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What to make of the rise in Bitcoin and other cryptocurrencies?

What to make of the rise in Bitcoin and other cryptocurrencies?

Website Administrator - Monday, December 18, 2017

What to make of the rise in Bitcoin and other cryptocurrencies?

Bitcoin has been in the news again, with exponential gains in its dollar price (currently over $18,000 per unit), coupled by the rollout of a futures market for the currency, which has left many intrigued about the future prospects of this and other cryptocurrencies. However, many traditionalists are quick to quote classic market wisdom that 'no tree grows to the sky,' as hyperbolic euphoria and emergence of new products related to niche investment themes have often been associated with market manias (and subsequent later pullbacks). The difficult part is that such episodes are far easier to spot in hindsight than in real time.

The underlying operations of 'blockchain' technology is beyond the scope of a few paragraphs, which, for Bitcoin, which includes new units created via a time- and labor-intensive 'mining' process, after which participants are rewarded with new digital coins for their efforts. Aside from its use in currency, blockchain appears to have viability in a variety of other areas, such as digital financial contracts, where security and mutual trust are valued.

As a starting point, to understand cryptocurrencies and their popularity, it's important to take a step back and understand what functions a currency fulfills. These generally are: (1) medium of exchange, (2) measurement of value, and (3) store of value. Some definitions seem obvious, but can be easy to take for granted until one or more are no longer properly serving their intended purpose. Here are a few thoughts to keep in mind.

To act as a medium of exchange, a currency needs to be based in something of value. Over human history, what's considered of 'value' is based on the particular culture and what physical items are readily (but not too readily) available, including beads, weapons, animal pelts, food items, as well as more familiar metal coins. Precious metals like gold and silver, as well as industrial metals such as copper and iron, have fulfilled a monetary function in recent centuries, as they've tended to be valued by a variety of societies based on their relative scarcity, caused by the need for mining and other processing. But not all cultures value the same things—ironically, Native Americans of the Northern Plains near the mineral-rich Black Hills found gold to be of little use, thus it offered no trading value as it did for European-American explorers. Such quirks define the history of currencies. In short, a medium of exchange needs to symbolize value for both sides of the transaction. Currencies must also have the ability to be divided into reasonably-sized lots to allow for smaller transactions, which fulfills the measurement function. Cryptocurrencies tend to offer some of these components, as they can be divided into smaller fractional lots and are being accepted as payment for goods and services on an increasing number of websites.

Currencies must also allow for the storage of value. The durability of metal coins has boosted their popularity, as these can be stored for extraordinary lengths of time without corrosion, spoilage, etc. In a practical example, silver has been more popular than food products, despite the latter being more useful and coveted in the near-term. Depending on the environment, 'real assets' have served to protect against bouts of inflation to a certain degree since their actual value can be more consistent than the value of traded currencies themselves. This explains the tendency for wealthy residents of emerging market nations to seek out alternative assets for the storage of wealth other than in their often-volatile and less trustworthy home currencies (this might also explain the cryptocurrency phenomenon to some extent). However, the durability of the crypto variety is reliant upon current technological limitations for storage of computer data, which can erode over time and requires electricity to archive, retrieve and process. Ironically, while alternative currencies often appeal to Armageddon 'preppers', one would have to think Bitcoins would be less desirable to rely upon for transactions during a lengthy power outage.

Fundamentally, currencies derive their value based on some degree of scarcity. Naturally, the less of something that exists, the more it is valued, while an overabundance of a good destroys its value. This is true of real assets, which explains the use of certain precious metals as currency, as the cumulative mined amount is in limited supply. As cryptocurrencies are based on digital bits being continually created, there is no limitation on the number of bits that can be ultimately created, and only appear dependent on a surprisingly large amount of energy resources (apparently enough to power a large city by some estimates). A lack of scarcity results in more difficulty in assessing an item's ultimate value.

A currency can also derive value from the entity that issues it. Such value is directly related to factors that 'back' the issuer, including structural elements such governmental and economic stability (both actual and perceptions of), property rights, rule of law, geography, as well as military might. Several of these factors explain why the U.S. dollar has become the world's foremost 'reserve' currency—relied upon for transactions as routine as global commodity purchases and as illicit as drug trafficking. Related to this is the fact that a significant amount of physical U.S. currency is held abroad. Investors tend to have similar confidence in other safe haven currencies, such as the euro, Japanese yen and Swiss franc. Essentially, participants require a sense of trust that a particular currency will hold its value over time and not be swayed by inconsistent policy or turmoil that could threaten this stability, and hence, impair its value. By contrast, several historical examples of unstable government regimes, mismanaged central banks and excessive money printing have led to hyperinflation, and for affected currencies to become nearly worthless. Trust is a critical element in modern currencies, since they're all of the 'fiat' variety—meaning the supply is not backed unit-for-unit by physical commodities, but rather, by central bank authority and monetary operations—understandably, this is a more difficult component to measure. Cryptocurrencies at this time aren't sponsored by a government entity or backed by physical collateral of any kind. To some buyers, this is exactly the appeal. However, there is also no guiding hand that could offset potentially destabilizing forces affecting such a currency over time.

Another potential risk to upstart currencies is competition. Unlike the dollar, yen, euro or gold bars, which feature a centralized supply and no organized competition, there is no monopoly on cryptocurrencies or restrictions on who is able to create a new one. In fact, other cryptocurrencies are being created seemingly on a continual basis through new initial public offerings in the wake of Bitcoin's success. Which will be the winner? Will there be several winners that are interchangeable? Which, if any, will lose some or all of their value? These are all questions that remain unanswered.

Institutional investors don't appear to have the same interest and/or ability to use cryptocurrencies as do retail buyers. For one, there are anti-money laundering and counter-terrorist financing regulations that have to be complied with for the bulk of investments, including precious metals like gold, while compliance with these rules when using such digital currencies is quite a bit murkier, with few defined rules as of yet. Debate exists as to whether these are 'investments' at all or even 'currencies', for that matter, as opposed to being legally treated like points from a rewards program or airline miles, oddly enough.

To put the sizing into perspective, the total size of all Bitcoins is about $250 bil. (with the total cryptocurrency market falling just short of $400 bil.), which is quite small in size relative to the overall global economy and various markets (the largest stock on the S&P 500, Apple, has a market cap of just under $900 bil.) It's dwarfed by the size of all global gold reserves (about $8 trillion), U.S. government debt ($20 trillion), and the U.S. equity market ($27 trillion). This small size could be a positive, as any pullback would likely result in lower global systematic risk that could disrupt other markets. Despite high-profile headlines, a large amount of purchase activity appears to be emanating from Asia, where no doubt concerns over capital controls in China and currency volatility in other nearby emerging markets could easily boost demand for an anonymous and border-free currency alternative. The fact that it's been appreciating based on demand from such flows is a self-fulfilling bonus for owners.

It's impossible to speculate on the future prospects of Bitcoin or other cryptocurrencies that have been gaining significant ground in recent months. But it's important to remember the risks. But the concept behind it and technology is so new that even regulators are left without much direction (the SEC has recently issued the following note: Regulators in the U.K. sounded even more dire, expressing the view that 'Bitcoin buyers should prepare to lose all their money.' No doubt there will be more to come on these currencies, which could become a model for modern transactions, a disaster that one can learn from, or fall somewhere in between.

Read our Weekly Review for December 18, 2017.

Read the previous Question of the Week for November 13, 2017.

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