Money Always Talks
Arguably the main reason why Bitcoin came into being is to be used as a currency, as a medium of exchange between parties. Ironically, it has evolved into more of a commodity than a currency, much more like gold for instance than the dollar.
The idea that Bitcoin was going to substantially replace the dollar and other hard currencies to a meaningful degree is still pretty far off, although one day that may happen, but along the way something very interesting happened. Demand for Bitcoin exploded, not for its value as a currency, but for its value as an investment of sorts.
There are still some who continue to be interested in Bitcoin for its higher ideals, but that drive has pretty much been replaced by people’s interest in it as an asset in itself. In other words, rather than be focused on Bitcoin as a medium of exchange, the overwhelming tide of interest that has gripped it has come from its perceived speculative value.
We have not seen an asset explode in value like this since the days of the Dutch Tulip Mania of the 1630’s, where the value of tulip bulbs rose so much that a single bulb fetched up to 15 years’ worth of the average person’s earnings, in the order of what today would be in the area of a half a million dollars.
The Dutch tulip market never stood a chance though, and collapsed in dramatic fashion in 1637, driving the price down far closer to its intrinsic value. This was good evidence of how demand can drive the price of something, and this event was simply demand gone completely mad.
The comparisons between Tulip Mania and Bitcoin Mania are not completely unfounded, although prognostications of Bitcoin meeting the same fate as the tulips are for the most part overblown.
This does not mean that there is not a significant risk of a major correction off its highs for Bitcoin, and at the time of this writing we have already seen a pullback off the high in the order of about 20% over a period of only a month.
This might be fairly concerning if we were talking about another asset, but this is Bitcoin, which is far more volatile than anything we’ve ever seen this side of Dutch tulips. The ebbs and flows in the Bitcoin market are to be expected, especially after the meteoric rise that it saw in the preceding year, where it increased in value almost 30 fold.
When you have an asset with the potential to double in value in a single month, and produce returns over a few months that dwarf what could be expected during even a lifetime in more traditional investments, this is going to generate a whole lot of excitement, and this is exactly what happened.
Bitcoin is designed to accumulate in value over time, due to its planned acceleration of scarcity, with less and less new supply being introduced over time. It was not designed to explode in value though, like it did, and the market itself drove this, just like it drove the price of tulips in the 17th Century.
All This Actually Impedes Bitcoin’s Utility
There are a couple of reasons why all this speculation serves to impede Bitcoin’s original purpose as a currency. Given the way it has risen in value, holders of Bitcoin are much more disposed to hang onto it rather than spend their bitcoins, which is not in harmony with the original intent of Bitcoin as a means of exchange of value.
You still can’t spend bitcoins at very many places, although the list is growing. The number of merchants who accept Bitcoin as payment is still extremely small though, and the demand for this isn’t growing as you might expect with a currency whose market cap is now over $250 billion.
This may be expected to grow, but for the most part, people who own Bitcoin aren’t spending it that much, and much of the spending has to do more with looking to close their positions rather than to purchase something they need.
This may change over time, but for now, Bitcoin just simply does not work that well as a currency of exchange, especially due to its incredibly high volatility. This has the effect of imposing a lot of additional market risk upon the currency.
People are now being paid in Bitcoin, a few anyway, but the prospects of losing a significant amount of your purchasing power in a very short period of time, a matter of days in some cases, is not something that a lot of people find appealing. Everything is great of course if it goes up, but when it goes down, that can be a real problem.
Merchants face the same dilemma, where if they take payments in Bitcoin and the value of it declines too much while they are left holding it, this can really impact their business. The price of Bitcoin can move quite a bit in a matter of hours, and this introduces uncertainty to the equation, and businesses generally don’t like uncertainty.
We now have Bitcoin offered on the futures market, where people can use this both as a further means of speculation as well as a hedge, as is the case with all futures trading. The ability to benefit from hedging with Bitcoin may benefit large miners, but for the rest of us, it won’t have much of an impact, so the practical usefulness of this trading as far as looking to stabilize the Bitcoin market is very limited.
Will Bitcoin End Up Like the Tulips?
The nature of Bitcoin makes it unlikely that we will see a real collapse of it like some predict. Its demand has and will continue to fluctuate though, and this means that we may encounter big moves to the downside as well as the upside ones that we have already seen.
The more something goes up, the more it can come down, generally speaking, and there’s no good reason to think that Bitcoin will be more immune from this, although if anything might, Bitcoin may, to some degree anyway.
It is far better to view Bitcoin not as a currency but as a commodity though, because that’s what it has really become, and commodities can indeed fluctuate in value a lot. Bitcoin is completely in a class by itself here, although we could count other cybercurrencies in this group as well, due to their similar nature.
Prices of commodities move according to the changing relationships between supply and demand, and the demand for Bitcoin has simply been enormous thus far, or rather, has grown enormously.
It could indeed be subject to a much bigger selloff than we have seen thus far, bringing its price more in line with its original purpose as a currency, although it’s very unlikely that Bitcoin will ever go down to the point where it collapses and becomes virtually worthless. If one is left with pennies on the dollar on their investment on it though, it may seem like it has become that way though.
Many are recommending caution here, and not without good reason, but what we need to realize is that the degree of risk that one is exposed to is for the most part self-selected. People who lose half their value in an investment for instance do so because they have chosen to expose themselves to the risk of this.
Bitcoin does go down as well as up, and even though it can move in both directions much more quickly and dramatically than other assets do, they don’t move so quickly that one cannot exit their position in a timely manner and limit their losses with it. It is only when one refuses to do so that the losses become really excessive.
Bitcoin is very likely here to stay, but ownership of it does require a whole lot more vigilance and carefulness than with any other type of investment.
Editor, MarketReview.com
Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.
Contact Andrew: andrew@marketreview.com
Areas of interest: News & updates from the Consumer Financial Protection Bureau, Trading, Cryptocurrency, Portfolio Management & more.
