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  • Bitcoins, Bubbles and Bullishness: 5 Reasons Why Bitcoin Will Bust

    December 7th, 2013  by  Asia-Pacific Global Research Group - Jasper Kim

    Top 5 Reasons Why Bitcoin is Doomed
    Bitcoin is billed as a virtual currency that acts as electronic cash. Its value has soared from below $1 in 2011 to over $1,200 as of today. What is its intrinsic value, though? It is probably really worth less than $1 and this dramatic price rise is nothing less than a speculative bubble that will burst in due course. Although Bitcoin may be doomed for reasons I will outline below, the idea of a virtual currency is appealing. Ideally, a virtual currency would be as widely accepted as cash. You would be able to pay with it electronically at the store with your cell phone instead of carrying cash. Merchants would like it because the transactions fees would be much less than credit cards and debit cards. You could transfer the currency to anyone around the world without the high wire fees at banks. Although virtual currencies hold promise for the future, Bitcoin’s design will not allow it to be successful.
    Here are five reasons why Bitcoin is not the virtual currency of the future:
    1. Bitcoin is Not a True Medium of Exchange
    Money has to have certain properties to be called money. Money needs to act as a medium of exchange. If you take Won currency into eMart in South Korea you can exchange it for anything at the store. Likewise, you can do so with Won currency anywhere in South Korea. The Won is a true medium of exchange in South Korea. Can you use your Bitcoin at eMart? No. Can you use it at other stores in South Korea? Maybe a handful. There are only a handful of places in the world that accept Bitcoin. There are so few, in fact, that when someone does announce that they are accepting Bitcoin, it makes the news. Cyprus University became the first known university to accept Bitcoin. I never heard of this university before reading that article. Bitcoin has to be widely accepted to meet the medium of exchange criteria. The demand for Bitcoin that is driving its price above $1,200 is not due to its desirability as a medium of exchange. When looking at Bitcoin’s value as a medium of exchange it is certainly worth less than $1 because the US Dollar is enormously more successful as a medium of exchange. Although Bitcoin is terrible as a medium of exchange, it is fantastic as a marketing tool. It seems that all you have to do is announce that your company or institution is accepting Bitcoin and you make international headlines. Richard Branson is no stranger to clever marketing and recognized Bicoin’s value as a marketing tool. He recently announced that his Virgin Galactic is now accepting Bitcoin to buy tickets into space.
    2. Bitcoin is Not a Good Numeraire
    Another property of money is that it is a numeraire. You can easily count your money to measure your wealth and compare it to others. Forbes publishes its annual list of the World’s Richest People. Because money is countable, you can measure how much you have or measure who has the most. Sure, you can also count how many Bitcoin you have, but it is not as reliable as counting in other currencies that are much more widely used and much more stable in value. If you try to measure your wealth in Bitcoin it will fluctuate as wildly as the price of the currency itself, which we mentioned was less than $1 a few years ago and is now greater than $1,200. Bitcoin does not satisfy this property of money either. Again, in measuring Bitcoin’s value as a numeraire, it is certainly worth less than one US Dollar, which is widely used and relatively stable.
    3. Bitcoin is Not a Good Store of Value
    The third property of money is as a store of value. If you have more money than you need today, you can simply save it for the future. You can put it in the bank or under the mattress or wherever you’d like. You are storing money for later use, and because money has value, it’s a store of value. You can also store Bitcoin. Bitcoin are stored in a virtual wallet. The virtual wallet could be on your phone, your computer, or even a virtual bank. Part of the reason the Dollar and the Won are a good store of value is that they are relatively stable and widely accepted. You can put your Won in the bank for several years and feel fairly confident that you can take it out later and buy what you need with it. Dollar and Won deposits are also insured by the government. Bitcoin deposits are not insured and there have been reported cases of hackers breaking into computer systems and stealing Bitcoin. Additionally, the fact that Bitcoin’s price is unstable and the fact that you can only use it at a few places like getting your degree at the University of Cyprus and then shooting yourself into space, limits its appeal as a store of value. Again, as a store of value the Dollar is much better than Bitcoin, so Bitcoin’s value in this regard should be less than $1.
    4. Bitcoin is in a Speculative Bubble
    Supply and demand determine the price of financial assets. The supply of Bitcoin is created by a process called mining. If you mine for Bitcoin you can earn Bitcoin, just like mining for gold could get you gold. To mine for Bitcoin you lend the use of your computer to help process and authenticate Bitcoin transactions. Unlike Visa or Mastercard, for example, there is no central payment processing computer system that verifies and approves transactions. Bitcoin uses a dispersed network of volunteered computing power to do this. In return for this you can earn Bitcoin. However, it turns out that mining for Bitcoin gets harder and harder over time. It’s been estimated that if you use your personal computer to mine for Bitcoin that it could take several years to earn a Bitcoin. The electricity you consume in trying to mine for Bitcoin may actually cost you more than it’s worth. There is also an arbitrary supply cap of 21 million Bitcoin. This means that after the 21 millionth Bitcoin has been mined, there will be no further Bitcoin produced. Thus, the supply of Bitcoin is increasing at a decreasing rate.
    On the demand side we’ve already shown that the demand for Bitcoin has nothing to do with its value as a medium or exchange, a numeraire, or a store of value. In other words, the demand for Bitcoin is not the result of wanting to use it as money. The demand for Bitcoin is purely for speculative purposes. This is a classic bubble that will burst once enough people realize that Bitcoin is no more valuable than a Dollar bill.
    5. Bitcoin is Allowed to Float Against Other Currencies
    I believe that one of the design flaws of Bitcoin is that it was immediately allowed to float against other currencies. An economy can’t survive a wildly fluctuating currency. This is why central banks will intervene to stabilize their own currencies. An unstable currency is bad for business. It’s also very bad for Bitcoin. Imagine a store like Wal-Mart trying to accept Bitcoin. They would have to somehow constantly update their Bitcoin prices on thousands of products several times a day. The cost of doing so would greatly outweigh the benefits of accepting Bitcoin. If you want a virtual currency to be widely accepted, it needs to be stable. The best way to do that is to fix the value of the virtual currency to the value of the currency in the economy it’s operating in. In other words one unit of virtual currency should equal one Dollar. This makes it easy to implement for merchants, who would otherwise have to have two sets of prices on everything. Because there is no central authority that can intervene to stabilize the value of Bitcoin, Bitcoin will never be stable and therefore can never be widely accepted as a medium of exchange.
    Bitcoin is doomed to crash and burn. It is a speculative bubble. Its free floating nature leads to instability, which will prevent its widespread use. Its true value is less than the value of one US Dollar because the Dollar is so much better in terms of the functions that money must serve. Accepting Bitcoin, in the short-run, does appear to attract a lot of attention to your business and may therefore be an excellent marketing tool. It has also done a great job of getting news out about a virtual currency. All that needs to be done is to create a new virtual currency that addresses the pitfalls of Bitcoin.
    The 3 Things Needed for a Successful Virtual Currency:
    1. The Virtual Currency Should Have a Reliable Institution Backing It
    2. The Virtual Currency Should be Completely Stable
    3. The Virtual Currency Needs a Virtual Bank With Insured Deposits

