At the beginning of April 2013, the market capitalization of Bitcoin passed the $1 billion mark for the first time. From there, it bolted upwards to a max of $2.6 billion only 10 days later, trading at an exchange rate of $266 per Bitcoin. From there, it plummeted though, to about $120 only two days later. Furthermore, only earlier in this year the exchange rate was only $13 per Bitcoin. So why did it happen and how did this kind of volatility hit a purely virtual currency which is completely decentralized – meaning it is not backed by any central bank or government authority – in such a short time frame?
Before we get to that, let us take a step back and look at what Bitcoin is meant to represent and how it was designed to be. We all have no real choice other than to put our money in a bank for safekeeping. The days of leaving enough cash under the mattress for a rainy day has come to an end and is highly impractical and unsafe. That’s where banks come in, but as we all have found out to some extent, there is a major flaw with this system. Leaving your hard-earned salary in someone else’s possession means placing a huge amount of trust in their capability to keep it safe. We have all been desensitized to this trust, as it just seems that this is how the world works – there are enough legal obligations, rules and regulations for a bank to comply with for your money to be safe.
Unfortunately, as we recently saw with the crisis in Cyprus, that is not entirely true. Banks closed for more than a week, leaving people stranded without cash. They weren’t allowed to take large amounts of the currency out of the country and bank accounts with large amounts of money in them were simply taxed – although I would say it is closer to politically legal robbery – to support the growing debt and keep the country afloat.
Not only that, but banks can be incompetent, lavish with their interest rates and fees – even for simply spending your money – and sometimes completely oblivious to your needs. So, in some ways, bitcoins are the perfect currency. Completely anonymous, very secure (as you would imagine it would need to be), completely liquid (in the perfect world) and frictionless – meaning they skim almost nothing off your transactions. What also makes it very appealing is that bitcoins are invisible to tax regulators and law enforcement.
But, as we’ve seen in the volatility of the price, these strengths can also be seen as weaknesses. It is possible to lose millions of dollars’ worth of currency in a day of two. Also, it is not completely immune to hackers – a very small amount of people have lost their money like this. I believe therein lies the inherent flaw of the entire premise of Bitcoin. While you can buy things on a day to day basis with bitcoins, you have no real guarantee that your money will have the same, if any, value when you wake up in the morning. And why would that be true of a currency, even if it is digital? This currency is behaving more like a commodity than a currency. In some ways, I guess, that is what Bitcoin was meant to be – something that would effectively blur the distinction between a commodity and a currency.
That is actually a very serious problem, because it means Bitcoin is actually becoming something linked to financial speculation rather than a value of account. If normal currencies had this kind of volatility, how would one do business? You would have no idea if you would pay R10 of R100 for a loaf of bread when you walk into the shop that morning. In fact, it can get so bad (as we saw last week with the market value), that in the morning you might be able to sell a loaf of bread for R100, but in the afternoon that price could very well be R50.
To me this is all too reminiscent – remember the dot-com bubble and how horrifically it burst? Look at the scary similarities between the Bitcoin market cap and the dot-com bubble.
Speculative influences build and burst bubbles, and Bitcoin is way too susceptible to these influences. Quartz did a study in March and found there is a very worryingly high correlation between the price of bitcoins and media coverage. In July 2010, the influential technology site Slashdot posted a short item about Bitcoin which sent the price soaring tenfold — from less than a cent to about 7 cents per Bitcoin — also in a few days. And a single post on Time.com in April was enough to double the price of Bitcoins in a week, from 80 cents to $1.60. Not only that, but in the month of March alone it looks like the amount of Tweets about Bitcoin is much correlated to the price.
So, this latest fall of price is a bubble that burst, but is it the last? In all likelihood, it is not. The New York Times talked to the Winklevoss twins. These are of course the guys that claimed Mark Zuckerberg stole their idea for Facebook (and walked away with an obscene settlement, though we don’t know exactly how much). They are huge investors in Bitcoin, and in light of the massive capitalization loss last week they simply said that “this week’s tumult is just growing pains for a digital currency” that they believe will become a sort of gold for the technorati.
That might be the case, but I believe it not to be. It will more likely be used by portfolio managers with a very high risk appetite, because Bitcoin will probably primarily serve as a risky commodity. Because of the fact that there is only a finite amount of Bitcoins available – it is “mined” very much like other commodities – their value will have to soar if a large amount of people start to use it for trading on a day to day business. As a result, another bubble forms, and it will pop again.
That doesn’t mean that a real digital currency couldn’t work. We came from minted coins, to plastic cards, to payment systems like PayPal. The next step in this evolution is peer-to-peer payment systems. We can learn from the successes and failures of Bitcoin and take it further. I just think that it doesn’t necessarily have to be its own currency, but rather a way of making transactions between currencies while working with the established monetary institutions. Think of something like the Euro, an encompassing currency, but in the digital realm. Just like the British can still use hard earned pounds, we would still have our respective local currencies, but those can quickly and easily be exchanged for the digital currency. There are still many hurdles to overcome before we get there, but I think it is truly possible. And I think THAT is the future, not Bitcoin.