In the crazed markets of the last year, between r/WallStreetBet redditors pumping over-valued stocks, and the inexorable rise of Tesla, one feature has stood out: the remarkable resilience of bitcoin.
Slammed last year as a bubble about to burst, bitcoin has, remarkably, been able to keep rising, reaching over $40,000 towards the beginning of January 2021, before settling at around the $30,000 range by the end of January.
Like it or not, it is important to take bitcoin seriously, and to evaluate the fate of similar cryptocurrencies – if only because other market participants, with very deep pockets, are doing the same.
What is bitcoin anyway?
Essentially, a radically decentralised currency. Unlike other fiat currencies, Bitcoin is not issued by a Government or bank. Unlike other currencies, bitcoin relies on blockchain technology. Simply put, this is a shared public record, which stores all confirmed transactions in an anonymous way.
Okay, so what’s the point of it?
To start with: it is important to determine what exactly bitcoin is argued to be. Is it an asset, or a currency?
This is an understated difference. One explanation of bitcoin is that it will serve as a hedge against inflation caused by excessive central bankers’ quantitative easing.
An alternate, but subtly different explanation, is that bitcoin can serve as a decentralised currency, away from the interfering grip of oppressive governments.
The argument goes that in a world of hyper-quantitative easing, and relentless money creation, both individuals and firms are likely to want an asset that can hold its value against inflation. Admittedly, gold has served this function for at least the last 3,000 years – but there are a number of advantages of bitcoin over gold.
Firstly, supply is artificially capped by design at 21 million bitcoins – and therefore, might be a better store of value than gold, where supply increases at roughly 1.5% a year.
Moreover, while gold is relatively fixed in its location (even when ownership changes hands, gold typically remains in the exact same vaults), bitcoin as a decentralised currency suffers from none of those limitations.
While gold can be seized by a government, bitcoin is independent of such authorities, and might be more useful for dissidents in oppressive regimes, for instance. Finally, bitcoin is eminently and infinitely divisible – while gold is less so.
But what are the problems of bitcoin as an asset?
In short, volatility. In the space of two months, the price of bitcoin has reduced from $40,000 to $30,000, a reduction of 25%. In particular, bitcoin has proven particularly volatile when it comes to market distress. It does not act as a market haven, in the way “safe harbour” assets such as the US dollar and Gold does.
This is what distinguishes it from Gold – both are essentially fiat assets, in so far as their value is determined by human convention rather than intrinsic worth.
One recent study shows the disparity drastically: looking at the period between July 2011 and December 2017, Bitcoin had a daily standard deviation of 5.76% – twice that of WTI oil price, and far exceeding that of gold (1.0499%) or silver (1.7633%) prices.
More interestingly than just simple levels of volatility, however, is the response of the price of bitcoin to market shocks. A key argument behind bitcoin is that it can serve as a replacement safe-haven asset separate from the rest of the financial system. When looking at market instability during the period noted, bitcoin prices were “extremely volatile” and “negative in general”.
Part of the reason by behind this is the extreme illiquidity of bitcoin. Only a small portion of the 21m bitcoins is traded frequently, meaning that the sale of relatively few bitcoins can have outsized effects on the price. Indeed, as one commentator noted, a sale of just 150 bitcoin resulted in a 10% fall in its price. Even if one were to use bitcoin as a safe-haven, it’s unclear it would retain its value if they tried to liquidate their position.
Moreover, 2.8% of addresses hold 95% of the bitcoin supply – and these 2.8% are among the least active traders. It would only take a few “whales” to start unloading their positions for the price of bitcoin to be radically transformed.
In short, as a safe-haven asset, and as a hedge against inflation that can retain its value – it is unclear that bitcoin currently fulfils this function. That’s not to say that it can never happen – perhaps, over time, as bitcoin becomes more established, and there is more of a market history, volatility may reduce. Until then, it may yet struggle.
How does Asset Management play into this?
Just because bitcoin might not serve the same function as gold, does not mean it can’t serve a role as an asset class.
If enough asset managers decide that bitcoin can play a role as part of their Alternative Assets portfolio, then bitcoin may yet go substantially higher. With Global AUM of $74.3 trillion, and the value of the gold above the ground of $12 trillion, it doesn’t take much to imagine what might happen if even a small proportion (2-5%) was invested in bitcoin instead.
Indeed, some firms have started doing this – one Asset Management firm, Ruffer, has put 2.5% of their holdings (c. $0.5bn) into bitcoin last month. And, if enough firms do this, JP Morgan has suggested a long-term price possibility of $146,000.
What about as a currency?
Here Bitcoin also runs into problems. In short, a currency is a medium of exchange for goods and services.
Bitcoin faces a number of problems as a currency. The first is the volatility – the yen and the dollar work as currencies because their value is, year on year predictable. Inflation is usually at a manageable level c. 2-3%, and bouts of hyperinflation are very much the exception.
This means that companies can accept the dollar or the euro as payment, knowing that it will retain its value in a year’s time. There is currently no such guarantee with bitcoin.
Moreover, as a currency, it has very significant transaction costs. Incredibly unecological, bitcoin uses the same amount of energy as Chile, while each transaction has the carbon footprint of watching around 52,800 YouTube videos – or on a more apples to apples comparison, 702,000 VISA transactions.
Moreover, with high transaction fees, and significant delays in processing transactions, bitcoin has clearly significant downsides when compared to conventional fiat currencies – is it possible to imagine someone paying for something as small as a coffee with bitcoin when the transaction costs are often more expensive than the coffee itself?
Finally, however, bitcoin will likely never be a currency in its own right. As Benjamin Franklin once said, “in this world nothing can be said to be certain, except death and taxes”. Unless governments start accepting tax receipts in bitcoins, then ultimately, even the most hardcore crypto-evangelicals will have to still transfer their bitcoins into dollars in order to fulfil their basic functions.
What about other cryptocurrencies?
Bitcoin, for all the marvellous ingenuity of blockchain, is a fairly flawed currency: with high transaction costs, devastating ecological impacts, and far too constrained supply. Other cryptocurrencies, although lacking the name recognition, are far more suited to the task of being a currency.
Litecoin, for instance, has a faster transaction confirmation time, while Ethereum is adopting a more cost-efficient algorithm for proving transactions.
One in time, may surpass bitcoin as the cryptocurrency of choice. However, bitcoin has a formidable advantage: network effects and name recognition.
What’s the final word?
Blockchain is likely to prove itself as a revolutionary technology. But bitcoin’s claims to be a hedge against inflation, a safe-haven asset, or a new currency are over-stated.
While successor cryptocurrencies may prove more functional, bitcoin’s weaknesses will prevent it from being truly revolutionary. Nevertheless, its price may soar further still.