Cryptocurrency bitcoin has rarely been out of the headlines.
First the price highs, then the dramatic decline, and now ongoing volatility caused by concerns over greater regulation.
Bitcoin remains the most popular cryptocurrency by some margin with a market share of around 35 per cent, despite the introduction of around 1,500 others. Although interest in them persists, we do not think cryptocurrencies will rival traditional money any time soon.
In the early years, interest in bitcoin was muted, but this has changed in recent years. The price of bitcoin skyrocketed, reaching a high of nearly USD19,500 in December 2017. Since then, cryptocurrency prices in general have tumbled by around 65 per cent, supporting claims that they had been the centre of possibly the largest speculative bubble since the global financial crisis, although prices have stabilised more recently.
Regulators around the world are taking different approaches to managing the cryptocurrency hype: while China has banned cryptocurrency exchanges and the Reserve Bank of India has recently stopped the transfer of money into bitcoin wallets, a bitcoin futures index has been launched in the US and Japan has accepted bitcoin coin as legal tender.
"A major problem is the anonymity bitcoin provides, which has encouraged its use for illegal activities"
A digital token
The advantages of owning cryptocurrencies like bitcoin are generally held to be threefold: firstly, bitcoin has lower transaction times and costs through its peer-to-peer function; secondly, it provides a level of anonymity; and finally, as bitcoin is supposed to have a fixed lifetime supply, it is also seen as a hedge against the sort of hyperinflation that can result from central banks printing too much money.
Despite these advantages, however, we expect bitcoin to remain a digital token, at best, with little potential to rival traditional money or even a commodity like gold. To be accepted as money, bitcoin would have to fulfil three important functions. It would need to act as: 1) a stable and trusted unit of account, 2) a medium of exchange, and 3) a store of value. Bitcoin fails to qualify on most of these parameters.
It is clearly not widely held or exchanged and while it is store of value, recent price movements show just how volatile it is. More importantly, a major problem is the anonymity it provides, coupled with little or no regulation, which has encouraged its use for illegal activities, raising concerns about its trustworthiness. According to recent research by the University of Sydney (Foley et al), almost half of all bitcoin transactions are associated with illegal activity, such as drugs or terrorist financing.
Unstable and risky
The decentralised nature of cryptocurrencies implies that there are few, if any, safety nets for users in the event of a collapse in prices or panic selling, making cryptocurrencies inherently unstable. Traditional currencies, by contrast, have central banks standing ready to stabilise and defend their value, acting as lender-of-last-resort during times of systemic crisis.
Another source of concern for bitcoin is that mining or producing it requires exponentially increasing computing power. According to the head of the IMF, Christine Lagarde, mining bitcoin in 2018 could utilise the same amount of energy as the annual energy consumption of Argentina. This is clearly not sustainable and will pose severe constraints on the usability of bitcoin and other cryptocurrencies.
"While some central banks and regulators are showing initial acceptance of bitcoin, we feel they will become increasingly wary of the risks associated with it"
So, if bitcoin can’t rival traditional money, can it rival a commodity like gold? Bitcoin has been called ‘digital gold’ in some quarters. But there is a problem here as well. Gold has the advantage of intrinsic value, but also a long-established tradition of being a safe-haven asset and a hedge against inflation and risk aversion. This in part stems from the multiple uses of gold (the main one being jewellery) that underpins its low correlation with other financial assets. Bitcoin does not have this and so it is hard to classify it as a commodity either.
While some central banks and regulators are showing initial acceptance of bitcoin, we feel they will become increasingly wary of the risks associated with it and other cryptocurrencies. As such, expect higher levels of regulatory oversight in future, which will likely dampen the attractiveness of the current breed of cryptocurrencies.
Even bitcoin, despite being the largest player in the market, might not be able to withstand increased scrutiny, at least not in its current form.