As the price of bitcoin has increased in the past few weeks there has been a plenty of talk about it being speculation-driven, often with reference to a huge crash since bitcoin's adoption and usage is not necessarily keeping pace with the increase in price.

However adoption, coverage, price, speculation and usage do not each exist in a vacuum.  They are interrelated and will feed each other; an increase in adoption will bolster media coverage which will bolster speculation and price, an increase in price will increase coverage which may encourage further adoption and speculation.  This cycle is not negative - it is part of bitcoin's growth and its path to the mainstream with adoption (actual usage of bitcoin) being the demand underpinning its value.  Whether we are in a huge bubble right now is whether we are seeing pure short term speculation vs actual adoption.  This depends to some extent on the psychology of the adopters and whether they see long term value in bitcoin. 

The more small-scale drops and crashes bitcoin recovers from the more adopters will feel comfortable in holding onto their bitcoins during a drop rather than cashing out and accelerating the fall.  Further as more early adopters cash out to buy houses and such there will be fewer fat-fingered sells that cause large downward spikes in the exchanges to trigger these sell offs.  It is worth pointing out that the recent drop from around $820 (MtGox) halted at $500, still higher than any previous value before the climb, and was quickly reversed, climbing back up to around $800:

Bitcoin has the potential to make some major changes to the payments and remittances industry amongst many others and as its adoption in this space increases we can treat this as a fundamental driver of its increase in value.  If thousands of people use it daily to send money from one country to another then they need to own bitcoins to do this and this creates demand which drives up its price.

But velocity (how long those bitcoins are held before they are sent on to take part in another transaction) is a key factor in this and one form of adoption that is often left out is as a store of value.

Anyone storing some portion of their wealth long term in bitcoin is actively using that number of bitcoins even if they are not transferring them.  They are using them as a store of value and contributing to demand which is every bit as valid as using them to send value around the world.  Despite the usual 'intrinsic value' claims much of gold's value comes from demand to use it as an inflation-resistent and well accepted store of value.

Demand from the various uses of bitcoin makes up its fundamental value.  Anything over that is speculation: perceived future value which has been taken into account now and has pushed the price up in anticipation that its fundamental value will increase in the future.

Clearly there is some speculation in bitcoin and some would argue that today it makes up a significant portion of its value however this does not necessarily mean it is overbought and bound to crash to a far lower price.

If people believe that a bitcoin may be worth $10,000 in a couple of years then they are likely to be ready to pay $1,000 for one today.  If we factor risk into that equation then it changes the price they will pay; the more confident they are that it will rise to $10k the more they will be willing to pay today since they are more sure of the return.

As I have said this isn't any different to how the stock market operates.  Companies don't sell for their exact value today, they sell for a price based on their value today plus expected future gains - this is why we have P/E ratios.  Given this then, if adoption is increasing and more investors can see the writing on the wall for companies like Western Union it is not unreasonable to predict that bitcoin's fundamental value will increase very significantly over the coming few years.  At this point a speculator becomes more confident of the return that they can get (bitcoin's price rising as a result of adoption demand) and they buy.  This doesn't necessarily mean they create a bubble, but it means it brings forward the price increase - the value increases are realised earlier and more quickly while speculators wait in expectation that the fundamental value will increase.

Over time these speculators (if they are correct) see the fundamental value increase past a level they predict and they cash out in the belief that they won't get further significant returns: that any future increases will be purely driven by (incorrect) speculation or will be small enough such that they will not produce an acceptable return.  Since speculators are human things are never going to be as simple and smooth as this.  They might get excited and bid the price up beyond what they can rationally justify or get worried when they see a fall in the price and cash out early accelerating it but overall the trend will be that the increase in value will be brought forward.  If everyone is confident that demand will increase ten fold in the next 12 months then we shouldn't expect to see the price increase steadily in step with that increase in adoption, we should expect to see it increase earlier as speculators buy in, maybe overshoot somewhat and eventually settle at a price which is closer to the future fundamental value.  

