Bitcoins: Modern currency or a bubble asset?

By Sujayata Choudhry

Money as we all know is an important part of our lives. Its origin traces back to the time when people engaged in barter, the exchange of merchandise for merchandise, without value equivalence. It is also evident that as the economy evolved, so did different forms of money. From commodity money to metal and from coins to paper currency, there has been umpteen number of transformations which the modern day money has seen. Along with such transformations, there has always been some attributes which led to such transformations. Some of these attributes such as medium of exchange, divisibility, store of value, durability, legal backing etc. have always played a pivotal role in deciding what kind of money is in circulation in the economy. Also one cannot forget the fact that technology has always given an impetus to such forms of money.

Money was not, hence, invented by a stroke of genius, but stemmed from a need, and its evolution reflects, at each time, the willingness of man to harmonize its monetary instrument to the reality of its economy.

Such an invention today is Bitcoins, which we call as the modern form of money. Let us trace its origin and know whether it can actually serve the purpose of modern day money or is it just a bubble asset which can take the economy from boom to bust.

 

How has Bitcoins evolved?

Bitcoin is a digital currency, also know as cryptocurrency that started in 2009 after the financial crisis by a mystery figure named Satoshi Nakamoto, whose true identity is still unknown.  It is unlike traditional currencies because it has no central bank, nation state or regulatory authority backing it up. The “coins” are made by computers solving a set of complex maths problems. To spend them, users buy bitcoin and conduct transactions with them using exchanges such as San Francisco-based Coinbase. Rather than a central authority validating transactions, they are all recorded on a public ledger, called the blockchain.

Bitcoin don’t actually exist but are digital keys that are stored in a digital wallet, which can also manage transactions. The wallet exists either in the cloud or on computers, and can be linked to bank accounts.

The attributes of bitcoins might sound very appealing due to the fact that there is an absence of any government or bank standing behind the currency.  This fuels its appeal to those unhappy with the financial system after the credit crunch. It allows people to bypass banks and traditional payment methods for goods and services. Data reveals that its price has surged by more than 900% in 2017 showing that how popular this cryptocurrency has become.

 

Bitcoins: From boom to bust?

But as the valuation of bitcoin increases, there are fears an economic bubble is forming as it becomes treated less like a currency and more like a store of value, open for speculators making ever increasing bets on how far it can rise.

Oliver White at Fathom Financial Consulting wrote that bitcoin “certainly fits the criterion” for a bubble asset. It has been found that the current value of bitcoin is running at six times its average price since 2013. Moreover, the cryptocurrency has oscillated with extreme volatility over the period. Senior financiers including the chief executives of JP Morgan and Goldman Sachs have warned against bitcoin in recent months and claimed it to be detrimental to the financial health of an economy.

Many economists have compared the ever increasing value of bitcoins to that of the Dotcom bubble, that began in the late 90s with the Nasdaq index in New York and burst in 2000 and similar to the tulip mania of the 17th century  Both examples highlight a painful collapse for a currency that has no intrinsic value.

The cryptocurrency has become increasingly part of the wider financial system, after stepping into the arena of world’s largest futures- the Chicago Mercantile Exchange (CME) became the second exchange to offer bitcoin derivatives trading. But is it not true that one key financial institution is enough to put the financial health of an economy at stake? Have we not learnt from past crises? Well all that can be said is beware!

 

Well there is a flip side to it. Many economists feel that since this currency is not a part of the wider financial system, even its increasing valuation might not shake financial stability of any economy per se. According to many others the currency is not comparable to any of the aforesaid history lessons. Bitcoin is special. It is not a company that could lose profitability and collapse. It is certainly not a speculative real estate scam that could crumble as a result of government and bank-induced chicanery. Bitcoin is also growing as a result of basic economics. The supply is limited to 21 million units and this necessarily makes bitcoin a scarce asset. When things are scarce and people want those things, their value will ultimately rise due to supply and demand being at work.

Well, the story does not end here. There is another concern apart from financial risks. This accounts for the risk of cybercrimes and bankruptcy. Bitcoin exchanges and wallets have a history of being targeted, and security experts say they become more vulnerable to cybercrime as valuations rise. The findings come after a South Korean cryptocurrency exchange appears set to file for bankruptcy after it was hacked for the second time this year, highlighting concerns about security amid booming trade in bitcoin and other virtual currencies.

What can be done?

It is evident that bitcoins have yet not posed any serious threat to the financial health because of its detachment from the global financial system, and thus one can hold sanguine beliefs of its future prospects. If people want to call bitcoin a bubble, they ought to explain why exactly it is, instead of incompetently comparing it to past bubbles that do not share any characteristics with bitcoin other than a big price tag. But as it gets more and more integrated with the financial economy, one has to be extra cautious of it. Afterall, one needs to learn from past experiences as well!

One might think that the government can lend its hand, because precaution is always better than cure. Governments should introduce greater controls for cryptocurrencies as their anonymity and opacity could help enable tax evasion and other criminal activities. But this diverges from the very idea of decentralization element of bitcoins.We can always hope of developing better working mechanism of this cryptocurrency that might help this modern form of money to sustain better in the future!

 

 

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