives Wild Price Swings
Alex Smith, quarterback of the Kansas City Chiefs, will make about $17 million dollars this season. That puts him in the middle of the pack for starting NFL quarterbacks.
Try to imagine for a moment that Alex's $17 million is all the money in the world. Alex has $17 million, and nobody else has even $1. Now you understand the scarcity of bitcoin.
For a currency, bitcoin is rare, with less than 17 million units currently available. Of those, there are an unknown number that are just being held by its owners. Some have been forgotten, and some have been lost. A man in Wales accidently threw away $100 million worth of bitcoin.
The supply of bitcoins will supposedly be capped at 21 million. Because the number of bitcoins in circulation is so small, the market tends swing wildly.
3) Is Bitcoin in a Bubble?
While some individuals are beginning to exhibit the frenzied behavior that accompanies bubbles, the wild swings in bitcoin can be explained by scarcity. The market for bitcoin is extremely thin, when compared to established currencies.
This leaves us with an interesting conundrum: bitcoin has some aspects of a bubble, yet it's entirely possible that bitcoin is not in a bubble. Bitcoin showed similar bubbly behavior in 2013 before crashing due to the MTGOX scandal.
Bubbles can only be determined in hindsight, and those who are calling this a bubble are merely expressing an opinion. They may be correct, or they may not be, but it's just an opinion.
The same goes for those who claim bitcoins are worth $1 million, or worth nothing. We're in uncharted territory, folks. None of us has been here before.
This commentary originally appeared on Real Money Pro on Dec. 29. Click here to learn about this dynamic market information service for active traders and get more great columns like this from ed Ponsi, Paul Price and others.