Bitcoin is a digital currency that uses a new technology known as blockchain to record the item’s transactions in a secure manner. In 2017 the trading value of a bitcoin went from about $1,000 in January to about $20,000 in December creating a feeding frenzy for investors bent on not missing out on the latest craze. The blockchain technology may become important in Finance with other future uses, but does bitcoin itself serve as a bona fide currency? A currency to be widely accepted must perform three major functions: a store of value, a means of exchange, and a unit of account.
Store of value: A currency’s store of value is arguably its most important characteristic. A wildly volatile currency would never last in a market dominated economy as it would add a great aura of uncertainty to investing. How could investors plan a rate of return for an investment to be made in bitcoin when the project covers many years to develop and many, many more years to recoup the original investment.
Means of exchange: There are certain uses for bitcoin as a medium of exchange. It’s currently accepted in some places in lieu of other currencies. It has an untapped potential as an international currency cutting out much of the complications associated with transacting foreign business. But, once again stability and not volatility is required. It would be all but impossible for any business to engage in an international bitcoin transaction only to see the bitcoin drop in value dramatically before the transaction is completed on all sides.
Unit of account: Currencies are important as a unit of account for debt and debtors. Could you manage to pay a mortgage lent in bitcoin that had to be repaid in bitcoins worth 20 times what they were a year earlier? How would banks be able to stay solvent if bitcoin were to suddenly crash? Lending money, be it consumer to consumer, business to business, or bank to bank must rely on the ability for the obligated entity or individual to pay what’s owed in a timely manner. This could be severely disrupted by fluctuations in bitcoin’s value.
Transaction cost: Every bitcoin transaction must be verified by a data mining process that consumes an abnormal amount of electricity. If the medium’s popularity were to grow, this cost would also grow pricing it perhaps out of the market place in favor of credit or debit cards. From an economic theory standpoint that could mean that the eventual value of the bitcoin would be equal to the marginal cost (the cost of processing one additional transaction) of this data mining process. There might be improvements in the underlying technology in the future that could reduce this transaction cost. But currently it is highly significant and a barrier to entry for many financial institutions.
Maintenance cost: Since no government authority anywhere actually owns bitcoin and is thereby responsible for it, who would step in to protect holders of bitcoins in the event of a crash. With all the market fluctuations the U.S. dollar has gone through since inception the federal government has had to charge the Federal Reserve with the responsibility of protecting the U.S. dollar from inflation, deflation, and sudden devaluations. This has made the dollar very stable and the world’s reserve currency. Should inflation impact bitcoin who would be responsible for righting the ship? Further, there are nightmarish tales of hackers disrupting bit-commerce by stealing bitcoins or fouling up the data mining process. Who would be responsible for blocking them out?
Summary: Bitcoin is a red-hot speculative opportunity that investors are entering into often without a full knowledge of what it is, how it could be used, and how easy (or difficult) it would be to liquidate. The underlying technology might someday have some valuable usages in the world of Finance. But before bitcoin could be taken seriously as an international currency it would need to be widely adopted and universally stabilized. Further, it would need to be owned and recognized by a responsible governing body who would be in a position to support it in the event of economic calamities.
Sources: “A Lot of Zeros”, Buttonwood, The Economist, December 2, 2017.