In segment 4.7, we're going to look at currency exchange markets. That is markets on which you can trade BitCoins against fiat currencies like dollars and euros, etc. We've talked earlier about BitCoin exchanges and other types of businesses that are involved in trading between BitCoins and fiat currencies. But now we want to look at this as a market. We want to look at the size of it, the extent of it, and how it operates, and we'll look a little bit at the economics of this market. The first thing to understand about this, if you're new to it, is that it operates in many ways like the market between two fiat currencies. Like the market between dollars and euros, the price will fluctuate back and forth depending on how badly people want to buy euros versus how badly people want to buy dollars on a particular day. So in the Bitcoin markets, we can looks at data. And, in fact, there are sites like bitcoincharts, this is Bitcoin markets page on BitCoins charts which shows exchanges that trade dollars against BitCoins. And you can see there is a list of different exchanges of different places where you can trade dollars against BitCoins here from top to bottom. Up here at the top we have BitStamp which on this particular day had the highest value. For each one there is the current price for BitStamp, on the day I took this screen shot, it was $582.54. You can get graphs, you can look at the average, the volume, etc. The 24 hour average price is $585, the volume was about 6100 bitcoins or about $3.6 over the previous 24 hours. So, you can see there's a lot of trading here. And if you go to this site live, you can see the prices move in real time as trades get made. So this is an active market. It's a liquid market and there are plenty of places you can go to to buy or sell Bitcoins. Another place you can go besides an online exchange, if you want to buy or sell Bitcoins, is it you can use sites that help you meet people to trade BitCoins in real life. So here I went to localbitcoins.com, it's an example. I said I want to buy BitCoins in Princeton, New Jersey, United States and it gave me a bunch of results. A bunch of people who on this particular day were willing to sell me BitCoins for what price and for how many? And so I could then contact these people, I could arrange to meet them at a coffee shop somewhere or in a park or whatever it is and I could give them dollars and, in exchange, they would give me BitCoins. And so this is another way to do it, you can just find a person near you or you can find somebody you know. The very first BitCoins I bought, I bought from one of my students who owned some BitCoins. I just gave him some dollars and he pays in BitCoins into my digital wallet. Another thing you can do is you can go to a physical place. There are some places in the world or some regular meet ups where it's known that people go to trade bitcoins. And so you can go to a certain park, a certain street corner on a particular day and you know that there will be people standing around wanting to buy or sell bitcoins and you can do business with them. And here you see a bunch of people at one of these meet-ups all looking at their phones with their apps to transfer or verify transfer of bitcoins. And so these are all the ways that you can trade, or the popular ways that you can trade bitcoins against dollars. Okay, now this is a market, as I said, and the market matches buyers who want to do one thing with sellers who are willing to do the opposite thing. It's a relatively large market, meaning millions of US dollars per day pass through it. It's not like the New York stock exchange or it's not like the dollars to euros market, which is vastly larger. But it's relatively large so that there is a notion of a consensus price and that a person who wants to come into this market to buy or sell a modest amount, at least, will always be able to find the part. The price of this market, this consensus price, like the price of anything in a liquid market, will be set by supply and demand. That is what is the supply of bitcoins that might potentially be sold and what is the demand for bitcoins by people who have dollars? The price through this market mechanism will be set to the level that matches supply and demand. But let's dig in to that a little bit more. First of all let's talk about what is the supply of bitcoins. The supply of bitcoins, that is the bitcoins that you might possibly buy in one of these markets is, first of all, equal to the supply of Bitcoins that are in circulation. Currently, of course there's a fixed number of Bitcoins in circulation. At the time of this filming it's about 13.1 million. And the rules of Bitcoin, as they currently stand, say that this number will slowly go up and hit a limit of 21 million eventually. But you might also sometimes include demand deposits of Bitcoins. That is, if someone has put money into their account in a Bitcoin exchange, and the account doesn't keep a full reserve to meet every single deposit, then you'll have demand deposits at that exchange that are larger than the number of coins that the exchange is holding. And depending on exactly what question you're asking about the market it might or might not be correct to include demand deposits in the supply. So when should you include demand deposits? Well basically you should include demand deposits in a market analysis when demand deposited money can be sold in that market. So for example, if you're talking about exchange of dollars for Bitcoins, that can happen in an exchange. If I have Bitcoins demand deposited in an exchange, I can trade those for dollars. And so if that's the scenario you're looking