Bitcoin: digital gold or fool's gold?

Over the past few months, I’ve taken one question more than any other: “What do you think about Bitcoin?” Through 2017, Bitcoin, the world’s first cryptocurrency, rose by almost 1,200%, prompting excitement and bafflement.

My answer: I’m enthusiastic about the Blockchain technology that makes Bitcoin possible. In fact, Vanguard is using such technology. As for Bitcoin the currency? I see a decent probability that its price will go to zero.

Are cryptocurrencies currencies?

Bitcoin’s creators introduced the cryptocurrency in the wake of the GFC. The goal was to bypass governments and banks when two individuals want to transact. No country, company, or institution controls the currency. But are Bitcoin and competing cryptocurrencies really currencies? Let’s think about what a currency is:

• A currency is a unit of account. Cryptocurrencies qualify, as they can measure the value of other goods and services.
• A currency is a medium of exchange. I’d give cryptocurrencies a qualified yes on this point. Currently, only a limited number of vendors globally accept cryptocurrencies, and recent volatility has already discouraged increased adoption.
• A currency is a store of value. Bitcoin is not. Its price volatility undermines its adoption, as fewer vendors will accept a currency whose value can fluctuate so dramatically. The prices of newer currencies have been similarly volatile.

The existential dilemma

Let’s call the verdict on the currency question mixed. Even if cryptocurrencies qualify as currencies for niche purposes, their prospects seem dubious.

The greatest threat is central banks, which have started to research Blockchain-based currencies and impose regulations on exchanges. Given the additional control and policy effectiveness that digital currencies could provide, central banks have good reason to adopt digital currencies in the coming decades. Those currencies would be ‘legal tender’, legally recognised forms of payment for all debts and charges.

If the choice were between Bitcoin or a Blockchain-based dollar, which would you rather have in your digital wallet?

Cryptocurrencies as investments

The investment case for cryptocurrencies is weak. Unlike stocks and bonds, currencies generate no cash flows such as interest payments or dividends that can explain their prices. National currencies derive their value from the underlying economic activity of the countries that issue them. Cryptocurrency prices, on the other hand, are generally not based on economic fundamentals. To date, their prices have depended more on speculation about their eventual adoption and use. The speculation creates volatility that, ironically, undermines their value as a currency.

Nor are cryptocurrencies a chance to capitalise on Blockchain technology, which is the method most cryptocurrencies use to record network transactions and ensure their accuracy. Although cryptocurrencies are built using a Blockchain, they are not necessarily tied to the value of Blockchain applications that may improve the cost, speed, and security of executing transactions or contracts. Bitcoin is an investment in blockchain in the same way that Pets.com was an investment in the internet.

For investors, adding some exposure to Bitcoin would mean reducing their allocations to tried and true asset classes such as stocks, bonds, and cash—the building blocks for well-diversified portfolios that can help them meet their goals. With no cash flows and extreme volatility, the investment case for Bitcoin is hardly compelling.

We are early in the development of Blockchain technology. We’ll likely see Blockchain adopted by governments and enterprises for specific purposes in the coming decades. As innovation quickens and competition increases, the majority of networks (and their associated cryptocurrencies) may be rendered obsolete, leaving many cryptocurrencies like tulip bulbs in 17th-century Holland—soaring to incredible heights before the speculative bubble pops.

And, unlike tulips, they don’t look good in a vase.

Content first published in the financial newsletter cuffelinks.com.au on February 15 2018.