As the daily gyrations in the price of Bitcoin continue to dominate the media cycle, inviting prognostications from financial commentators and Christmas dinner participants alike, one cannot help but think: just what is going on? How has the fate of Bitcoin, once the exclusive province of crypto-nerds and drug dealers, become the matter of the moment? This article will seek to shed light on how and why Bitcoin’s notoriety has grown, and just what may lay ahead over the forthcoming year.
Overcoming the Payment Problem
Whilst discussions concerning Bitcoin almost invariably descend into a babble of crypto jargon without so much as a 30% fall in the price of Bitcoin; the problem which Bitcoin actually seeks to solve is perfectly intelligible. Indeed, the problem can be neatly summed up in one word: trust.
The fundamental problem any electronic payment system must overcome is analogous to the familiar problem which besets any new couple: how to create a trusting relationship between two people who lack any definite guarantee that the other is trustworthy. After all, just like in romantic relationships, there is the potential with every electronic financial transaction that one individual will attempt to cheat the other. To be specific, electronic payment systems must prevent the scourge of ‘double spending’ – where an individual spends electronic currency multiple times over leading the other transacting parties to be left out of pocket.
Whilst in the realm of romance the problem of trust is usually overcome – to a greater and lesser degree – through a proverbial leap of faith, economies require a far more reliable means of producing and sustaining trust in order to operate efficiently. As a result, banks have stepped in to fill the trust vacuum by acting as credible third parties – the brokers – who guarantee electronic transactions. Thus, banks have over time become the de facto gatekeepers of the electronic payments network. Indeed, their control over the electronic payment system in the developed world is now so pervasive that most of us cannot imagine it being any other way.
But what happens in a situation where there exists no credible banking authority to underpin the electronic payment system? Whilst pre-2008 this difficulty may have been considered the sole reserve of countries with undeveloped financial institutions, the deterioration of confidence in the big banks which resulted from the global financial crisis has made this issue increasingly salient within the developed world. The undermining of trust in traditional banking institutions has therefore created an occasion to rethink the role of third parties in electronic payment systems. Could the keys somehow be wrested from the gatekeepers?
The Point of Bitcoin
This is where Bitcoin comes in. In 2008, Satoshi Nakamoto – the founder of Bitcoin – set out to create an electronic payment system which would resolve the ‘problem of trust’ without so much as a modicum of involvement from any banking authority. Nakamoto’s genius was to create an electronic payment system based on a nascent technology called ‘blockchain’ whereby banks would be replaced, in effect, by cryptographic puzzles.
That is, rather than employ the traditional approach of having banks verify each and every transaction within the electronic payment network, transactions would be verified instead by supercomputers solving increasingly complex mathematical puzzles. And in return for their role in upholding the payment system, the owners of the supercomputers would be rewarded with Bitcoin of their own in a process which has come to be known colloquially as ‘mining’.
Thus, with the flash of an algorithmic wand, Nakamoto eliminated the need for trust between transacting parties without acceding control to the big banks, or indeed any other third party. Whilst the initial result of this breakthrough was to provide a secure medium through which criminals could carry out illicit transactions and money laundering – leading Bitcoin to be the currency par excellence within the online drug industry – Bitcoin has become increasingly regarded as a legitimate medium of exchange over time.
Indeed, such has been the proliferation of Bitcoin’s adoption in recent years, that crypto-enthusiasts have begun to envision a world where Bitcoin surpasses traditional currencies as the most convenient method of processing electronic transactions. According to Bitcoin’s proponents, it is only a matter of time before the old world of debit cards and big banks gives way to a new world of Bitcoin and supercomputers. Bitcoin would be the world’s primary digital currency: a surefire way to purchase goods and services from the golden hills of California to sprawling tributaries of Shanghai.
Bitcoin as a Failed Currency
The idealism of crypto-enthusiasts has however been blunted by the dull edge of reality. The hitch is that in order to function as a viable “cryptocurrency”, Bitcoin must be more than a mere medium of exchange. Currencies are not necessarily spent straight away – people save and invest in financial assets – and therefore a functioning currency must also act as a ‘store of value’ in order to facilitate such activities. Moreover, a currency must also function as a ‘unit of account’; a way to denominate the prices of assets and liabilities such that people can use the currency as a measure of value.
Unfortunately for Bitcoin though, its contemporary popularity has undermined its ability to function adequately on either basis. Speculators have begun purchasing Bitcoin not as a currency to be used as a medium of exchange, but rather as a financial asset which can be later sold to turn a quick profit. Indeed, the CME – the world’s biggest futures exchange – has now allowed investors to bet on the value of Bitcoin without actually owning the currency itself, fuelling the speculation further. This has led to an exponential increase in the value of Bitcoin over the past year; starting from $1,000 in January 2017 and peaking at $19,000 in mid-December. Such has been the extent of the bubble that the daily fluctuations in the price of Bitcoin have now become staggering, with Bitcoin losing over 30% of its value within the space of 24 hours in December.
As a result, the mind-boggling volatility in Bitcoin’s value has made it the antithesis of a robust store of value, with fortunes being both made and lost within the space of hours purely from holding currency. One can only imagine the anguish which would face home-owners had they made the perilous mistake of taking out a new mortgage at the start of the year denominated in Bitcoin rather than their native currency. Given that Bitcoin has increased in value by 1,200% over the past year, such homeowners would be faced with financial armageddon as the value of their mortgage payments rose correspondingly without any comparable growth in income.
Likewise, the lack of price stability has made firms loath to denominate their prices in Bitcoin. It is telling that the price of Bitcoin is quoted in dollar terms rather than the other way around. One can only imagine the chaos that would ensue in a restaurant which chose to quote the price of its dishes in Bitcoin rather than native currency, with new menus being printed by the hour in order to adjust for Bitcoin’s daily price oscillations. For instance, had one been eating at a Bitcoin-denominated restaurant between 18:30 and 19:30 UTC on November 29th, one would’ve found that the price of the meal had fallen 10% by the time the final bill came. In economics, there may be no such thing as a free lunch, but there certainly is the possibility of discounted gastronomy à la Bitcoin!
Conclusion: Heading to Zero
Therefore, until Bitcoin finds price stability, it will fail to function as a working cryptocurrency able to challenge the supremacy of traditional currencies. The inherent difficulty is that Bitcoin will only find price stability when the speculative bubble comes to an end and market works out how to price Bitcoin according to its “true value”. But Bitcoin’s “true value” is precisely its value insofar as it is a functioning cryptocurrency. Therein lies the paradox: Bitcoin cannot become a viable currency until it finds price stability, and Bitcoin cannot find price stability without first becoming a viable currency. Unless this paradox can be somehow resolved, Bitcoin’s “true value” is zero. Investors should take note.
In this sense, Bitcoin has become a victim of its own success insofar as it has jeopardised its chances of ever becoming a functioning cryptocurrency. The very technology which made Bitcoin so attractive in the first place as a genuine peer-to-peer payment system has rendered the currency it fashioned completely defunct: there is no third party – no central bank – which can intervene to stabilise the price of Bitcoin. One can almost imagine the big banks – the traditional custodians of the electronic payments system – grinning smugly and offering perhaps the most damning assessment of all: ‘I told you so!’.
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