David Woo’s earlier discussion of the ‘maximum’ fair value for Bitcoin, we thought his colleague Ian Gordon’s view on the advantages and disadvantages of the virtual currency were worth noting. Woo believes Bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers. As a medium of exchange, Bitcoin has clear potential for growth, in his view, but its high volatility, a result of speculative activities, is hindering its general acceptance as a means of payments for on-line commerce…
Via BofAML’s Ian Gordon,
A cost-benefit analysis
Money/currencies are generally thought to have three distinct roles: as a unit of account, medium of exchange, and store of value. To the extent that Bitcoin offers users many benefits and efficiencies as a medium of exchange, this means it possesses some fundamental value that may increase over time as it gains wider use. However, as a unit of account and store of a value, it has considerable shortcomings which we believe will ultimately hinder it from ascending to international currency status. In this section we will review Bitcoin’s advantages and disadvantages in more detail.
As a medium of exchange, Bitcoin is attractive as it offers low transaction costs. It does so by eliminating the need for a central clearing house or financial institution to act as a third party to financial transactions. Using a decentralized, peer-to-peer network, transactions are verified independently by network users (i.e., miners) who are rewarded for their work with newly minted Bitcoins. In addition, it provides an alternative payment method to users who may not have access to credit or debit cards, or, other forms of electronic payments.
Bitcoin offers an attractive alternative to cash in terms of security, transparency of transactions, and counterfeiting. Bitcoins reside in an encrypted format on their owner’s computer, making it difficult, though not impossible, for hackers to access and steal electronically. Physical Bitcoin theft is also possible, but it seems no easier to carry out on a large scale than for cash.
In addition, given their digital format, Bitcoins are much easier to carry than cash, which could be a particular benefit in economies where large scale transactions are conducted in cash. Bitcoin also offers the benefit of being easier to track than cash given that each coin contains an electronic record of each transaction that coin has gone through since it was created. Not only is each transaction recorded on each Bitcoin, but all transactions are recorded in an online public ledger, offering a level of transparency that is not available with cash. Such transparency offers regulators means to track potentially illicit activity. Lastly, the digital format with automatic verification also makes it impossible to counterfeit.
There is a finite supply of Bitcoins. The design of Bitcoin seeks to mimic the supply of gold in that the system will create a finite supply of the currency, which its proponents see as a way to protect its value from profligate governments or central banks. The system is designed such that the supply of Bitcoins will increase over time until it reaches a total supply of 21 million. In order to achieve this target, the incremental supply of new Bitcoins will decrease geometrically by 50% every four years.
Bitcoin’s relative anonymity is advantageous to citizens of crisis countries. It has been reported that some believe Bitcoin can be used by those seeking to avoid evade high taxes, capital controls, and confiscation. For example, there was a sharp increase in Bitcoin interest on March 16 when Cypriot authorities, as part of their European assistance package, were prepared to implement a private sector haircut of deposits (Chart 5). Additionally, China has also seen a sharp increase in Bitcoin activity and now accounts for a majority of transactions when broken down by currency, likely reflecting the currency’s value as an outlet for those wanting to avoid capital controls or potential confiscation (Chart 1).
“Winner Takes All” market ensures that increasing acceptance and popularity of Bitcoin increases likelihood of success. As Bitcoin becomes more popular, competitors will face higher barriers to entry, making it less likely they will be successful in supplanting Bitcoin’s market share. Several other digital currencies with similar features to Bitcoin have been introduced with limited success. However, we believe the structure of the digital currency market is one of “winner takes all” whereby as Bitcoin becomes more popular and is easy to use, consumers will have much less incentive to experiment with an alternative currency with similar features.
Bitcoin offers large benefits (from an asset allocation perspective) given its negative correlation with risk sensitive assets, much like gold. For example, following the October FOMC meeting in which the market interpreted the statement as suggesting a less accommodative stance of policy than was anticipated, gold fell as much as 1% in the aftermath while Bitcoin fell 3%.
