The topic of Bitcoin and cryptocurrencies has once again risen to the surface with the cryptocurrency market recently delivering eye-watering returns in the wake of greater institutional acceptance and Tesla recently acquiring one and a half billion US Dollars’ worth of Bitcoin with plans to start accepting the cryptocurrency as a means of payment.
A collective insanity has sprouted around Bitcoin over the last decade and it is difficult to predict whether this cryptocurrency will eventually prove to be a great investment or just a passing storm.
The below gives a brief overview of cryptocurrencies and highlights some of the broader challenges that this sector may face that question the astuteness of a cryptocurrency and in particular a Bitcoin investment.
What is a Cryptocurrency?
A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.
Cryptocurrencies are systems that allow for the secure payments online which are denominated in terms of virtual "tokens," which are represented by ledger entries internal to the system. "Crypto" refers to the various encryption algorithms and cryptographic techniques that safeguard these entries.
What is Blockchain?
A blockchain is a shared digital register of recorded data. For cryptocurrencies, this is the transaction history for every unit of the cryptocurrency, which shows how ownership has changed over time. Blockchain works by recording transactions in ‘blocks’, with new blocks added at the front of the chain. Blockchain technology has unique security features that normal computer files do not have.
Types of Cryptocurrency
The first blockchain-based cryptocurrency was Bitcoin, which still remains the most popular and most valuable. Today, there are thousands of alternate cryptocurrencies with various functions and specifications with approximately eight thousand five hundred cryptocurrencies currently in circulation.
Bitcoin was launched in 2009 by an individual or group known by the pseudonym "Satoshi Nakamoto." Its current market capitalisation is approximately $900 billion. A market capitalisation of this size would make Bitcoin one of the biggest companies in the world, with its’ market capitalisation having gone from zero to nearly a trillion in just twelve years. Only a few companies, like Facebook and Tesla, have grown that fast. This amount of growth is absolutely staggering when you consider the uncertainty regarding its future as well as the fact that Bitcoin theoretically has no intrinsic value. However, there is no way to accurately determine a value for Bitcoin and to justify whether this market capitalisation and growth is warranted.
Advantages and Disadvantages of Cryptocurrencies and Bitcoin
The advantages and disadvantages of cryptocurrencies and in particular Bitcoin are discussed in detail below.
The premise of cryptocurrencies is that they will allow for the transfer of funds between two parties without the need for a trusted third party, some of the major advantages which include Bitcoin’s finite supply, transactional freedom as well as increasing liquidity are highlighted below.
Finite Supply. Bitcoin’s own source code limits the number of new Bitcoins that can ever be created to exactly 21 million units, and this limited supply allows Bitcoin to resist inflation. This is in contrary to current traditional fiat currencies which in theory have an infinite supply and are therefore constantly under inflationary pressure.
Transactional Freedom. Bitcoin transactions don’t carry with them the same level of fees and legal hurdles that encumber traditional currencies. International Bitcoin transactions are no different than local ones and fees charged tend to be generally far lower than other modes of digital payments such as credit card and PayPal. However, the fee to transfer Bitcoin between parties may be low but the fees charged to exchange traditional currencies to Bitcoin can be as high as 4% per transaction.
Increasing Liquidity. Over the years, Bitcoin has been becoming an increasingly liquefiable asset with it becoming easier and more accessible to convert its value in traditional fiat currencies. Bitcoin is arguably one of the most liquid investment assets due to the worldwide establishment of trading platforms, exchanges and online brokerages. Other cryptocurrencies and digital assets still are struggling to gain acceptance and many of them cannot be exchanged with real-world money without them losing a significant portion of their value.
The major issues with cryptocurrencies and in particular Bitcoin are discussed below, which question the ability of these digital currencies to be a reliable medium of exchange and deliver a meaningful return on investment over the long term.
Volatility. Since its’ inception Bitcoin has an average daily price volatility of 3%, with extremely volatile days having price movements of around 30%. Comparing this average daily volatility to foreign exchange rates (approximately 0.5%) raises concern around its appropriateness as a medium of exchange. It is integral that a currency be relatively stable so that merchants and consumers can determine what a fair price is for goods and services.
Threat of Online Hacking. The Bitcoin system and cryptocurrencies in general have some imperfections and weak points that can be exploited by sophisticated hackers looking to steal Bitcoin and cryptocurrencies for their own use, leaving holders susceptible to hacking and theft.
