There was a time when bitcoin was the next big thing. Those who sold at those dizzy heights will be happy – because for those left holding bitcoins, the tide has turned, writes Andrew Kenningham, of Capital Economics.
It’s been all downhill lately for bitcoin, which has lost nearly 80 per cent of its value since its peak in 2017.
The electronic payment system, a type of cryptocurrency, now trades at a price of around US$3,500 – but it could fall a lot further.
It’s been a wild ride since the first purchase in 2010 – two pizzas in Florida, when the currency was valued at just US 8 cents.
It really took off in 2017, peaking at nearly US$20,000 in December of that year.
However, it’s since slumped to just US$3,600, as of January 2019. What will happen to it in the future? Is there a future at all?
Why people love it
The most innovative feature of bitcoin is that the stock of currency is created and controlled by a network of computers, rather than a government or central bank.
For fans, this is its big appeal: no government could mess it up.
The people who create bitcoin, known as miners, do so by solving very complex mathematical problems using powerful supercomputers.
Supply is capped at 21 million bitcoins, which means that it should maintain its value.
Other currencies can be inflated away by electronically printing unlimited amounts.
But what’s its value?
It’s hard to put a value or price on bitcoin, because it’s not backed by anything.
There’s no flow of income attached to it that can be assessed, nor can you exchange it for a specific number of goods or products, like you can with supermarket loyalty points or virtual tokens issued by airlines.
Unlike gold, bitcoin has no intrinsic value, nor is it of aesthetic value, given that it’s invisible.
Of course, paper money doesn’t have any intrinsic value either, but it’s backed by central banks and governments, and we’ve been happily using and trusting it for centuries.
Bitcoin enthusiasts argue that it, too, could eventually be accepted as an alternative to paper currencies or even replace them. However, this seems far-fetched.
For now, bitcoin doesn’t fulfil the three textbook functions of money: as a medium of exchange, unit of account, and store of value.
It’s not an efficient medium of exchange, because transactions take a long time. It’s not a good unit of account or store of value, because it’s volatile. In theory, someone could solve these technical problems, but there are plenty of other obstacles to adopting it.
Moreover, the claim that its supply is limited is only partly true. In theory, there’s a finite number of bitcoins, but there’s no limit to the number of new cryptocurrencies others can create.
Rivals trading in competition to bitcoin include ethereum, ripple, Litecoin and EOS.
Just as Facebook replaced earlier vintages of “social media”, bitcoin could be displaced by a more efficient, or more fashionable, challenger.
The currency of crime
Bitcoin suffers from a host of technical problems. These include the risk of hacking – a lot of bitcoin has been stolen in recent years – the crazy amount of energy used to ‘mine’ new bitcoins using complex computer programmes, the size of the computers needed to keep track of the network, and the risk of its value being manipulated by cabals of bitcoin miners.
Central bankers have been reluctant to endorse cryptocurrencies to protect vulnerable investors, and because they’re used to pay for illegal goods and services on the ‘dark web’.
Given all these crypto-complications, Wall Street banks have been slow to adopt bitcoin. Several did pledge to set up trading platforms last year, but they’ve since got cold feet.
Others say they are still planning to invest in the infrastructure needed to trade cryptocurrencies.
Limited fallout if the bubble bursts
It’s hard to know whether the collapse in bitcoin’s price is the beginning of the end, or whether it could survive as a niche financial asset. Either way, it looks as if the bitcoin is, for now, far too small to pose a systemic threat to the financial system.
If the bitcoin bubble were to burst completely, and the currency were to be erased from the face of the (virtual) earth, the pain might be felt most strongly in surprising places. It’s popular in Sweden and South Korea, for example.
But the implications for the rest of us would be limited – for three reasons.
Although the total value of the supply of bitcoin of US$60 billion in January 2019 sounds large, it’s only a fraction of the value of the subprime market in 2007. It’s less than 1 per cent of the value of gold outstanding, and is negligible compared to global debt markets, which are worth over US$100 trillion.
Experience suggests the fallout from bursting bubbles is large only when there’s been an associated lending boom – like property loans. But high street banks have not been making loans to individuals wanting to speculate in cryptocurrencies.
Mainstream financial institutions have very little exposure to bitcoin.
Overall, investment in bitcoin looks highly risky. Its future and its value are unknown, so it’s certainly not something to rely on to fund your retirement, or pay for your children’s uni fees.
The regulator’s view on cryptocurrency
The Financial Markets Authority (FMA) says cryptocurrencies are high risk, highly volatile, and are not regulated in New Zealand. If you’ve bought cryptocurrencies you’re more likely to be a target of online fraud and scams, the FMA says. Before you invest, it says to understand common warning signs of a scam and the steps you can take to protect yourself. Read more at fma.govt.nz.
Bitcoin: A virtual currency invented by a group of anonymous software developers led by the fictional ‘Satoshi Nakamoto’ in 2009. They agreed rules and a system of computer-powered cryptography that meant transactions were recorded identically on ‘ledgers’ on a network of computers.
Bitcoin mining: ‘Miners’ earn bitcoin by running the servers needed to do the complicated calculations for bitcoin transactions on the blockchain. Bitcoin’s creators designed the system to halve the number of bitcoins that could be mined every four years, which limits the number of bitcoin to just under 21 million.
Blockchain: How computers create the digital ledger needed to record the encrypted transactions using bitcoin and other virtual currencies. It’s a system of ‘blocks’ of computer code that identify transactions and their owners.
Cryptocurrencies: A cryptocurrency is a digital or virtual currency that uses computer cryptography for security.
Published 26 February 2019
Story by Andrew Kenningham
This article does not contain any financial advice and has not taken into account any particular person’s circumstances. Before relying on it, we recommend you speak with a financial adviser. This story reflects the views of the contributor only. Content comes from sources that we consider are accurate, but we do not guarantee that the content is accurate.
Sign up to our newsletter to receive the latest news, updates and event invites from JUNO investing magazine.