How closely the value follows adoption or, conversely, how quickly the price today incorporates predicted increases in value will be a function of investor confidence, as will the volatility on the way there.

Things are hotting up for bitcoin right now with the price over $420 on MtGox. CNBC's interview yesterday of the Winklevoss twins shows both the fundamental lack of understanding of bitcoin by the interviewer (asking "where is the Ben Bernanke of bitcoin?") and also the feeling many bitcoin supporters have right now: that even with the price increasing quickly (although whether the current price increase is 'quick' is debatable given the many calculations of a final prices in the order of $40k+), adoption, this time as least, seems to be increasing similarly quickly with big time players like Baidu and Shopify coming on board.
  
Peter Schiff though gives a scathing response to their comments: that bitcoin is a bubble (he even likens it to the Tulip bubble of 1637), that people are buying bitcoin because they think their value will increase, and that he expects it to implode.

Bubbles don't form simply because people buy into something that they think will increase in value.  A bubble forms when the primary reason for the increase in price is an increase in demand fuelled by people thinking the price will increase (but otherwise see no significant value in it).

Peter along with many others seem to think that because people are buying bitcoins with the view that they are undervalued this constitutes a bubble, yet this is the basis of much of investing.  If I buy stock in a company then it is for one of only two reasons:

• A) The dividend payment
• B) The stock price will go up

With (B) being a significant part if not the vast majority of investing in the world.

In terms of viewing whether a company stock is in a bubble we can look at the company's fundamentals, how much profit they make, what their long term prospects to make profit are, and we can invest based on how profitable we think the company will be not just now but in the future.  This often leads us to evaluate whether companies are over or undervalued by their price to earnings (P/E) ratio.

With bitcoin, the fundamental driver of its underlying value is not selling products to make profit, it is its adoption and usage.  If bitcoin's adoption is increasing (enough) then its price increase is justified.  Instead if there are people piling in buying bitcoins all hoping to hold them for a short while then sell them for short term gain then the price increases while demand is there but then falls away as people being to cash out.  This then accelerates are more people get concerned that they will lose their investment and cash out.

The nature of the bubble, when/whether it will pop and how far it will go if it does pop will depend on the investors, the question is: are bitcoin investors in it for the short term or the long haul?

I can't speak for everyone and there will without a doubt be those that do hope to just play the price in the short term for gains but at the same time my own perspective on and appreciation of bitcoin is nothing special so my own thinking and strategy may well match up to others that believe in the fundamental value of bitcoin, so here it is:

The first step is to believe that bitcoin is a genuinely beneficial and new invention.  How you get to this point and what level of understanding you need is very individual but if you're going to buy bitcoin then this is likely a given.

The next step is to accept that you can't predict how life will pan out for bitcoin, and that you may be wrong.  I can't predict regulation and its effects, I can't predict the development path of quantum computers, and I can't predict whether bitcoin will survive being the worlds most profitable target for hackers the world has ever seen.

What I can say is that bitcoin looks to have a lot of potential, and that I accept these risks.  

The next conclusion if I think bitcoin has fundamental value beyond its current price is that it is better to buy early, while the rest of the world hasn't caught on yet and while they still think bitcoin is no different to PayPal.

Because I accept the risks and because bitcoin is cheap at this point, I don't bet my house on it because I don't need to.  I can buy a bunch of bitcoins and if the positive predictions of bitcoin going to $100k work out then I don't need to hold a lot of them.  If the predictions don't work out and it all fails then I don't lose much.

In short, if bitcoin wins out, I win.  If bitcoin loses out, I don't care - I walk away.  My investment was low because I wasn't trying to secure a return of 2 or 3x, I was investing with the view that it could go to 100x.

