Bitcoin’s Winner’s Curse – What Auction Theory Teaches Us About Bubbles

I encountered bitcoin for the first time when I was researching anonymous web commerce. The exchange rate at the time, almost $10 for a single bitcoin, seemed as an awfully high premium for anonymity. I was dead wrong. When the total value of bitcoins in circulation rose above billion dollars, a media frenzy started and the increasing interest drove prices through the roof, reaching $266 at the peak.

For those unfamiliar with bitcoin, it is a new type of currency with the following differences from regular currencies:

  • Anonymous – customers of online contraband drugs or pornography – few of bitcoin’s main use cases – prefer anonymity. Unlike credit cards, bitcoins are not attached to a name of a person but rather to a large set of different computer generated ids.
  • Decentralized – like any commodity, the value of currency is driven by supply and demand. When a government increases the supply of a currency (for example, by printing more notes), it depreciates its value. People who do not trust their governments to handle fiscal responsibilities properly are always looking for alternatives to depreciating currencies. Since bitcoin is not regulated by a central bank, and its algorithm ensures that there will never be more than 21 million coins in circulation, bitcoins should hold their value better than centralized currencies.
  • Virtual – when the Cypriot government decided to tax the domestic bank accounts of all its citizens by almost 10%, people all over the world started looking for safe alternatives. Bitcoin’s virtual nature and the fact that there is no central repository that holds them, makes them nearly impossible to confiscate or tax by governments. This is similar to why peer-to-peer file sharing networks like BitTorrent are hard to shut down.

While bitcoin was created as an alternative for common currency, it is hardly used in online commerce. According to the bitcoin official website, less than 0.3% of bitcoins are used in trade. When the value of a currency constantly increases, the amount of bitcoins an item costs constantly goes down, stagnating trade in the process. But why the value of bitcoins increases?

People love get-rich-quick schemes. There is nothing better than to be the person who succeeded to do that and the center of everyone’s conversation. Since both the financial and the emotional rewards are high, the demand for such opportunities is high as well. According to auction theory, excess demand for an item of limited supply, leads to the overvaluation of those items. This phenomenon is known as the “Winner’s Curse”.

The winner’s curse states that in common value auctions (auctions where the value of the item is identical to all bidders) with incomplete information (auctions where people do not know the real value of the item), the winner of the auction will tend to overpay. Think about an auction of a jar of coins, the winner of this auction will be the one that thought that the jar contains more money than anyone else in the auction. The probability that the winner is the only one who is right and everyone else underestimated the value of the item is very low, which leads to overpayment. The higher the demand for an item, the higher the error. Bitcoin is limited in supply by design. The fact that most of the bitcoins are hoarded and not available to buy, lowers supply even further, leading to exorbitant prices.

The value of bitcoin can double or halve within a week so it cannot be used as a currency, and since it has no intrinsic value, it is no good as an investment. Historical trend driven valuations such as: the 17th century tulips, early millennia dot-com companies and recent real estate, have all eventually crashed. The catalysts for bitcoin could range anywhere between the lose of public interest in the coin to the rise of a competitor which will reduce the scarcity of virtual coins, the main driver behind bitcoin’s price.

Bitcoin is a fascinating achievement in both cryptography and new economic thinking that solves a series of real problems. Its only fault – it was cursed with success.

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