Bitcoin, hailed by some as the future of money, has grown since 2009 from a relatively unknown niche traded on the ‘deep web’ to a global phenomenon, entering the mainstream.
Bitcoin futures can now be traded on the Chicago Board Options Exchange (CBOE), enabling investors to bet on whether Bitcoin prices will fall or rise. However, there are fresh warnings that Bitcoin’s meteoric rise is a bubble, and there are huge risks involved for investors.
Bitcoin is a ‘cryptocurrency’ which means it’s a digital currency in which encryption techniques are used to regulate the generation of units and verify the transfer of funds.
Rather than being supplied by a central bank, as normal currencies are, bitcoins are created by a process known as ‘mining’, which involves solving complicated algorithmic searches with computers.
These algorithms determine the rate at which new bitcoins are created until they reach a maximum limit of 21m in the year 2140.
A great diversifier?
The stellar performance of bitcoin in recent years has prompted some to consider whether it should be treated as a mainstream asset in the same league as traditional investments, such as equities or fixed income investments.
As the economy moves in an increasingly digital direction, shifting away from cash transactions towards digital payments, the growth of cryptocurrencies could continue, potentially causing prices to rise and a positive expected return.
On the face of it, bitcoin also appears be a useful diversifying asset for investors, as its performance appears so far relatively uncorrelated to most traditional asset classes. However, correlations should always be treated with caution, given how unstable they can be. Bitcoin has also only been around for a short period of time, so it’s difficult to make any firm conclusions at this stage.
Proceed with caution
There are plenty of risks from treating bitcoin as a mainstream asset, and, in our view, these far outweigh its potential benefits.
Importantly, bitcoin’s value is based only on the market’s expectations of it eventually maturing into a credible currency on a par with traditional currencies such as sterling and the US dollar.
There are several other cryptocurrencies available, such as Ethereum and Ripple, so it’s too early to say how big a role bitcoin will play in the digital economy in years to come. To make a big bet on bitcoin’s future is therefore likely to prove just that: a gamble, not an investment.
It’s also worth noting that as the price movements of bitcoin are derived from speculation, it is highly susceptible to violent swings in sentiment and the formation of bubbles, as corroborated by academic literature,1 meaning investors need to brace themselves for a potentially very bumpy ride.
This huge volatility makes bitcoin virtually useless as a credible store of value, and means only the extremely risk tolerant may want to consider significant holdings. Remember that all investments can go up as well as down, and we might expect bitcoin to be more volatile still. You could get back less than you put in. If you’re unsure, seek professional financial advice.
The main appeal of bitcoin, and cryptocurrencies more generally, is that its supply, like that of gold but unlike paper money, is independent of any other authority.
That means quantitative easing (QE) whereby a central bank creates new money electronically to buy financial assets like government or corporate bonds, will never reduce its value. Supporters of bitcoin therefore argue that if the economy crumbles due to QE creating hyperinflation - where price increases spiral out of control - the world could eventually be forced to adopt a new monetary system, with all currencies backed by bitcoin.
However, almost a decade of unconventional monetary policy hasn’t led to hyperinflation,2 and a ‘bitcoin Standard’ would severely constrain a country’s discretionary management of its economy. For example, imagine the UK economy is in recession and the Bank of England wants to lower interest rates to stimulate the economy.
As currencies are fixed against one another, investors could potentially borrow bitcoin in the UK and then shift it to another higher-yielding country, therefore exploiting the price difference between the two. This would reduce the money supply in the UK, offsetting the Bank of England’s aim of boosting economic growth. The Bank of England is prevented from setting interest rates in the UK to be different from the global rate, and therefore wouldn’t be able to do anything to prevent negative shocks to the economy. Every central bank that tethers its currency to an external quantity would be affected in the same way.
To make things worse, as the total amount of bitcoin is limited to 21m, this finite supply would be perpetually chasing after an increasing amount of goods, leading to deflation. Deflation occurs when prices drop because the supply of goods is higher than the demand for these goods. Although this might seem appealing, as your money will go further and the real value of your savings will increase, a sustained period of deflation can be very damaging. Companies are often forced to cut their costs and therefore may need to make redundancies, and when people expect falling prices, they become less willing to spend and borrow, pushing the economy further into deflation.
Even if payments are fully digitised in future, in our view, they would likely be dominated by non-physical conventional currencies rather than cryptocurrencies like bitcoin.
Don’t be swayed by past performance
Although investment fads like bitcoin might appear tempting, especially given previous impressive returns, remember that past performance should never be considered a guide to future performance. Given its uncertain future and volatility, bitcoin should be treated with extreme caution. Given its inflexibility, a monetary system based on bitcoin is unlikely to be a desirable one.
If you’re unsure where to invest, seek professional financial advice.