Bitcoin: Disaster or opportunity?

Bitcoin: Disaster or opportunity?

In the current low interest rate environment, investors are increasingly being pushed into risky assets to earn a decent return.

This relentless and desperate search for yield has seen money pour into some spectacularly awful investment ‘opportunities’ such as Argentinian 100-year bonds.

Bitcoin may also prove to be a poor investment.

While the cryptocurrency has soared from $0.05 in July 2010 to US$17,160 on 7 December, 2017, don’t fret if you think you’ve missed an incredible ‘opportunity’. Consider first exactly what you’re missing out on.

Bitcoin may be functional, in the sense it can be used to buy items, but is it really a form of currency? A currency has three main functions: it is a store of value, a means of exchange, and a unit of account.

Due to its narrow and illiquid market, Bitcoin is extremely volatile. The reported price can move up and down by $1,000 or so within a few hours rendering it a nail-biting store of value. For instance, if you had bought an iPhone in January with Bitcoin you would be kicking yourself now as the same coin would have bought an iPhone for the whole family for Christmas.

It is also a poor means of exchange as the costs of doing so are high and increasing. Each transaction needs to be verified by “miners” who require an astronomical amount of computing power to do so. In total, Bitcoin uses as much electricity a year as Morocco, or 2.8 million US households. The process of exchange is also susceptible to hacking where Bitcoins have been stolen whilst on-route to their new owner with no legal protection to retain your investment value.

A currency should also be a unit of account for debt, although if you had financed your house with a Bitcoin mortgage, your debt would have risen tenfold while your salary would not have.

Consequently Bitcoin most certainly does not fit the criteria for a currency. So what is behind its recent rally?

There are three arguments for this: its limited supply causing high demand to drive up prices;  excessive quantitative easing has raised concerns surrounding the long-term value of government (fiat) currencies; and the desire for anonymity.

These factors may be valid and explain the appeal of Bitcoin but it doesn’t explain the recent surge. Supply has increased with numerous rival cryptocurrencies becoming available, inflation remains steady, and criminal cohorts have not recently grown exponentially.

A more plausible explanation of the price spike is a behavioural one. As Charles Kindleberger, a historian specialising in bubbles, once stated:

“There is nothing so disturbing to one’s wellbeing and judgement as to see a friend get rich”.

Investors are not buying Bitcoin because of its use as a currency in their daily lives or its intrinsic long term value. They are acting on success stories from fellow investors because they want a piece of the action. The ruthless hunt for yield is creating investment FOMO (fear of missing out).

FOMO has symptoms which include clouded judgement, extreme short-termism, following the herd and crowding into speculative overvalued assets. It is highly contagious and when enough investors catch it, a bubble forms.

While Bitcoin investors may be millionaires on paper, getting out of an illiquid asset is much harder than getting in. It is very difficult leaving a bubble with your wealth intact. If everyone tried to realise their Bitcoin wealth, the price would crash. Investors know this could happen therefore there is every incentive to sell first. When the crash comes, and history tells us it can’t be far away, it will be disastrous.

Jessica Schlosser is an investment analyst at ClearView.