    Part of the reason the US Dollar is such a reliable form of money is that it is backed by the US Government. The central bank of the US will intervene in currency markets to stabilize the Dollar if needed. You don’t necessarily need the backing of the US government to have a successful virtual currency. For example, Apple could launch a virtual currency called iMoney. You could buy iMoney with US Dollars. Apple would back iMoney such that the value of iMoney would always equal the value of 1 US Dollar. If someone offers you less than $1 for your iMoney, you could sell it back to Apple for $1. Therefore, iMoney would never drop below $1 in value. If someone wanted to buy iMoney they would never pay more than $1 for it because Apple stands ready to sell iMoney for $1. iMoney would therefore be stable in value and backed by an institution that is trusted. A stable virtual currency backed by a reputable institution will lead to greater adoption of that currency by merchants. Merchants would pay a fee for iMoney transactions similar to, but much smaller than, Visa or MasterCard transaction fees. Apple in turn would use some of this iMoney profit to purchase insurance on iMoney deposits. Your iMoney would then be protected against theft if it is stored in the iBank, just as your US Dollar deposits are insured when deposited at a bank. The iPhone 5S would be a perfect way to use your virtual currency. You go to the checkout counter at the store. The cash register connects to your iPhone via Bluetooth or some future technology. You place your finger on the fingerprint scanner and the virtual currency is transferred from your iPhone wallet to the store’s iBank account.
    Alternatively, Samsung could do the same with a sMoney virtual currency that is fixed in value to the Won. They would launch it in South Korea. South Korea, having some of the most tech savvy consumers in the world would be the perfect place to launch such a virtual currency.
    Brian Sullivan is an Assistant Professor of Finance at Hallym University in South Korea. He is a graduate of both The University of Chicago Booth School of Business and The University of California at Berkeley. His wife is from the Philippines.
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