Bitcoin, the world’s largest cryptocurrency, has caught the world’s attention (again). Infamous for its volatility, it has faced scepticism from institutions and finance leaders. However, during the last year alone, Bitcoin has jumped from lows of $4000 to highs of almost $42000. What explains the eye-catching increases?
Bitcoin was created in 2009 by the pseudonymous Satoshi Nakamoto at a time when the world was experiencing the dire effects of the global financial crisis. It was devised as a response to the malfunctioning economic system. Nakamoto no longer trusted the financial system. He put his confidence in a decentralised currency that was free from the control of governments and central banks – i.e. a currency whose supply could not be determined by central banks. For the most part, he has succeeded in this. Bitcoins must be mined to enter circulation, much like gold. It is different to fiat currencies in that its supply is fixed by blockchain technology rather than by policymakers. Due to the way Bitcoin’s blockchain technology works, there can only be so many coins in circulation at any time – with an ultimate ceiling of 21 million Bitcoins (to be reached sometime before 2140). So on this metric, Bitcoin can be said to be a success. But is it a useful currency?
One defining feature of modern currencies is that policy makers DO have control over how much is in circulation at any given time. If the economy is moving too slowly, inject money. Too quickly – pull it back out. This is a crucial monetary tool that helps to combat the effects of recessions (currently being felt across the world). If central banks were using cryptocurrencies right now, their ability to reflate economies would be severely limited. Thus a cryptocurrency that behaves exactly like Bitcoin isn’t very appealing to policy makers.
However, if the money supply ever increases too quickly via this ‘loose’ monetary policy, inflation will eat away at the spending power of domestic currencies. The problem is ‘too much money chasing too few goods’. A cryptocurrency like Bitcoin is unlikely to ever deliver this phenomenon (because it cannot be mined fast enough), whilst a conventional currency might. This is made even more problematic in a time of expansionary fiscal policy (like the coronavirus stimulus spending). In these times, the combined effect of monetary and fiscal policy could deliver unsafe levels of inflation – reducing the purchasing power of pay packets that may not keep pace with inflation.
Partially inspired to hedge against this, investors have flocked to Bitcoin. During unprecedented times, investors often turn to ‘safe-haven’ assets. A safe haven asset is presumed to retain or increase in value in times of market turbulence. Examples of such assets include gold, government bonds, and blue-chip stocks. The coronavirus pandemic has immensely affected financial markets and has created vast levels of market uncertainty. For example, the price of gold increased almost 18% last year whereas the FTSE100 lost 11% during the same period. We know that gold is finite in both its theoretical (total mined and unmined) and current (total mined) supply. However, since we do not know the amount of theoretical supply, it is not possible to deduce the total supply of gold globally. The fixed 21 million Bitcoins means that it is very attractive as a store of value, especially in such times where uncertainty is so high. In this sense, Bitcoin acts more like wealth (an asset) rather than income.
A number of high profile companies and individuals have given legitimacy to Bitcoin. This is a bullish move for Bitcoin because institutions in the past have been sceptical of the cryptocurrency. Payments company Square recently purchased 4,709 Bitcoins. Large investment companies have also taken an interest. UK based asset manager Ruffer invested £500 million in Bitcoin, representing 2.5% of the firm’s assets under management. Bitcoin has previously been used as a means of speculative trading and illegal activity, despite its intended use as a method of payment. Another reason as to why the price of the cryptocurrency has increased is due to the uptake of it as a method of payment. Payments giant PayPal has agreed to embrace Bitcoin and other cryptocurrencies. With an active user base of over 300 million, this may move Bitcoin to its intended use. Such approval is good news for Bitcoin and may serve to further its price surge. Equally, we may see a broader acceptance and lower volatility.
Bitcoin experienced a previous rally in 2017 to $20000. However, this time is different. In 2017, the majority of cryptocurrencies experienced a rally (with the likes of Ethereum gaining significant interest), whereas the recent rally has been specific to Bitcoin. The focus is now very much on Bitcoin. As Bitcoin’s role becomes the centre of the cryptocurrency world, the popularity of others have faded out. There is, however, a possibility that the interest from Bitcoin is shifted to competition from more reputable financial institutions such as Central Bank Digital Currencies. The challenge for Bitcoin will be whether it can achieve mass adoption as a payments method before these competitors. The Lindy Effect is a theory that, for non-perishable items (such as Bitcoin), the future life expectancy of a product increases with how long it has lasted. The reasoning behind this is that, with time, the product faces more challenges. Survival of these challenges is an indicator of future success. Applying this to Bitcoin, we could see Bitcoin around for a while. On the other hand, using the Lindy Effect, Bitcoin has an extremely long time to catch up to more established stores of values such as gold. Unlike the recent one, Bitcoin’s 2017 rally was mainly powered by a speculative bubble with little fundamentals propelling it. Over the last year, there has been larger institutional interest combined with stronger network fundamentals and regulatory clarity in Bitcoin which all indicate that Bitcoin’s upwards move in 2020/21 is stronger than that of 2017.
Bitcoin has undoubtedly made a move towards being mainstream. The recent rally is promising in that many institutions have backed its potential. With global finance figures, such as Larry Fink, CEO of BlackRock, predicting Bitcoin to be a ‘global market’, the future could be very promising indeed. JPMorgan has forecasted a figure of $146,000 per Bitcoin if Bitcoin grows in popularity as a gold alternative. We are becoming increasingly accepting of Bitcoin. Bitcoin’s value can increase exorbitantly but also decrease just as greatly. For it to be a viable payments method, there must be stability. It cannot be used as both a useful hedge against the markets as well as a successful payment method until its volatility is stabilised. Without stability, Bitcoin stands to merely be an asset used for speculation.