Bitcoin here for the long run

Bitcoin has assumed cult proportions, and naysayers in both financial markets (through their dire warnings of a Dutch Tulip redux) and global governments (through pre-emptive executive actions) have not really been able to fully dampen the enthusiasm of cult-followers. The real question though is if Bitcoin would be ever able to transcend its cult-status into its promised nirvana, ie, an alternative global currency. Prospects of that happening, while enormous challenges remain, are perhaps not the in “not in my lifetime” domain. Why? Let us examine the key hot buttons — demand and supply considerations of an alternative global currency. 

Starting with demand — is there a demand for an alternative global currency? This is an easy answer — it is a loud, unambiguous YES. There are multiple intellectual convincing and politically powerful support for Bitcoins as an alternate currency. 

First, the current international financial system is predicated on the status of US Dollar (USD) as the de facto reserve currency. Bulk of trade settlements, capital flows and money transfers happen in USD — giving the US government supranational powers to regulate the international financial system. Along with USD as the reserve currency, the entire global financial architecture is run by financial institutions around US rules. This gives enormous political powers to the US government — it can (and has) try to influence behaviour of people, corporations, even countries, by sanctioning their access to the global financial system. States at the receiving end of such action — Russia, Iran, Venezuela come immediately in recent memory — have enormous interest in breaking out of the straightjacket of USD. Bitcoin, where custody, transfer and trust are ensured by a disaggregated, decentralized protocol (rather than US laws), reduces the leverage of sanctions today that US government has. 

Second, the crisis of confidence in the traditional monetary regime. Under the traditional monetary policy, new money is primarily created by “fiat”, or by central banks (representing their respective sovereign governments) printing money. Post the global financial crisis in 2008, central banks around the world used this power to print very large sums of money (popularly described as Quantitative Easing), with the objective to keeping interest rates low, finance government buy-outs of toxic financial assets, and give a general “monetary boost” to a crisis-hit global economy. In some parts, it worked. But it also left in its wake a crisis of confidence with a section of thought-leaders  — as currency as an asset was seen to have been devalued by printing such large amounts, opening up possibilities of run-away inflation in the future. 

Next, what about supply? Is Bitcoin (and the whole family of cryptocurrencies at large) geared up to become an alternative form of money? Any form of money has two features — as a medium of exchange and as a store of value. At an overarching level, money also has to support business cycles in the real economy. 

As a medium of exchange, Bitcoin (and cryptocurrencies in general) shows the maximum promise — as a decentralised, public architecture — since money transfers can be done faster, cheaper and without taking credit risk on various intermediaries along the chain. A typical international wire transfer today navigates its way through multiple banks, clearing houses, custodians and transfer protocols (like SWIFT) — takes several days, with the only beneficiary being the intermediary banks making money out of the idle float. Cryptocurrencies like Litecoin can do the transfer in minutes, and cost virtually nothing.  

The real issue with Bitcoin today though, is as a store of value. Rather, as a “stable” store of value. Volatility in Bitcoins today is very high, 20-25 times the volatility of stocks. Now, no one would generally like to be paid in a form of money that can be worth 15 per cent more (or less) the day after. Part of this is growing up pangs, Bitcoins do not have the normal full suite of financial products underlying the asset — most financial assets that do not have well-traded option contracts tend to be non-ergodic (in simple terms, subject to massive blow-ups). Recently, mainstream exchanges like Chicago Board of Trade and Chicago Mercantile Exchange started offering futures contracts on Bitcoins. Its not enough, futures contracts, sans a large, liquid options market, will not bring volatility down markedly. The point though is, this is just the beginning. Moore’s Law in financial market innovation will kick-in at some stage, especially with mainstream financial market participation increasing, and newer derivative instruments would start trading off Bitcoin underlyings. However, this is the toughest condition for Bitcoin to achieve for it to become a form of money. 

Which brings us to the last issue, does Bitcoin lend itself to viable monetary policy formulation, one that can support the real economy? The first objection would be in terms of its finite quantity – Bitcoin is limited to 21 million. In times of economic downturn, it limits the ability of governments to expand the money supply to tackle the same. This isn’t as such a difficult problem, as Bitcoin is but one of many cryptocurrencies, there are many more (like Litecoin, Dash etc).  

The bigger issue, though, is around the power of the State associated with money. Fiat money today is printed by governments, it’s a sovereign obligation. How would states react to a new architecture stripping that power away? 

Philosophically, this would be the biggest supply-side question that Bitcoin has to answer. Good news (for Bitcoin fans), is that there is a modern precedent. About 500 million citizens in dozens of States, gave up their sovereignty to print money to a common shared pool — the European Monetary Union, on January 1, 1999 — giving birth to Euro. Some of the objectives of the Euro are not very dissimilar to the demand-side arguments for Bitcoin. In a nutshell, it has happened before! While the obstacles are many, so it would seem are the arguments in favour of Bitcoin. How the cookie crumbles would be an interesting story of our lifetime!

The author is Managing Partner of ASK Wealth Advisors. Views expressed are personal.