Is bitcoin a tantalizing investment or fool’s gold?
Within a year, the price of bitcoin in U.S. dollars went up 2,100 per cent, litecoin (an improved version of bitcoin) by 8,400 per cent and ether, the cryptocurrency that fuels the ethereum virtual machine, by 8,700 per cent.
Watching these price rises is nothing short of mesmerizing, and there is talk that this will bring about the mass-market adoption of cryptocurrencies.
Not so fast. Yes, these new technologies provide huge opportunities. But the dramatic price rises over the past weeks are likely caused by simple dynamics of a massive influx of fresh money seeking few coins. Although there are reports of people taking out mortgages to buy cryptocurrencies (please don’t), it’s probably enough if many people spend some pocket change.
Most platforms require no more than $100 (minus a 5-per-cent fee) and, with worldwide reach, if 100 million people buy just $100 worth of bitcoin each, then there’s $10 billion of fresh money rushing in. Of course prices would shoot up.
What really concerns me about the current craziness is the role of the cryptocurrency exchange platforms, such as Coinbase, Quadriga or Bitfinex, which most people use to buy bitcoins. These are like banks that hold deposits.
For cryptocurrencies to succeed, it is critical that these interfaces with the real world are financially robust. Are they? Do they have all the bitcoins they sell? Can they always satisfy depositors’ demands? Are they run-proof? Can their technology handle massive volumes? I don’t know the answer to these questions and I’d wager these platforms don’t either.
Let’s talk about the nature of cryptocurrencies. What is the fundamental value of a bitcoin? Stocks are claims on assets that produce cash flows. Bonds are contracts. Commodities are inputs to physical goods. But money, a means of exchange, has no fundamental value except that the government guarantees to accept dollars as tax payments.
None of this applies to crypto-money. Is bitcoin a store of value? Maybe, but just as with classic cars or rare wines, you need to hope that bitcoins don’t rust or turn into vinegar.
Many insiders in the crypto world say you should buy bitcoins now because you will need them in the future when they are the world’s universal currency.
As money, however, bitcoin is fundamentally flawed. It’s not just that the technology is not remotely able to handle Visa-level transaction volumes, that the proof-of-work protocol consumes insane amounts of electricity or that a settlement on the bitcoin blockchain currently costs in excess of $60 (U.S.). All that may be fixable with technology.
The crux is the static and, in the case of bitcoin, limited supply of coins, There will be no more than 21 million bitcoins, ever. It’s true that fixed supply prevents hyperinflation caused by a government printing money.
But here’s the problem. When an economy grows, people need more and more units of money to pay for the growing number of goods and services. But when the number of coins is fixed, holding coins in and by itself becomes profitable. That not only defeats the purpose of money as a means of exchange, it also leads to deflation.
That’s what we see already with cryptocurrencies — nobody uses them for purchases.
Part of a central bank’s mandate is to adapt the supply of money so the act of storing money has no value. Instead, many coins, including bitcoin, are built to appreciate in value. If the main purpose of a coin is that it will be used, then such a structure is economic nonsense.
I like the idea of a digital, distributed cryptocurrency, I like the idea of censorship-free money and I’d be very happy if such a currency works without the involvement of a nation state or central bank. But digital money should be based on sound economic principles, and bitcoin and many alt-coins are not.