Bitcoin and other Internet currencies are viewed by some as a Beanie baby fad and, as Citi's Steve Englander notes, by others as revolutionizing the financial system. Market acceptance of alternative currencies now looks to be growing a lot faster than the pace at which the supply of Bitcoin and Bitcoin wannabees is expanding the Internet money supply. The responses fell into five categories which we feel are well worth considering before trading or utilizing the digital currency (including Bitcoin's role in reserves management).
Englander's previous "Bitcoin as a currency" report generated a lot of comment. In the note, he argued that something as replicable as Bitcoin would generate a lot of imitators and that there was an infinite supply of Bitcoin-like competitors at low marginal cost. The responses generally fell into five categories:
Citi's Steve Englander Addresses 5 key responses to his previous more negative view on Bitcoin.
1) Bitcoin is a generic payment system as much or more than a specific store of value and has tremendous advantages over current payments systems
2) Its run-up in price represents dissatisfaction with central banks and money printing and the desire for a currency not driven by political opportunism
3) First mover and networking economies of scale advantage will make Bitcoin and a couple of other internet moneys dominate Internet money in the future
4) It can keep growing as long as there was a group of individuals and businesses willing to accept it
5) It’s a tulip bubble and will collapse
1) Bitcoin as a payments vehicle
Many commented that Bitcoin was revolutionary as a payments mechanism, rather than as a store of value. The run-up in the price of Bitcoin could be viewed as speculative but its impact on the payments system would be durable, even if the price stabilized or fell. Bitcoin’s competitors are credit card companies, wire transfer companies, weak fiat currencies and the like. Its advantage was that that its secure cryptography gives it strong security with respect to falsifying transactions and the transactions cost is almost zero. So you would not have to hold Bitcoin in order to transact in it, at least not for very long.
Anonymity was also viewed as a plus by many, but whether governments can, will and should get some handle on internet transactions is under debate. Some also argue that its decentralization is an advantage. The ‘ledger’ that keeps track of Bitcoin transaction seems resistant to fraud, but there have been issues with Bitcoin exchanges and other elements of the transactions process.
Investors who focused on the potential Impact of Bitcoin on the payments system sometimes saw the Bitcoin appreciation as a distraction. Bitcoin’s sharp price run-up is attracting more involvement now, but could be a disadvantage if price ever took a big fall.
2) Bitcoin as an alternative to fiat currencies
When G3 central banks are expanding their balance sheets like there is no tomorrow, you can understand the search for alternative stores of value. Some make a ‘wisdom of crowds’ argument that monetary management is likely to be better if it reflects the judgment of a diffuse constituency of users rather than a central bank governor or board. In short, this is the gold standard, but with a lot more portability and ability to transact. That said, Bitcoin protocols are decided by a group of programmers, and their goodwill is taken for granted.
To some investors it is perfectly clear that the combined judgments of individuals across the globe will be superior to the centralized policies made by central banks. To many holding this viewpoint, the ineptness of global central banks has made the bar for outperformance pretty low. This view probably appeals to you if you think the panics of 1837, 1873 or 1893 were preferable to the Great Recession of 2008 (http://en.wikipedia.org/wiki/Panic_of_1837, http://en.wikipedia.org/wiki/Panic_of_1873, http://en.wikipedia.org/wiki/Panic_of_1893). In those times the absence of a central bank did not preclude private sector speculation from generating bubbles and panics. Admittedly, some of those panics started because of failed attempts to manipulate or corner certain markets, a feature Bitcoin’s proponents may feel it is immune to.
Bitcoin started as an experiment in a currency that was neither commodity-based nor backed by a governmental authority. There is a risk that participants in the Bitcoin ecosystem may become more self-interested over time, the way broadcast television started with Paddy Chayefsky and quickly morphed into The Beverley Hillbillies. Even now it is unclear to what degree the ‘miners’ out there should be seen as public servants.
We are left with the possibility that the properties of a Bitcoin ecosystem that comes to be driven by individual self-interest will differ from its intended properties. Greed and panic could enter as a significant part of the ecosystem. By contrast, central banks have a mandate to stabilize the economy and financial system, even if you see their performance as inept in practice. Nevertheless, it is not so obvious that a good system driven by individual self-interest will produce a more stable economic and financial system than an imperfect system of central banks trying to stabilize economic and financial markets. Many supporters of Bitcoin argue strongly that this is the case, however.
2a) Bitcoin as a reserves alternative
Reserve managers are likely wondering whether Bitcoin is the answer to their most perplexing problem – where to find a pure store of value, how to avoid currencies backed by erratic central banks and how to dethrone the USD from its perch in the international monetary system. Bitcoin is much more interesting than the IMF’s SDRs from a reserve manager perspective because it is independent of major currencies. The reserve manager operational problem is two-fold: 1) how to sell a truckload of USD, and to a lesser degree EUR and JPY, without excessively depressing the value of the USD that they are selling and 2) what to buy when there are few attractive, liquid alternative. Bitcoin doesn’t avoid 1) but addresses 2) to some degree.
