Currency Risk with Bitcoin

What is Currency Risk?

Currency risk involves the risk of holding one currency and seeing the value of your money in another currency decline. Currency risk is an issue for instance with those who sell their goods in other countries and need to convert their revenues from the foreign currency to the domestic one.

If the value of the foreign currency rises relative to the domestic currency, the value of their revenue increases, which in this case would be a good thing. If the opposite happens though, the money they get paid ends up being worth less, and the risk of this happening is what currency risk consists of.

If someone buys a foreign currency, for instance to use for a trip, and uses it in their country of destination, each unit will buy a certain amount of goods and services in that country. In this case the foreign currency is being used domestically, in the country or region in which it is accepted as payment, just like using your own currency in your own country does not depend on currency exchange rates normally.

If what you are looking to buy is imported, then fluctuating values of currencies will matter, whereby the cost of the imported good is ultimately going to change to reflect this new valuation.

For example, if you live in the United States and buy something that is produced in Europe, if the dollar weakens against the euro, and remains there long enough so that the supply channel reflects this new price, the cost of the goods will go up in U.S. dollars, even though its price in euros remains unchanged.

In a perfect world perhaps, the value of currencies would never change against one another, and if you held an amount of dollars they would still be worth the same amount in another currency such as the euro in the future. The same effect would be produced if there were only one currency in the world.

How Currency Exchange Plays Out

That’s not the way things work though, as currencies trade against one another in the marketplace, in the foreign exchange market, which is actually a more efficient way to run things from an economic standpoint at least. Improved economics in one country or area can be priced into the marketplace with currencies being exchanged, and this is generally preferable, unless your currency has taken a beating that is, where you may wish that things operated differently.

Even in cases like this though, it is still better that currencies get devalued when conditions dictate, as this for instance allows a country to receive more for their exports than otherwise would be the case if not for the devaluation.

China for instance has been accused of intentionally keeping the value of its currency down, which they do benefit from as a net exporting country. If the currency was valued less than the market would set it if freely allowed to do so, this would indeed boost profits from exports relative to what they would be if not for the suppression.

Governments regularly take action to influence currency exchange rates though, and so it’s not that this is left entirely to the free market, unless we consider these actions to be actually free market activities. In any case, the value of currencies against one another plays a very big role in global economics and trillions of dollars’ worth of currency change hands each day in foreign exchange markets,

Bitcoin and Currency Exchange

In a real sense, bitcoin functions as a foreign exchange of sorts, if it is understood as a currency apart from the national currency of a country or region. The terms foreign and domestic currency have sufficed for all these years, before the coming of bitcoin, although now we need a different term to describe non-national currencies such as bitcoin, and the word we’ve come up with is cybercurrency, owing to their existing only in cyberspace and not represented by physical money or physical anything.

When we spend domestic currency, we can buy or receive a certain amount of it which has a certain value. This value does change over time by way of changing prices, but if you hold a certain amount of money in your own currency, you still have that much in nominal terms in the future, even though its buying power will be reduced by inflation.

Inflation therefore is the only way that the buying power of a domestic currency can be reduced, which we call inflation risk. There is currency risk involved here as well with domestic buying power with a domestic currency, but only indirectly, and only manifests when the price of imported goods goes up or down.

We could group that together with inflation risk though, as inflation risk involves the risk of prices going up, whether this involves domestically produced goods and services or imported ones. There is no currency conversion involved so we don’t really worry much about how our currency is faring relative to other currencies.

We could say then that domestic currencies function rather independently of currency exchange, where you get paid a certain amount in a certain currency, which you then spend to buy things in that currency, and the whole thing is pretty stable. The costs of things eventually rise, and you need to increase your income in accordance, but this is a gradual process and is relatively easy to manage.

With bitcoin though, this is not possible, as cybercurrencies have not evolved anywhere near the level that would be required for one to use it as a general currency. In this case, you may get paid in bitcoin, but there are so few things that you can purchase with it that you may and likely would have to convert all or almost all of it into your domestic currency to be able to spend it.

