Wednesday 27 November 2013

Bitcoins and Tulips

Bitcoin, the online digital currency, has been a topic of great media furore. Since trading began in 2009 the value of one bitcoin has gone up exponentially from a measly $0.0007 to over $900 in recent weeks (i.e. one dollar invested in '09 would now be worth close to $1.3m). Many reputable businesses are signing up to accept them, one of the latest being Richard Branson's Virgin Galactic - the space travel company. This adoption by business is obviously a sign of success/popularity, but is the currency truly sustainable?

The Bitcoin website promises it's users instant peer to peer transactions, worldwide payments and zero or low transaction fees. However due to it's huge volatility against regional currencies, vendors routinely hedge transactions, which must negate ( I assume) some, if not all of the transactional savings. Other problems linked to the currency have been it's usage in illegal trade such as drugs and weapons due to the fact that bitcoin transactions are hard to trace, and also people hacking bitcoin 'wallets' and stealing them. 

The exponential growth in the value of bitcoin can be largely attributed to its relative scarcity. There are currently around 12m bitcoins in circulation and their supply is growing at an ever decreasing rate that is pre designed to cap at 21m bitcoins in a few decades. If the rate of bitcoin adoption continues to outstrip supply it's value is almost certain to increase.

Speculators & Investors have cottoned on to the deflationary properties of bitcoin and have almost certainly exacerbated its volatility. But does their bet/investment make any sense? Currencies do fluctuate in value against one another but these movements are usually nowhere near the scale we are seeing between dollar/bitcoin. For a currency to be a successful medium of trade surely it must be less volatile, and probably mildly inflationary in character. Also expected returns for a currency should be relatively low as it is essentially a non productive asset. A currency that is designed to appreciate in value against all others seems destined for problems and potentially may have been deliberately designed as a Ponzi scheme. If this is the case it is little wonder that its pseudonymous creator, Satoshi Nakamoto, kept his/her real name a secret.

I see some faint parallels between the exponential growth of bitcoin and the tulip mania experienced in Holland in the 1630s. In that scenario the newly introduced tulip took Holland by storm due to its vibrant colours, and because of its relative value and scarcity it quickly became a status symbol.
As a tulip takes around 7-12 years to grow from seed to flowering bulb the stock of them (like bitcoin) was essentially fixed. Speculators entered the market and traded futures contracts which drove the finite stock of tulips to extraordinarily high prices. At the peak of the mania single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. Of course the bubble eventually imploded and many of the speculators involved towards the end met financial ruin.

What does fate hold for bitcoin? Nobody can say for sure, but currencies don't last forever, the world has seen thousands come and go. Speculating on it might be fun and potentially profitable but punters should be wary that the intrinsic value of bitcoin is significantly less than a tulip bulb. They won't produce a nice flower for you to gaze at when you're skint ;)

Sources: Wikipedia &

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