Bitcoin with its inelastic supply and deflationary bias would look attractive to reserve managers as a complement to gold, and in contrast to fiat currencies in unlimited supply. As a group, reserve managers are conservative and probably would like to see how Bitcoin evolves. Given the reserves management problem discussed above, there is some incentive for the biggest reserve managers to encourage development of this market to see if it is viable in the long term. Even if it ends up just as a transactions vehicle, countries may choose to transact in Bitcoin or the like, if it enables them to reduce the overhang of USD that they need to hold because of its role in international trade and finance.
Conclusions: i) Reserve managers will not be the first to adopt Internet currencies but they have incentives not to be the last; and ii) The USD would likely be undermined on its international role, were this to occur.
3) First mover advantages
This may be the most contentious area. Bitcoin fans argue that being the first in any area where there are networking economies gives you an immense advantage. Replicability is not an issue because potential imitators will find that businesses and households will sign up with the network that gives them the greatest ability to interact. The analogy is drawn to Internet retail and social media businesses where the business model can be copied but where a couple of companies at most dominate the space. (On the other hand, I still have my login/passwords to a variety of ‘first movers’ services that no one under 40 would even recognize.)
With respect to money, households and businesses will choose the one with the greatest acceptance, so the first mover has a big advantage even if the technology can be copied. This is a very important argument for entrepreneurs involved with Bitcoin and the few other currencies that are leading the charge to commercialize it..
Where diseconomies of scale enter Bitcoin is through the price exposure. The maximum amount of Bitcoin is predetermined and looks likely to be hit in the 22st century. The supply of Bitcoin is set to grow relatively slowly, arguing that the price should keep rising. You can argue that the price of Bitcoin is irrelevant, since it simply reflects the unit of account for transactions. You can also see that there is a host of alternatives that may have some modest advantage over Bitcoin. Both holders of Bitcoin and transactors in Bitcoin have to assess whether the Bitcoin network advantage is strong enough to outweigh the benefits from Bitcoin alternatives. You can find examples of both, but networking situations in other domains are less dependent on reputation than are Bitcoin and other Internet currencies. And such reputational equilibria are very fragile, and probably will not survive any unaddressed issues of theft or fraud.
Moreover, if you transact in Bitcoin, you likely will choose to hold some to facilitate transactions. The speculative surge in Bitcoin may be a disadvantage if you can find a substitute that has similar characteristics but less of a speculative component. The question is how expensive is it for a business or individual to have more than one internet currency and how much of a disincentive is it to hold a Bitcoin if the price is high, when there are good substitutes with lower prices.
4) The Bitcoin ecosystem is growing exponentially
There is a short to medium term Bitcoin argument that goes something like this. We are just scratching the surface of payment system/alternative currency development. Whatever the competitive environment, in a market that is growing exponentially fast, any reasonable player will get bid up. Ultimately when market growth flattens out, there will be a sorting out of winners and losers, but that flattening out is not visible anytime soon, barring disaster. If this is a repeat of the Internet bubble, we are in 1997, not 2000, so the gravitational pull of the technology will mask small warts and crevices in individual applications.
This is not an argument most of us feel comfortable with, because there is the risk that our calculus is wrong or that some disaster either through fraud, government interference or some breakdown in the system occurs before the market flattens. However, many investors feel so confident that we are just in the takeoff stage, that they see themselves with a margin to invest. They also have incentives to advocate forcefully the widening of the market because that enhances the value of all existing applications.
5) Tulip bubbles
About 40% of the comments I received argued outright that Bitcoin and similar internet currencies were bubbles, or tools to evade taxes, or conduct illegal activity. Basically, the view was that the Bitcoin appreciation reflects a mixture of greed and optimism, as in Boileau (1674), “A fool always finds a greater fool to admire him." The major issues have been touched on above – replicability, susceptibility to government interference, security vulnerabilities outside the ‘ledger’ level, inability to reverse any transaction, dependence on reputation, fragility and so on. Those who think this is the internet in 1997 should recall that the NASDAQ was back to 1997 levels in 2002, and even briefly touched 1996 levels, so getting in early may mean getting in really early. Just as with the railroads and Internet, it may revolutionize society more than it makes money for investors.
Some investors argued the reverse of most of the pro-Bitcoin commentators, seeing it as most likely a bubble but on the off chance that it wasn’t, it was worth buying a couple in case the price kept shooting up. It was viewed as the high risk, high return investment, with compensation that it was good cocktail party conversation.
Conclusions
Bitcoin and other Internet currencies are viewed by some as a Beanie baby fad and by others as revolutionizing the financial system. Market acceptance of alternative currencies now looks to be growing a lot faster than the pace at which the supply of Bitcoin and Bitcoin wannabees is expanding the Internet money supply. That is unlikely to persist over the medium and long term, but for now it looks as if it would take a major scandal, security breach or heavy-handed governmental intervention to derail it.
Internet currencies suffer from the absence of an anchor to determine their value and from their dependence on reputation and fashion. Replicability is an issue that the Internet currencies will not be able to overcome easily. The role in the payments system is very concrete to investors, although many also see value in a currency in inelastic supply whose value is determined by consensus rather than the monetary authority. Among skeptics, a minority think that security is a much bigger issue than proponents admit. However correct the longer-term concerns, there is nothing obvious to derail the expansion of Internet currencies in the near-term, as they are meeting both legitimate and illicit economic and social needs.
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