at, it would make sense to include demand deposits in that exchange as part of the supply. It's worth noting as well that when economists conventionally talk about the supply of fiat currency, they typically include in the money supply, not only the currency that's in circulation, that is the actual paper and metal money, but also the total amount of demand deposits. And that's for the logical reason that people can actually spend their demand deposited money to buy stock. And so although it's tempting to say that the supply of BitCoins is fixed at 13.1 million currently, or 21 million eventually, for some purposes we have to include demand deposits, where those demand deposits function like money. And so the supply might not be fixed in the way that some BitCoin advocates claim. And we could need to look at the circumstances that the particular market were talking about in order to understand what the proper money supply is. But let's assume we've agreed on what supply we're using based on what market we're analyzing. Let's now look at demand. There are really two main sources of demand for bitcoins. There is demand for Bitcoins as a way of mediating fiat-currency transactions and there is demand for Bitcoins as an investment. So, first let's look at mediating fiat-currency transactions. So, here is the scenario. Imagine that Alice wants to buy something from Bob or wants to pay some money to Bob. And Alice and Bob want to transfer, let's say, a certain number of dollars. But they find it convenient to use Bitcoin to do this transfer. Perhaps they're at a distance, Alice wants to be able email the money to Bob. Perhaps they like the fact that they can have very low transaction fees in Bitcoin and lower than some other service. Whatever the reason they want to use Bitcoins to mediate this transaction. So, the way that works is this, that first, Alice buys Bitcoins for dollars. Alice then sends those Bitcoins to Bob as a Bitcoin transaction. Once that transaction is recorded in the block chain and it's confirmed to Bob's satisfaction, Bob will sell those Bitcoins for dollars and get the dollars back. So Alice starts by putting in dollars, Bob ends by getting out dollars. But the key thing for the purpose of BitCoin demand is that the BitCoins that are mediating this transaction that are bought by Alison step one and sold by Bob in step three have to be taken out of circulation and they're devoted to serving this transaction during the time that the transaction's going on. And that creates a demand for those BitCoins. If there are a lot of people who want to mediate transactions like this, whether those fiat-currency transactions or other transactions, if they want to mediate transactions, that will generate demand for bitcoins. So, that's the first source of demand. The second source of demand is that bitcoin is sometimes demanded as an investment. That is somebody wants to buy bitcoins and hold them in the hope that the price of bitcoins will go up in the future and that they'll be able to sell them. So to the extent that people are buying and holding those bitcoins, those bitcoins are out of circulation. But there's a demand to buy bitcoins at least depending on the price. When the price is low, you might expect a lot of people to want to buy bitcoins as an investment. But if the price goes up very high, then the demand for Bitcoins as an investment won't be as high. So that's the second source of demand. Now we can do some simple economic modeling to understand how these markets will behave. And I'm not going to do a full model here, although that's an interesting exercise. What I want to do is look specifically, at the market at the effect of this transaction mediation demand and what affect that might have on the price of bitcoins. And we can build a simple model for doing that. So here's a simple model of the demand that is driven by transactions, by transaction mediation and what it tells us about what the price should be. So we're going to assume some parameters here, first we're going to say T is equal to the total transaction value that's going to be mediated via bitcoins by everyone who's participating in the market. And that's going to be measured in dollars per second. We're going to assume for simplicity that the people who want to mediate these transactions have in mind a certain dollar value of the transaction. Or if it's some other fiat currency we'll translate it into dollars for simplicity. So there's a certain number of dollars per second of transactions that need to be mediated. We're going to say, D is equal to the duration of time that bitcoins need to be held out of circulations in order to mediate a transaction. That's the time from when the payer buys the bitcoins to when the receiver is able to sell them back into the market, and we'll measure that in seconds. And then S is going to be the supply of bitcoins that are available for this purchase. And so that's going to be all the bitcoins that exist, that is, all of the hard currency bitcoins, all of the 13.1 million or eventually up to 21 million bitcoins. Not including those that are held out by people as long term investments. So at any point in time there's some supply of Bitcoins that are sloshing around and available for this purpose. Okay, and now we can do some calculations. The first thing we'll do is we'll calculate how many Bitcoins become available in order to service transactions per second. Well, there are S bitcoins in total that are used. And because they are taken out of circulation for a time of D seconds, then every second about 1 over D fraction of those bitcoins will become newly available because they