This means that bitcoin is going to be directly exposed to currency exchange and currency risk any time it is received or held, and this currency risk is the number one limiting factor by far in its growth as a more widely accepted medium of exchange.

Bitcoin’s Currency Risk in Action

For someone to provide something of value and agree to accept bitcoin as payment, this will always involve not only needing to convert it to another currency, it also involves that we speculate on the changing values of bitcoin during the period in which it is held.

If a merchant, for instance, accepts bitcoin for the sale of something, the wide fluctuations of bitcoin make it much more difficult to price. If something cost us $10 to produce, and we’re looking to sell it at a 50% markup, we might want to charge an amount that is in line with the current value of bitcoin.

Since it takes at least a couple of days for payments to settle, there will be a wait involved in receiving this money in domestic currency. This happens with foreign transactions, but foreign currencies are pretty stable over such a short period of time, and if the seller does end up adding a little to compensate him or her for the currency risk involved, it wouldn’t amount to very much.

With bitcoin, exchange rates can fluctuate a great deal over a couple of days, and the currency risk is such that it is even hard to quantify with any great certainty. In our example, if the merchant needs to get $15 in U.S. dollars back for the sale, and they end up getting considerably less, this is going to be a problem.

In addition to the currency risk involved, there will also be costs involved in the exchange itself, as no one provides this service for free, with bitcoin or any other currency conversion. This needs to be compensated for, but in comparison, the currency risk involved in these bitcoin transactions is much more significant than conversion costs, which are minor and can be priced in with sufficient certainty.

Comparing Bitcoin Currency Risk and Investment Risk

Bitcoin’s popularity as an investment stems from its enormous volatility, something that can be very appealing to many investors. This volatility also has its negatives as well, as it adds a lot of investment risk. The more volatile an investment is, the more money you can both make and lose over time, and bitcoin and other cybercurrencies have taken the concept of volatility to entirely new levels, far surpassing any other type of investments.

The craze with bitcoin investing is what has added both its very high investment risk and its very high currency risk. If bitcoin merely functioned as a currency, or primarily functioned as one, then its price would just be set by the supply and demand of bitcoin for currency purposes, as a means of exchanging value.

In reality, what happened is bitcoin’s demand has been driven almost completely by speculation, to the extent that its use as a currency still exists but is pretty minimal compared to the speculating side of things.

This has calmed down quite a bit over the last while after bitcoin’s huge runup finally came to an end, and it ended up pulling back significantly. It’s still speculated on though, but doesn’t move up and down in price anywhere near as much as it during both its meteoric rise and great fall.

There are a number of things that need to happen before bitcoin ever realizes its potential as a widespread digital currency, and a big one is seeing the currency stabilize a lot more, seeing its currency risk lower enough so that people will become more comfortable using it as a currency and not just a speculative investment.

One of the challenges of bitcoin is that it needs to be exchanged in the first place though, so it isn’t even enough to reduce the currency risk with it, we also need to be able to use it to pay for a lot more things than we can now.

While the acceptability and usefulness of bitcoin has grown, the percentage of merchants that accept it is still a very tiny percentage compared to other payment methods such as credit cards.

Reducing bitcoin’s currency risk will certainly help though, although we still need to wonder why people would want to use it apart from those who like the idea of an anonymous currency that much to go to all the trouble and risk to deal in it, apart from transactions that by nature look to circumvent the authorities such as gambling payments in some countries and of course the proceeds of crime.

We’re nowhere near the point that we can say that the widespread use of bitcoin is even on the horizon, and even traditional online payment processors, those who deal in so called hard currency, are in a much better position and aren’t going to be unseated anytime soon.

In time though, especially if currencies like bitcoin can become much more stable than they are now, we may one day see it being a lot more popular and perhaps even fairly widely accepted as point of sale payments. That time is off in the future, but we’ll have to see how long it takes bitcoin to close this big gap in a much more meaningful way than we’ve seen thus far.