If I hold bitcoins then and their value is increasing, then you might think there is an overwhelming tendency to want to cash out and realise gains in case it crashes (or maybe when it crashes?).  This assumption is wrong for a number of reasons:

1. I don't care if my investment loses its value.  I am in it to see a 100-1000x increase, not 2 or 3x, so bitcoin increasing 2 or 3x is interesting but its not anywhere near a trigger point for me.
2. Even if their value increases very significantly (say 100x), because I understand and appreciate bitcoin I would still rather keep a lot of money denominated in bitcoin than USD (or some other currency) because I know currencies around the world today are inflating horribly due to Quantitative Easing and because of the risk of bail-in (confiscation).  Therefore even if the price of bitcoin skyrockets and goes to $10k per bitcoin, I don't suddenly think that the best place to keep my money is in USD in a bank!
3. Because of the nature of the gains I expect bitcoin may make (orders of magnitude), as it hits certain points I can extract a portion of my bitcoins to realise some of the gains and diversify while still retaining the bulk of my bitcoins (and therefore the demand for bitcoin if others take the same view will remain high).  For example if I bought bitcoins at $25 each, then maybe I would sell 10% at $250.  This covers my initial investment 100% yet I still retain 90% of my bitcoins, thereby reinforcing (1).  Similarly when it reaches some other higher number maybe I cash out another small amount to diversify yet retain the bulk. This isn't possible when the gains you expect are 10 or 20%, its only possible when you think bitcoin is undervalued by orders of magnitude.

This is just my strategy but it is based on simple logic that anyone who:

• A) believes bitcoin has significant utility and that demand will ultimately drive prices much higher as a result of its adoption for that utility.
• B) believes they realised this early enough that they think bitcoin will make significant gains

In this case anyone can buy a small number of bitcoins, wait, cash out partly when they can cover their investment with a fraction of the gains and then sit on the rest purely as savings.

This act of saving (which some would describe negatively as 'hoarding') is not bad for bitcoin, it is an important use of bitcoin as a safe store of value and a valid part of its demand.  If people save bitcoins then it reduces the pool for other forms of adoption like use by merchants which naturally means their value must increase to meet that demand.  Saying that every bitcoin must be in circulation for it to be viable is like saying USD will fail if anyone keeps them in their wallet or bank account too long.

Where it does become bad for bitcoin is if I fundamentally believe bitcoin will ultimately fail and I am holding it with a view to making some gains before cashing out.

Some will hold this view and they will undoubtedly create bubbles and pops as bitcoins adoption progresses but to call bitcoin predominantly a bubble we need to ask the questions:

• Does bitcoin have fundamental utility (value)?
• Are most bitcoins held by people who think it has fundamental utility (and therefore don't plan to dump them all in exchange for USD they think 'the bitcoin bubble is popping')?

Given that roughly 90% of bitcoins in circulation today were mined before the end of 2012 (when the media still laughed at them) my guess would be 'yes' to both.  If I'm right then we will see bubbles and pops but rather than crashing to zero bitcoin will retain a strong base of value which will increase in line with adoption.

If you keep on top of bitcoin news you've probably stumbled across stories from one of its most vocal followers - Joe Wiesenthal.  Joe regularly makes posts about bitcoin's development and progress, for example:

• (Up) Nov 5th - Bitcoin is Going Totally Ballistic
• (Up) Nov 6th - Bitcoin Is Going On An Astronomical Tear
• (Up) Nov 7th - Bitcoin Goes On An Overnight Nuclear Melt-Up
• (Up) Nov 8th - Bitcoin Is Going Crazy Again
• (Up) Nov 9th - Bitcoin Is Having Another Preposterously Huge Day
• (Down) Nov 10th - Bitcoin Crashes Nearly 25%
• (Up) Nov - 11th - Although bitcoin has regained its pre-weekend value we have as yet no headline about it going on an Astronomically Huge Preposterous Nuclear Melt so far... perhaps Joe has decided that the early-stage and growing bitcoin is simply more volatile than the assets he is used to?  Then again the night is young...

Bitcoin is such a new phenomenon that before investing time, money or effort into it, it makes sense to assess it as clearly and in as much depth as possible.

