Since its creation in 2009, Bitcoin has resembled a tech stock rather than a currency. In fact, after the typical boom and bust, its price resurgence is akin to that of the survivors of the Internet bubble. Does it mean that it is also posed to experience a manifold increase? [*]
Bitcoin captures the Zeitgeist of today: it is digital, disruptive, and smart, with its early adopters turned millionaires. The crypto-currency is also a rebellion against the established order, as it challenges the State’s monopoly of money. Furthermore, its scarcity – the amount of Bitcoins is limited by design to 21 million – connects with the “gold-bug” narrative so present these days. In fact, Bitcoin combines two libertarian features in one: an anonymous payment technology that keeps a decentralized – stateless – ledger for all Bitcoin transactions (the so-called “blockchain”), and a fiduciary currency whose supply is not controlled by any state.
However, its widespread acceptance as a reserve currency meets some formidable challenges. First, extricating the state from the monetary system leaves us at the mercy of a more unpredictable master: Technology. What if computing advances (quantum computers, faster algorithms) enable someone to amass a disproportionate share of Bitcoins, or worse, to fake the blockchain? Or what if a superior digital currency emerges rendering Bitcoin obsolete?
Moreover, despite its intuitive appeal, limiting the amount of currency in circulation is not such a good idea. If the amount of goods in an economy grows whilst money supply remains constant, sooner or later the former falls into deflation. Theoretically, an economy could run in reverse, with falling prices and negative interest rates, but our current system is steered towards inflation for good reasons. When interest rates are negative, retail deposits vanish, resulting in a more fragile financial system that is reliant on wholesale financing. Furthermore, falling prices give an incentive to postpone consumption and increase savings. As a consequence, the economy runs in a suboptimal state. It goes without saying that the transition from an inflationary regime to a deflationary one would cause a momentous economic depression.
The challenges for Bitcoin’s acceptance do not end here. Gresham’s law dictates that “bad money drives good money out of circulation”, as people prefer to spend the bad coins and keep the good ones. However, if Bitcoin owners would opt to hoard them, its use as a fiduciary currency will remain marginal, and its price will ultimately be nil. The difficult equilibrium between storage value and propensity to exchange could explain the huge price swings that Bitcoin has experienced to date.
A last problem faced by Bitcoin is one of costs. So far, transactions are processed by “miners” who receive newly created Bitcoins in exchange. However, by design, the amount awarded decreases, whilst the complexity of processing the blockchain ever increases. Ultimately, only a processing fee can make the service economical, at the cost of reducing Bitcoin’s appeal.
Paradoxically, the acceptance of an electronic currency could be way easier if endorsed by the state. Knowingly, the strategy most governments seem to be following is to leave development efforts to the private sector, waiting for the technology to mature. The benefits that the tax authorities would gain when replacing cash by a traceable blockchain would be immense. The irony is that if this was ever to happen, what started as a libertarian dream could easily end as an Orwellian nightmare.
[*]On Bitcoin’s valuation:
Assuming that gold price is relatively fairly valued, and – critically – that Bitcoin could reach a similar status as a reserve currency, a theoretical fair value could be derived for the latter, as the supply of both currencies is ultimately limited. According to Thomson Reuters GFMS’ survey, there are about 174,000 tons of gold above the ground. To this you have to add 52 tons minable in the ground, according to US Geological Survey estimates. That compares with the total ceiling of 21million Bitcoins, of which about 6 million are still to be mined (curiously a similar percentage). The current price of about $1,330 per Troy ounce of gold (42.8 $/gr), would translate into a staggering $460k/Bitcoin. If one takes the more optimist gold reserves estimates from the Gold Standard Institute (2.5 million tons), the price will increase by 16-fold to $4.9M/Bitcoin. Lastly, if one accounts only for gold reserves of a monetary nature – excluding gold used for jewelry or industrial use – you will arrive to a price of $167k/Bitcoin. These estimates compare to a current price around $630/Bitcoin. The fact that the market price is, in the optimist case, only 0.4% of its potential price, is a reflection of the low probability that the market gives to Bitcoin establishing itself as a real reserve currency anytime soon. For the sake of full disclosure: I do not own any Bitcoins directly or indirectly.
Fernando de Frutos, MWM Chief Investment Officer
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