The history of money has certainly evolved since the barter days. Over the years, payments have been used in the form of tobacco, elephant hair, stone money, salt and also in the form of commodity currency, or money that could be redeemed for precious metals or objects with limited supply. More recently, economies around the world have created and authorized what's known as fiat currency, that is, money that has no intrinsic value and cannot be exchanged for precious metals. Its value depends on the confidence of a particular people or governments.
The advantages of fiat currency can also be considered its disadvantages. For instance, when a particular government faces a debt crisis, in which its borrowing rate approaches catastrophic levels, the government's central bank can issue enough funds to pay back its debt, improve its debt outlook, and lower its borrowing rates. Such an action would lead to dilution of the economy's currency, which also means that the cash amounts the citizens are holding would be equivalent to the lower, diluted amount in relation to other basket of currencies (that's the disadvantage). That cycle reverses eventually as the economy is seen as a haven for cheap goods and services - inviting trade to its shores. Perhaps overseas travelers might find this particular economy as an attractive travel destination, one in which their country's currency might go a long way. Growth then picks up through trade and eventually the currency's value recovers. Notice how in this example, a stronger currency revives a weaker currency in exchange for goods and services demanded.
What is a bitcoin?
A bitcoin (BITCOIN) is a bit different. It is not a commodity currency so it is not backed by gold (GLD) or silver (SLV) and while it is considered a fiduciary currency since it is backed by confidence and can be exchanged for goods and services, it is also fairly unique. That is - the bitcoin, its value, its creators (miners), and its participants are not regulated by any government body. Perhaps that was the idea behind its design - a free market currency the value of which is controlled only by its participants.
Bitcoins are created through a complicated process called mining, in which bitcoins are awarded to miners uncovering new coins. The process is discussed in more detail by economist Francois Velde, but basically, miners solve difficult mathematical problems that require much computer hardware, electricity, and time. Their work is then validated by a community of other miners and new bitcoins are added to a ledger in the form of blocks. Every four years the new currency units issued are equal to half of the prior four years. So 10.5 million were created in the first 4 years, 5.25 million will be created in the next 4 years, then 2.125, and so on. Total number of bitcoins will eventually come close to but never exceed 21 million. That means that over time, bitcoins will be more difficult to create so less on-the-run bitcoin will be issued. We've currently just surpassed ~11.8 million bitcoins (10.5+5.25/4) and the total balance as of this writing was $4.6 billion (that balance was only $105 million a year ago).
Why it's incredibly risky…
While I consider Satoshi Nakamato, pseudonymous creator of bitcoin, a smart guy, I nevertheless find enormous flaws in this so called currency. Building confidence in fiat currency is always extremely important - in that sense, bitcoin's popularity and acceptance is definitely a good thing. As the community generates more confidence, more individuals and businesses should accept bitcoin as a form of currency for goods and services. Excellent.
Now here comes a list of issues.
What makes major fiat currency attractive is its full acceptance, at least in its domain. While it has no intrinsic value, in most major countries (all I believe), for example, currency is backed by the collateral held at its central banks in the form of securities. The central banks control the value of the collateral and the currency in circulation. The governments, institutions, and all other entities accept and distribute payments in this currency leading to the currency's liquidity, relative stability and full acceptance. The governments support the currency and the institutions where the currencies are accepted and trade balances, which are vital to a country's GDP, are absolutely critical to that currency's relative stability.
What is the bitcoin backed by? What system is driving bitcoin? How do you value bitcoin relative to other fiat currencies? The value to me seems to be driven by only three factors, factors which are commonly embedded in extremely risky assets: flow of funds (of off-the-run bitcoin), new issue of on-the-run bitcoin (a known amount), and the value assigned to both only through the speculation of bids and asks. No collateral. We have no idea how much of the recent spike in value is actually being driven by trade for goods and services (it is likely minimal). The miners are also not in actuality uncovering anything valuable. They're solving math problems to create pieces of code.
This is pure speculation.
In that sense, I see a bitcoin as "valuable" as a risky penny stock operating on unsecured loans with a promise to its investors that it will make money at some point in the future (at which point its value would rise). So as long as enough bidders believe that the price per share will rise based on pure speculation, then the penny stock will continue to increase in value, sort of like the bitcoin.
In a world where even the S&P 500 (SPY) is considered a risky asset, despite our ability to value its future cash flows using real drivers and dividends, some investors are pouring money into code that has absolutely no actual value and they consider it a safe haven.
But bitcoin is also risky for a different reason.
I do believe that governments will and should eventually intervene to protect themselves and their citizens from this currency.
Why? For the same reason governments should have intervened in the past when risky investments were passed on to the less knowledgeable with a promise that these securities will just keep growing in value.
Another reason why governments might intervene is because individuals and businesses might turn to bitcoin to avoid paying taxes. For instance, if you're a lucky owner of a $1 million house and you accept bitcoin as payment, you could technically sell your house for $1 (or however much to avoid capital gains) and 2,584 bitcoins (at the time of writing). I am not a tax attorney, but how do you pay taxes on bitcoin? You can then technically go to a bitcoin exchange and trade the 2,584 bitcoins for $1 million. This seems to me like a huge risk for governments to take. Technically you could do the same with cash, but then you could be criminally charged with tax evasion. That general deterrence keeps citizens from turning to tax evasion, something that doesn't yet exist in the bitcoin market. By the way, this is also why bitcoins appeared to be a popular form of currency for money launderers. Criminals chose to hide their money in a currency that is free of regulation (unless you count the FBI as its regulator).
Another way to understand why governments will intervene is to view bitcoin through a prism of an extreme example. Imagine a world in which all seek out bitcoin as their currency of choice, and all have lost confidence in other fiat currencies. The odds of this happening are about as high as all converting to that one penny stock with a promise, but if true, you'd technically have a race towards bitcoin that would eventually lead to a state of chaos and global anarchy. Accepted would be only bitcoin, scarce resources, like gold and silver, and real assets, which would all be in the hands of a few, while all others would face tragedy.
And in a world where governments would not allow for that to happen and eventually find a punitive way to control bitcoin, the currency would lose much of its flavor.
At that point receivers of bitcoin would need to assess its value relative to other fiduciary currencies (which they can't do) and decide whether or not to accept payment through this arbitrary currency, one that at least until now has seen much more volatility than other fiduciary currencies. Reputational risk might also be a huge factor in destroying this currency's speculative value.
(click to enlarge)
The spike of the bitcoin from $10 to nearly $400 (+4000%) in about a year (chart above), without any way to assess if the increase was legitimate or just pure speculation doesn't seem to strike some as odd - they think they've uncovered something valuable - and no one else has found it just yet.
In my research, I even noticed an investor who is taken seriously in some circles who said that one bitcoin would eventually rise to $700,000. Imagine that. Paying for a nice house with one coin that doesn't even exist. Or we can live in the world of reality where that's never going to happen.
Additional disclosure: This article is intended for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation, or endorsement to buy or sell any security or private fund.