will emerge from that out of circulation state. And so on average, S over D bitcoins will become available for mediating transactions every second. That's the supply side. On the demand side, the number of bitcoins per second that are needed to mediate transactions, well we have T dollars worth of transactions to mediate. And in order to mediate $1 worth of transaction we need one over P bitcoins. That is, we need to take this T, which is measured in dollars per second, and divide it by the price in dollars per bitcoin, and the result we get is bitcoins per second. These are the number of bitcoins per second that are needed in order to serve all the transactions that people want to serve. Okay, so if you look for a particular second of time, for that second, there is a supply of Bitcoins of S over D and there is a demand of T over P. And now, if you think about the dynamics of this market, it behaves like many markets, in that, the price will fluctuate in order to bring supply into line with demand. if the supply is higher than the demand, then there are Bitcoins that are going unsold. And so the people who are selling Bitcoins will be willing to lower their price to try to sell those Bitcoins. And so the price will come down if supply is higher than demand. And when the price comes down, that will cause demand actually to go up. Because, P, the price is in the denominator of demand so if supply is bigger than demand, then demand will be pulled up. On the other hand, if demand is higher than supply, that means that there are people who want to get bit coins to mediate a transaction who can't get them because there aren't enough bitcoins around. And so those people will bid more, in order to get their Bitcoins. They'll have to bid more, because there'll be a lot of competition for that limited supply of Bitcoins. And so if the demand is higher than the supply, the result is that price will go up. And when price goes up, then because price is in the denominator of the demand, that means demand will come back down. Demand for Bitcoins will come back down as the price goes up. So if you have supply here, and demand here, then the demand will be pulled down toward the supply, right? And so if the supply is at some point that the demand, we've argued, will always be pulled toward the supply and, in fact, the two will come into equilibrium. And so the equilibrium condition, the point where you'll end up in this market is where this supply S over D, is equal to the demand T over P. And so if you set those two expressions equal to each other and then you solve for P, the price, what you get is this, that an equilibrium, the price should be equal to T times D divided by S. All right, so what does this mean? Well, one thing we can conclude about this is that if you think of D the duration as not changing, because probably the duration, you need to hold the BitCoin to do a transaction, is not going to change. So if D doesn't change and if S, the supply, is not changing, then what this tells us is that the price is going to be proportional to the demand for transaction mediation as measured in dollars. And so if demand for transaction mediation in dollars doubles, then the price of bitcoins should double. And we could in fact, graph the price against some estimate of the demand for transaction mediation and see whether they match up. And when economists do this, they do tend to match up pretty well. So we could graph the price of bitcoins against the demand for transaction mediation as you can estimated in hours per second. And those thing should tend to be proportional over time and when the economists do that, they tend to do the match up pretty well. The other thing we can note is that supply is in the denominator here, and that supply includes only the BitCoins that aren't being held as investments. And so what that tells us is, if more people are buying BitCoin as an investment, the result would be that coins are withdrawn from this status where they are available to mediate transactions. And so the S that we're using here will go down. So that if investors are buying a lot of BitCoins, it will drive down S and therefore P will go up and so that makes sense. If there's more demand on the investment side, then the price that you need to pay to mediate a transaction will go up. Now this is not a full model of the market. In order to have a full model, we need to take into account the activities of investors. We need to bear in mind that investors will demand bitcoins when they believe that the price will be higher in the future. And so we need to think about investors expectations and investors expectations, of course, have something to do with what is the expected total transaction value demand in the future. And we could build a model that's more complex. I'm not going to do that here, but you get a flavor of the kind of thing that you can do. So the bottom line here is that there is a market between BitCoins and dollars or BitCoins and other Fiat currencies that that market has enough liquidity that you could buy or sell in modest quantities in a reliable way, although the price does go up and down. And that it's possible to do economic modelling and get some idea of how supply and demand interact in this market and predict what the market might do. As long as you understand unknowable things like how much are people going to want to use Bitcoin to mediate transactions in the future. That kind of economic modelling is important to do and very informative, and I'm sure that there are people who are doing it in some detail today. But a detailed economic model of this market is beyond the scope of this course.