Bitcoin’s role as a store of value is seriously compromised by its elevated price volatility. The dollar price of Bitcoin has moved 10% on a daily basis since its inception including days when the price moved 190% from that day’s highs to lows. It can be argued that these swings reflect shifts in estimates about the fundamental value of Bitcoin as more people become aware of it, or, use it. For example, the Bitcoin’s dollar price increased 50% to $785 following a Senate Hearing on November 18th after which a couple regulators took a more positive stance towards the use of Bitcoin as another form of payment. This is consistent with indications from European officials on Bitcoin. However, it is more likely a function of the highly speculative nature of the market which produces such unstable returns amidst very low circulation and poor liquidity as investors are enticed by the extreme return opportunities. High volatility also undermines Bitcoin’s role as a medium of exchange as large retailers are much less likely to accept it as a form of payment with prices so volatile (Chart 6). Stores accepting it now are effectively internalizing the costs of this volatility and not passing it onto consumers, but we would not expect such likely unprofitable practices to last.
Regulators could try to impose controls that would increase the transaction costs for using Bitcoin despite its efficiency and the transparency relative to cash. Firstly, the government is unlikely to want to promote a new currency that could be viewed as one that could help facilitate “black market” activities, or, tax evasion. As a result, regulators are currently thinking about how Bitcoin will fit into the broader payment and tax system, and what makes sense in terms of regulation. The bottom line is any new regulation will raise Bitcoin’s transaction costs, offsetting and/or eliminating one its main benefits. In addition, the ease with which Bitcoin can be used internationally increases the need for international regulatory coordination. While coordination raises the risk of an uneven regulatory landscape for Bitcoin, stringent regulation by a few large countries/regions would significantly increase the costs of using Bitcoin, thus limiting its usefulness as a medium of exchange.
The quality of Bitcoin exchange security, where consumers exchange dollars for Bitcoins (and vice versa) is suspect. For Bitcoin users not able to mine their own Bitcoins, their only alternative is to exchange their local currency for Bitcoins at an exchange. Aside from the FX risks these customers take, a large number of Bitcoin exchanges have been hacked with large amounts of customer Bitcoins stolen. In one reported case Bitcoinica, an exchange, lost 18,547 Bitcoins from its deposits after its systems were hacked. More recently, a European exchange called BIPS lost 1,295 Bitcoins (or $990,000) following a security breach. As the vast majority of potential Bitcoin users cannot mine their own Bitcoins, exchanges will be critical for linking local currencies with Bitcoin. Without deposit (FDIC) or investment (SIPC) protection, Bitcoin users/investors have little recourse to retrieve stolen funds so in addition to investment risk they are also carrying credit risk.
Seigniorage is currently accruing to the “miners” of Bitcoins who have the fastest CPUs. Over time this will undercut seigniorage as a source of revenue for the government as they do not control the creation of Bitcoins. This means the government will have an incentive to crack down on Bitcoin if it becomes too big.
A 50 minute wait before payment receipt confirmation is received will prohibit wider use. Fifty minutes is the time needed for enough additional blocks to be added to the chain to protect against double spending. This is less of an issue for two parties that know each other because they trust the other will not double spend, but when dealing with an anonymous counterparty this creates a high level of unhedgeable risk. As a result, in the absence of a central counterparty verifying transaction/clearing Bitcoin is likely to remain illiquid, and will prevent it from becoming a significant international currency.
Bitcoin’s use as an international currency will likely be hindered by the fact that it is not a legal tender. Unlike fiat money, nobody is under any obligation to accept Bitcoins as a mean of payment. Therefore, its value is only as good as the perception of its worth by its users. Without a backstop buyer, Bitcoin could disappear very quickly should perceptions of its usefulness decline. Repeated bouts of volatility and further cyber-attacks which put consumer and investor money in jeopardy will certainly inform this perception even as Bitcoin does offer many benefits. Some aspects of the characteristics of Bitcoins (e.g., it is not centrally cleared and there is a confirmation delay) makes us doubtful about its potential in the OTC market (where most FX trading turnover is executed), even though we cannot rule out that a non-deliverable forward market could emerge.