As a computer scientist the elegance and power of certain algorithms is immediately apparent.  Binary Chop always springs to my mind for example but probably an even better example of this, more understandable to a non-programmer is Diffie Hellman key exchange, described in this excellent video by Khan Academy.

As Seymour Papert described some time ago in his book Mindstorms, people regularly exposed to algorithms come to think not just formally in terms of them but concretely, understanding them at a more intuitive level and naturally applying them to other situations.  When faced with a new algorithm it is absorbed far more easily and the consequences, strengths and weaknesses are much more readily apparent.

Algorithms like these do not need to be complicated, but they elegantly solve a very difficult problem which can then have very far reaching consequences.

As Tim Lee has described bitcoin falls into this category.  It is fundamentally different to centralised systems with trusted entities like PayPal, Amazon Coins, or even US Dollars.  It isn't different because someone says it will be and the 21 million coin limit isn't there because someone says they won't create more, any more than Diffie Hellman key exchange allows exchange of a secret key simply by virtue of someone saying they will keep it hidden.  It is the fundamental operation of the algorithm and its properties which gives it its strength.  

If you want to decrypt a document encrypted with AES without first obtaining the secret key then you will have to break AES.  What this means is you will have to spot something in the algorithm that everyone else has missed, or run calculations for longer than the death of many universes to discover it by random chance.  This is why cracking AES is hard, its not just a function of spending money or the speed of computers.

These algorithms open up possibilities that simply weren't there before.  As Richard Brown, IBM's executive director points out: like many others, until Bitcoin existed he simply didn't think it was possible.

Bitcoin then, is a very exciting idea.  To understand bitcoin is to understand the doors that have been opened by its invention in the same way that Diffie Hellman and RSA opened doors.

To understand bitcoin in the context of recent issues such as the Cyprus Bail-ins is to see these doors opened at perhaps the perfect time both to protect a lot of average people and for bitcoin to flourish as a result.  Further, anyone experiencing the actually poor security, high barriers and high fees of the existing payments infrastructure has even more reason to get excited about it.

However, metacognition warning bells begin to ring.  Exciting, but this sounds too good to be true?  What are the flaws?  What are the arguments against?  Where are the holes?  As Harvard Business Review wisely recommends the best way to not get caught up in the hype is to appoint or play devil's advocate and try to look for flaws, holes, reasons why this isn't what it appears to be, reasons why it will fail.

This approach can lead to some valid concerns about bitcoin, particularly in its earlier days - 51% attacks, effects of regulation, knowledge of the NSA's hand in weakening cryptography standards and the security of its implementation. These are valid criticisms and concerns which come from an understanding of the benefits and risks of bitcoin.

Unfortunately Joe appears to be leading the charge of the majority of vocal bitcoin critics who fall into the other type of criticism for bitcoin - that based on a hollywood level understanding of it.

Without understanding the doors that bitcoin has created and opened and the fundamental strengths and weaknesses of its design its not possible to distinguish between it and existing technologies which are superficially similar and it therefore becomes easy to laugh at it and dismiss it.  Why is it any different to PayPal?  Who says there will only be 21 million bitcoins?  Everything is cracked (and therefore destroyed?) at some point / at some price.  

Joe's arguments are more economic but still appear to stem from a lack of in depth understanding or maybe just a lack of critical thinking.

Joe writes that "If you believe in bitcoin then you should never buy anything in bitcoin" making the case that a deflationary asset (one that increases in value) means that you will continually hoard it and never spend its value.  Unfortunately Joe misses the point that supply-limited deflationary assets already exist - in fact in his profile he states that he owns gold - but he fails to see the parallel.  Similarly Joe must realise that people can and do invest in the stock market with the expectation of making returns (their money invested will become a larger amount of money next year - the fundamental quality of a deflationary asset).  Given the existence of the stock market and the opportunity to make returns his argument would suggest that we must all be putting every penny we have into Amazon stocks and hoarding all our cash because we see it increase in value.  What he misses is that people are making a value and risk judgement.  I can invest in Amazon stock and be happy to watch it go up without operating purely on the black and white case of either investing and keeping all my money in it or not.

