Crypto-currencies: fad or future?

By now, most people have some basic awareness of crypto-currencies like Bitcoin – though only specialists seem to have mastered the details. One of the big confusions is the degree to which they truly are currencies.

Currencies have three functions. They serve as means of payment, units of account and stores of value. It’s not clear that Bitcoin functions on any of those levels.

For a start, there isn’t much you can buy with Bitcoin. It tends to be expensive and unwieldy to use. Indeed, high transactions costs and lengthy settlement times mean that even a recent conference on Bitcoin refused to accept the crypto-currency as payment for tickets.¹ Few goods are priced in Bitcoin. And you can’t hold underlying assets in it, either. 

What’s more, governments guarantee the usability of their currencies – if only because they’re the means for paying taxes. By contrast, there’s no overarching authority backing Bitcoin. Supporters argue that’s exactly the point of crypto-currencies – no government or institution can inflate them away and their ultimate supply is built into their ground rules – but these  are not as cast-iron as is often suggested.

Bitcoins can be undermined by anyone who manages to amass a majority of 51 per cent of Bitcoin mining power. In effect, they can increase the fixed maximum quantity of Bitcoins, which is set at 21 million and is the cornerstone of many arguments for why it will hold its value better than fiat currencies.

Fig. 1 too big to ignore

Value of Bitcoin as a %

Given that some 79 per cent of Bitcoin mining is said to be based in China and that Chinese are some of the most significant holders of Bitcoins,²  there is a non-negligible risk that authorities in Beijing could find a way to take control of the crypto-currency.³

Indeed, government involvement represents a major risk to Bitcoin and other digital currencies. Regulators are worried about crypto-currencies’ ability to facilitate black-market activities, about their already vast consumption of electricity for mining – in November alone, the energy consumed to mine Bitcoin rose by some 30 per cent and accounted for 0.13 per cent of global energy demand –transactions purposes, and their potential to trigger systemic banking problems as people take on debt to buy them.⁴  For instance, the South Korean government mooted banning Bitcoin trading⁵, a worry given that the country is one of the crypto-currency’s major marketplaces, before backtracking.

The potential for systemic problems goes further than individuals using credit cards to buy Bitcoins. At current market prices, the value of Bitcoins in circulation is USD170 billion, equivalent to 4.2 per cent of the US monetary base, 2.1 per cent of global gold stocks and 0.8 per cent of the global monetary base. We estimate that Bitcoin mining has accounted for as much as 11 per cent of the expansion in the global money supply.

And it’s worth noting that, among other things, although crypto-currencies are meant to defend against seigniorage – which is to say governments’ ability to debase their currencies – authorities like having this power and are likely to combat any efforts to undermine it.

If crypto-currencies aren’t really currencies, what are they? For a time, rocketing valuations (in traditional currency terms) made them look like spectacular investments. Bitcoin started 2017 at USD985. By August it had quadrupled. And then quadrupled again by the start of December, peaking at over USD19,000. But easy come, easy go. Prices are back down to just under USD10,000 after waves of bad news. With nothing backing Bitcoin except investor enthusiasm, there’s no reason valuations won’t fall back to where they were at the start of last year. As an investment, they have shown the ability to generate spectacular returns, and equally spectacular losses.

Bitcoin as an investment is only for those who tolerate risk. It has a 90 per cent annualised volatility – a white knuckle ride, but not unprecedented. Bear in mind that gold had an annualised volatility of around 70 per cent during the inflationary surge of 1979-80. 

Fig. 2 fly me to the moon (and back again)

Bitcoin price in USD

Indeed, the crypto-currency is often compared to gold – the US Commodity Futures Trading Commission classifies Bitcoin futures as a commodity.⁶ Like gold, Bitcoin also doesn’t generate a yield and is largely priced according to investor perception. But digital currencies don’t have gold’s history. How long they retain investor confidence is open to question. And Bitcoin is not a physical entity. The digital exchanges trading it have been hacked. Digital wallets have been pilfered. And computer crashes and glitches have wiped out Bitcoin wealth.

Above all, investors should worry about the recent frenzy of enthusiasm for crypto-currencies, a key signal that it is experiencing a bubble – as is Bitcoin’s price trajectory. Could it rise further? Sure. If it is a bubble, Bitcoin’s closest parallel is probably the Dutch Tulip Mania of the first half of the 17th century.

Bitcoin seems particularly attractive to those who have no memory of the dot com bubble – millennials.⁷ A recent survey showed that while 2 per cent of Americans own Bitcoin, that proportion doubles among those born between the early 1980s and early 1990s.