Bitcoin has the glitter but it is not gold

From Wall Street, to the streets of Kigali, Bitcoin has recently been a term on most people’s mind. The cryptocurrency, once pronounced a fraud, is now taking on the world by storm.

From Wall Street, to the streets of Kigali, Bitcoin has recently been a term on most people’s mind. The cryptocurrency, once pronounced a fraud, is now taking on the world by storm. The popularity of Bitcoin has come following the lucrative valuations it achieved, surpassing gold, the most regarded expensive asset. Developments like the recent announcement by the Chicago Mercantile Exchange (CME) Group to launch Bitcoin Futures have also helped to create a positive buzz for Bitcoin.

Bitcoin has re-energised the debate around cryptocurrencies that were once an area of technology reserved for financial technologists and speculators pushing libertarian philosophies. The increasing significance of cryptocurrencies in the global economy is also attracting the attention of regulators globally, who seem to have been caught by surprise. Some argue that cryptocurrencies will be transformative while others believe they spell disaster.

For people looking to make quick financial returns however, Bitcoin looks a plausible option. But, is it?

Bitcoin has been trading at record highs, and its price has dramatically increased in the past months. At the time of writing,this piece, Bitcoin had risen past a record of $11,000 from around $8000 in the past two weeks; since October alone it has seen a price increase of more than 50 percent and has risen more than 700% in 2017. With these lucrative valuations, individuals across the world and in Rwanda are joining the bandwagon to invest in Bitcoin.

It is, however, important to note that much of what is driving Bitcoin’s price is speculation and that their price is the most volatile. Any change in sentiment on Bitcoin may therefore lead to a huge drop in Bitcoin prices, thus depleting the value we are seeing today. This volatility was evident on November 8 where over four days, the price of Bitcoin slumped by more than 25%, before bouncing back on 13th November.

Investor enthusiasm for Bitcoin is at a fever pitch, which has parabolically pushed up the price of a single Bitcoin. Much of this enthusiasm is driven by expectations that the cryptocurrency will gain wider acceptance and use in the global economy.

However, it is worth going back to the basics of what Bitcoin as well as other cryptocurrencies really are. Most cryptocurrencies like Bitcoin are denominated in their own units of value and do not have intrinsic value but instead depend upon user perceptions of value. They are also not tied to a sovereign currency and are therefore not a liability of any person or institution. Their value is based solely on users’ expectations that they can exchange these units for something else of value, such as goods and services, or sovereign currencies at a later date.

These expectations can change greatly, and introduce greater volatility and risk of loss in the value of the units than is typically observed. The adoption of Bitcoin or any other cryptocurrency as a global currency is suspect; partly because of regulatory reasons and partly because, creating a world currency from scratch, especially given the mandatory limitations on bitcoin creation, is no mean feat.

The dollar is today’s reserve currency and accounts for roughly two-thirds of all financial and economic transactions globally. The daily value of foreign exchange trading tops $5 trillion, alone, while bitcoin does a mere fraction of that. Bitcoin also fails as money because convertibility is suspect in some nations where bitcoin exchanges have been banned; which creates some confusion as to how the currency can be used.

The widespread use of Bitcoin is also unlikely because of the risks it poses for sovereign regulatory bodies. Traditionally, Central Banks have long been the guardians of official money. Money depends on the authority of the state for credibility, with Central Banks managing its price and/or quantity. Countries still have the need to maintain control of their respective currencies and money supplies. As such, the emergence of Bitcoin is seen as a threat to financial stability and monetary authority since governments have less control over it, if Bitcoin or other cryptocurrencies become widely used, this could render monetary policy obsolete. This will therefore force many Central Banks across the world to ban the use of Bitcoin, limiting its use.

Bitcoin as well as other cryptocurrencies are widely used in the dark web for a wide range of illicit activities, from money laundering and tax evasion to drug dealing, prostitution and circumventing government controls, among others. In China for example, authorities issued a ban on private cryptocurrencies because they were being used to circumvent capital controls. These reasons will continue to limit the widespread use of Bitcoin, which therefore undermines the basis on which investor enthusiasm for Bitcoin is centered.

The Bitcoin buzz has also led to a proliferation of cryptocurrencies, such as the new launches of other cryptocurrencies on a daily basis, attempts by banks to create their own cryptocurrencies and the increasing creation of Initial Coin Offerings (ICOs) which will limit their respective values and may be a sign of a bubble building.

Bitcoin may be the new poster child for quick financial gains, but it is in a bubble that may soon bust. The ground on which the financial gains it promises are based is shaky and the risks for those engaging in these schemes are far greater.

As the old saying goes, not all that glitters is gold. Bitcoin undoubtedly has the glitter, for now, but it is definitely not gold.

The author is Economist in the Monetary Policy and Research Department at the National Bank of Rwanda.

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