Joe also claims that "Bitcoin is a joke" because it lacks "intrinsic value" and is "mostly just a speculative vehicle" with other activity predominantly limited to "PR stunts about bars and other shops accepting bitcoins".  Joe apparently sees the current gold price of $41,000 per kilogram as being entirely a function of its ability to conduct electricity, resist corrosion and look attractive.  I can only assume he is investing heavily in clearly undervalued aluminium, copper and plastic beads.  We will no doubt all look like fools when one day in the not too distant future Joe sits atop his mountain of fake plastic pearls and sells them to us at $40,000 per kilo.

Similarly Joe's criticisms that bitcoin hasn't already built all its possible infrastructure and saturated its market to greatly reduce volatility remind me of Clifford Stoll's now legendary criticism of the internet back in a 1995 Newsweek article, helpfully describing the future in very accurate detail while at the same time claiming none of it will come to pass.

Whether we are missing something fundamental in our understanding of bitcoin is open to debate and to that debate I am very open.  Whether the doors it has opened and the strengths and weaknesses of its design are as they appear or not is an interesting and valid discussion, as with any groundbreaking new algorithm or technology.  Unfortunately bitcoin's potential to have such a profound effect on the often non-technical and very vocal world of finance appears to mean arguments like these are by far the most common within the discussion yet don't add a lot to it.

The news around bitcoin recently has been awash with reports of the price hitting new highs.  Recently the price has surpassed the $260 mark it high it hit in April.

The problem with these stories is that they come from finance-oriented sites that think because bitcoin is described as an asset and a currency all the typical knowledge they have about assets and currencies applies to bitcoin.

These are websites that get excited about a few hundred basis points (few percent) move in the price of gold so when bitcoin doubles its value in a short time its an amazing feat.

Thats not to say that doubling value isn't a significant change, but it just doesn't mean the same thing as say, gold, doubling its value.

Bitcoin is a new technology, but its also a new asset and currency.  The price of a bitcoin is affected by many things including psychology, macroeconomics and news but by far the most important effect on its price is its level of adoption.

If there were only ten people in the world interested in gold and trading it between themselves would they trade it at $1300/oz?  What about if those ten people suddenly had another 100 interested? would they trade it at the same price?

Bitcoin's price and its adoption are closely linked because adoption of this particular technology is close to being the same thing as demand for it as an asset.

Here's a bitcoin chart you may not have seen already:

Mundane right? sure there's a bit of volatility in there but not much to speak of, generally it looks like a pretty straight line.

The chart above is the bitcoin price in USD from day one until today.  The reason it looks like a straight line though is that the scale is logarithmic, not linear.  Here's the USD bitcoin price charts with their different scales:

This is the same data, the only difference is the scale.

Interesting, but so what if bitcoin is following an exponential curve in its price, maybe its just a fluke or a massive bubble?

The reason why this makes sense is that new and groundbreaking technologies are not linear, they are S-curves.

Here's a chart of Facebook's users:

As you can see its not linear, its exponential.  Growth starts out small, maybe stays linear for a while but at some point a critical mass is reached and adoption propagates like a chain reaction with each new user causing more new users to adopt.  Later when saturation is nearing the curve slows down and starts to level off (you can just see that starting to happen at the end of this chart).

Bitcoin is following a similar adoption curve, the only difference is that the price is also affected by other factors like greed, fear, news, and the economy.  This adds volatility to the curve and even creates bubbles within the curve but the overall trend stays the same - an exponential curve (with bumps) that will at some point level off.

The levelling off will occur when bitcoin nears saturation, not just from individual user adoption (people that know about it and maybe own a few) but adoption for any and all purposes that it is useful for (store of value, remittances, merchant transactions...).

The bitcoin price isn't going on some huge inexplicable upwards streak, its following a standard adoption curve.