Security Issues. While a lack of regulatory compliance or legal oversight grants cryptocurrencies more flexibility, it also makes it both more susceptible to scams and frauds and less likely that such activities could be prosecuted by law enforcement agencies. Even worse is that for victims of transaction fraud, there are little hopes of getting their money back as the Bitcoin’s highly decentralised makes it virtually impossible to hold the culprit accountable.
Little or No Regulation. The cryptocurrency market currently operates with no major regulations. It isn’t taxed and governments have no clear stance on it. As a result, cryptocurrency holders stand exposed to fraud and malpractice.
Limited Use. Bitcoin and cryptocurrencies in general are currently only accepted by few online merchants. Many companies don’t also recognize cryptocurrencies as a legitimate exchange, making it an unfeasible investment vehicle.
Potential to Become Irrelevant. Perhaps the biggest risk facing cryptocurrencies and Bitcoin is that it may become irrelevant with the likelihood that central banks and major corporations will launch their own digital currencies. Should these large institutions successfully launch their own digital currencies, it would make wide spread acceptance and usage of Bitcoin and private cryptocurrencies unlikely, resulting in a rapid (and possibly permanent) decline in the value of these digital currencies.
Currently, sixteen central banks are developing their own digital currencies with the digital Yuan the closet to being launched. In addition, should for example Amazon launch their own digital currency it would pose a serious threat to the widespread acceptance of Bitcoin and private cryptocurrencies. This is indicated by the fact that the number of Amazon customers is nearly double the amount of estimated cryptocurrency users.
The advantages and disadvantages discussed above elude to the fact that although cryptocurrencies may be revolutionary there are still a lot of flaws which hinder their effectiveness to fulfil their primary purpose of being a reliable medium of exchange, thereby reducing the likelihood of their widespread acceptance.
What Impacts the Price of Cryptocurrencies?
Cryptocurrency markets move according to supply and demand, with the price of cryptocurrencies rising and falling in line with broader market interest. This is clearly illustrated in the graph below which indicates the correlation between Google searches of Bitcoin and the price of Bitcoin, with these two variables nearly perfectly tracking each other over the past five years.
Therefore, given that Bitcoin and cryptocurrencies have no intrinsic value and uncertain future prospects, the success of an investment into this space would likely be based upon the ability to time the market as opposed to being based upon a notion of fundamental value or certainty in long term growth prospects. This advocates the inherent risk of a cryptocurrency investment and is something that investors should be comfortable with before allocating funds to this space.
In addition, to supply and demand the following factors have a significant impact on the prices of cryptocurrencies –
Supply – The total number of digital tokens and the rate at which they are released, destroyed or lost;
Market Capitalisation – The value of all the digital tokens in existence and how users perceive this to be developing;
Press – The way the cryptocurrency is portrayed in the media and how much coverage it is getting;
Integration – The extent to which the cryptocurrency easily integrates into existing infrastructure such as e-commerce payment systems; and
Key Events – Major events such as regulatory updates, security breaches and economic setbacks.
The large amount of volatility in the price of Bitcoin and cryptocurrencies poses a serious issue with regards to its wide spread acceptance as a medium of exchange. In addition, its potential to be made redundant by central bank digital currencies or major corporations launching their own digital currencies seriously hampers the long term growth prospect of investment into cryptocurrencies and Bitcoin and would make an investment into this “asset” class very speculative. The creation of digital currencies by central banks and major corporations would likely displace existing cryptocurrencies such as Bitcoin in legitimate commerce, reducing their aggregate demand to a potential store of value speculation and illicit dealings.
Bitcoin may continue to grow and deliver astounding returns, however the writing may be on the wall and the current value of Bitcoin is more than likely a result of market inefficiencies and present economic climate as opposed to being based on the long-term growth prospects of the cryptocurrency.
Bitcoin and cryptocurrencies have a long way to go before they are considered legitimate currencies on par with the U.S. Dollar, Euro or Pound and there is no guarantee that Bitcoin or any other decentralised, virtual currency not controlled by a national bank will be a viable alternative to fiat currencies. Cryptocurrencies could remain niche, become mainstream, vanish without a trace or anything in between, and any investment into cryptocurrencies should be considered as very high risk.
There is no doubt that cryptocurrencies and Bitcoin are engrained in sophisticated technology which is moving the world of currencies and online transactions forward. However, the volatility, uncertainty regarding its’ future as well as the fact that cryptocurrencies like Bitcoin are not rooted in any material goods would make it a very speculative investment.