Bitcoin believers v sceptics

At the heart of the debate is the idea that the cryptocurrency derives its value from its use as a payment system – a new and improved Visa or PayPal – and as a new form of fiat currency. How well it provides advantages over these may well be the defining factor in whether Bitcoin is a good investment.
 

A better way to pay?

As a payment system, Bitcoin is a way of getting money from one person to another, rather than a currency itself. So, when you buy or sell Bitcoins to make a transaction, you are in fact trading the tokens attached to Bitcoin’s payment protocols. These tokens can then be converted back into the native currency of the buyer and seller in the transaction.

Rather than having a central clearing house – like those used by traditional payment systems – Bitcoin has a decentralised network of ‘miners’ that contribute processing power to make transactions.  Miners are rewarded for this service in Bitcoins.

This means that there is no single, overarching authority managing Bitcoin transactions. No one owns Bitcoin, and in the eyes of believers, this frees it from some of the limitations attached to other forms of payment.

For example, there is no ‘institutional risk’ that the company controlling Bitcoin might collapse. Additionally, no single institution sets the fees for Bitcoin transactions – Bitcoin exchanges can compete to set fees as they wish, which should theoretically keep transaction prices low. 

However, in practice things are not quite so straightforward. Transaction fees for Bitcoin are, in fact, quite high compared to other forms or payment. The number of Bitcoin miners contributing processing power for making transactions is relatively small, and so when there are a lot of transactions happening, the laws of supply and demand kick in. When there are more transactions than processing power, miners will prioritise users who are willing to pay more.

With demand for Bitcoins taking off in the last few months, the cost of making transactions has risen to as high as $40 per transaction, according to bitinfocharts.com. A little high if you are trying to buy a sandwich for lunch. By comparison, debit card transactions typically cost around 30 basis points of the transaction – a £4 sandwich might come with a transaction cost of around a penny.

In addition, the number of transactions that can be processed each minute is limited by the way Bitcoin is designed. Only about 2,000 transactions can be contained in each block in the blockchain, so the more transactions there are the more blocks there are to process. Currently, it can take up to 92 minutes to process a transaction, but transactions times recently peaked at almost 24 hours. Compare this with Visa which is widely quoted as being able to process 50,000 transactions per second. 

 
The new gold?

According to its backers, Bitcoin, like gold, shares characteristics with both currencies and commodities. Like a currency, it can be exchanged with other cryptocurrencies and used as form of payment. Like a commodity it requires energy to extract (‘mine’). And like gold, its quantity is limited and no government can inflate away its value by issuing more of it. Its value as money should therefore derive from its use as a store of value and as a medium of exchange.

However, in addition to the issues of transaction costs and trade confirmation times, its exponential rise has led to extraordinarily high levels of volatility. Its recent 30-day volatility (a standard measure of how risky an investment is based on the variability of returns) is above 120, compared to around about 6.5 for 30-day volatility of sterling versus the US dollar. 

On some days, if you had ordered a book in the morning the value of the Bitcoin you used to pay for it could have fallen by a third by the time it gets delivered. This makes pricing items in Bitcoins a nightmare; vendors could potentially make huge losses, although some have probably made huge gains.

Either way, it adds a level of unpredictability to transactions that’s clearly putting retailers off. The number of major e-commerce retailers supporting Bitcoin is low, and in fact declining.

This is a very dangerous circumstance for anyone holding Bitcoins, as the price is very vulnerable to manipulation. It would only take a few comparatively small transactions by a few individuals to see the price plummet.

As it stands, the division between believers and sceptics is also a division between retail investors on the positive side, and institutional investors on the negative. While this may be an example of the establishment protecting itself against the new disruptive technology, it’s surely significant that professional investors have remained on the side lines and have been unwilling to make any significant bet on Bitcoin.

In the struggle between believers and sceptics, we remain firmly on the side of the sceptics. Bitcoin’s value does not seem justified by its role as money, payment system or commodity and we struggle to assign a fair value to it. While some form of cryptocurrency might, in the future, co-exist with traditional currencies, it is our view that Bitcoin, in its current form is unlikely to be one of them.