Bitcoin’s value surpassed the 7 000 USD psychological limit during the first days of November. Most of the investors are cheering, however, it is not surprising given that there is a bubble inflating on its market, fuelled by wild speculation. Such euphoria is not unusual when an asset price reaches a new high each week. The tulip bulbs of the 21st century are not exceptions.
The Blockchain technology backing the digital currencies can actually be valuable. It is a decentrerlized, immediately available information system can save money, effort, and time compared to its linear peers. For instance, in case of an online marketplace, whether it is for physical goods or invesments, used or new, the use of a mediator during the transaction is almost universal. The role of these mediators vary between providing payment methods, IT infratructure, financial clearing, or acting as an agent for the parties; but it is almost always a common denominator. The spider web like, immediately available information is superior in its efficiency compared to the individually sent bits and pieces. Digital accounting might be the real innovation, not digital currencies. Wouldn’t be the first time in history that the application of a new accounting method and more efficient informational system, not the modern currencies improved the efficiency of commerce.
Regarding the financial application, the viability of the system is just as straightforward. Replacing multilayered interbank transactions with P2P technology, where each party can see the changes right away, can save days for clients. In case of investing and margin payments even hours can make a difference, but the saved time is also significant from cash-flow and working capital management perspectives. Unfortunately, the creators of the digital currencies are precisely aiming to break down the banking system by introducing P2P solutions, hence these benefits can not be harvested. Controversially Bitcoin and its peers try to create an alternative for cash payments, the exact type of transactions which are mostly between only two parties, leaving no leverage for the technology, and no effective need to ‘inform’ the entire network of the transaction other than its operative use. Consequently the technology becomes counterproductive, and economies of scale becomes diseconomies of scale. The more participant there are the more redundant information channels will be created. According to ING’s calculation, Bitcoin is one of the least efficient payment method when it comes to the costs of making a transaction (see charts).
So what creates the value of a Bitcoin? In order to understand the phenomenon, let us see what supports the value of traditional money. Primarily the value of money is created by basic economic (supply and) demand for currency. Purchasing goods and services requires an intermediate of exchange, creating demand for liquid assets. As a second step, add the debt markets and financial intermediaries to the equastion; the big picture remains mostly unchanged. Investors and speculators give credit in exchange for interest or principal appreciation, however, they need demand for liqudity on the other end to be able to lend money. Once again, the other end means demand for goods and services, where the debtors use proceeds to finance their physical investments or consumption. Of course we could say that loans could flow towards other financial assets, but once again real economy must stand at the end of the financing line, or we deal with mindless speculation, just like in the case of Bitcoin.
But how does the case of Bitcoin look like? The digital currency’s market capitalization (value of a coin x number of coins in circulation) is around 117 billion USD. To put it into context, the Fed’s balance sheet, providing liquidity for the global market of US dollars, is approximately 4 500 billion USD. In order to measure whether market cap is too high, let us think about the goods, services, assets, commodities and bonds USD liqudity can be exchanged for gloablly (creating demand for the greenback), and then compare it to the ubiquity of Bitcoins in commerce. Compared to these measures, there is no real demand behind Bitcoin, other than the trust that there will be a bigger fool than me, who will buy it at an even higher valuation. Since everyone plays according to this rule, once inflows dry up there will be no buying power and everyone will try to sell at the same time.
Advocators of the digital currency often cite low volatility and high turnover/financial liquidity (in terms of Bitcoin exchanges to other currencies) on its market. The second part might be true due to speculation and the asset’s ability to circumvent authorities in case of international settlements. Likewise, historically low volatility is rather the sign of a smooth, increasingly suspicious upswing in the rate, rather than a balanced market of supply and real demand. Lastly, a thought regarding an appreciating currency and its commercial viability. Since there is no banking sector which could counterbalance the appreciation (deflation) of the currency with low nominal yields, every percentage points of increased value counts as real interest. Nowdays, when real returns are scarce, it is not puzzling that speculators will jump onto an asset with such remarkable appreciation. The only issue is that why would you spend something if in the future its value will increase, and why would a vendor price anything in a unit which’s value changes by the minute.
Bitcoin, in its current form, is not viable. It is a free floating nothing, supported by speculation and some benevolance. A necessary collapse, which also seems to be inevitable, could kickstart digital currencies. After the price settles on a lower level, where market capitalization is in tandem with its real demand, the commercial use becomes more likely. However, the diseconomies of the technology even then remain unsolved… and immerse amounts of ‘wealth’ have to evaporate until that moment.