Bitcoin has proven to be a phenomenon of the modern financial system that will just not go away. Despite a rollercoaster ride for speculators and holders of the alternative currency, interest in Bitcoin and other cryptocurrencies is again reaching record highs.
Bitcoin, along with a range of other cryptocurrencies, have emerged in the last few years with proponents proclaiming them to be a viable alternative to the fiat currencies issued by central banks across the world. Buyers of bitcoin range from speculators, who see an opportunity to capitalise on high returns in short periods of time, to those that see it as a future of our economic system.
Cryptocurrencies, such as Bitcoin, were developed in order to offer an alternative to mainstream central bank-issued currencies, such as the British pound and US dollar. It is claimed that the issuance of a decentralised currency would allow people to transact in a more secure way without the value of their capital being determined by central banks and governments who set monetary and fiscal policy. They are underpinned by blockchain technologies, which through highly secure encryption, enable secure anonymous transactions to take place electronically.
Bitcoin was adopted for use early on by criminals using the dark web as a way of avoiding scrutiny by authorities. This opens up a broader question, which is, do we as a society, truly want anonymous financial transactions when it comes to criminality and funding of terrorism, for example. This raises both interesting legal and philosophical questions and highlights the difference between an individual’s natural desire for a degree of privacy against the need for transparency and openness when it comes to maintaining trust in transactions for society as a whole.
However, putting these legal and philosophical issues aside there are some serious problems with the premise behind cryptocurrencies, which investors should be aware of before putting their capital at risk. When central banks issue currency into the economy, this is carefully monitored and matched against the value of goods, services, and labour in the market. By judicious use of financial levers, such as the setting of interest rates and the various taxations applied, governments and central banks can aim to effectively control inflation and the availability of capital. This is a critically important factor within the functioning of an economy and widespread use of cryptocurrencies would deeply undermine this by negating the central bank’s ability to control the level of money supply in the economy.
Additionally, there is another major stumbling block that stands in the way of widespread adoption of cryptocurrencies. Governments demand payment of tax in domestic currency. This means that even if an individual were to be paid and carry out their day-to-day transactions in bitcoin they would still need to convert a large percentage of their funds into the domestic currency to pay their tax liabilities. This would mean that the value of bitcoin would always be viewed relative to the value of the domestic currency rendering it as a second-tier currency despite how widespread or popular it may be.
In addition, there is also a fundamental problem attached to bitcoin in the way that users generate new currency. Ever-increasingly complex cryptography algorithms must be solved in order to “mine” or unlock new bitcoins. This requires immense computing power with huge costs in terms of hardware, storage, and electricity consumption.
To give you an idea, it has been calculated that Bitcoin mining currently uses around seven gigawatts of electricity, equal to 0.21% of the world’s supply. That is as much power as would be generated by seven Dungeness nuclear power plants at once. Over the course of a year, this equates to roughly the same power consumption as Switzerland.
This limitation of the ability to produce new Bitcoin could also create problems if sufficient money supply cannot be created to keep pace with economic activity or trigger deflationary pressures.
This year has seen a dramatic increase in the level of interest with British investors exchanging 38 times more sterling value for Bitcoin than this time last year according to Kraken, a popular cryptocurrency exchange. This has seen the value of Bitcoin soar to just under £18,000 this month.
In a year that has seen huge global turmoil, uncertainty is driving the demand for Bitcoin. However, this does not strengthen the case for the widespread adoption of Bitcoin across economies.
There are of course those who point to the blockchain technology as being factor that underpins cryptocurrencies. However, the reality is that increasing numbers of governments issue the bulk of their currency digitally, and banks and financial institutions already use highly advanced levels of encryption, including variations of blockchain technology, when carrying out transactions around the world. On the back of the coronavirus pandemic, we have already seen reduced levels of cash with some retailers preferring to handle transactions electronically wherever possible.
This trend is likely to continue and we may well see a fully cashless society within the next five to ten years. This will almost certainly take the form of a fully digital version of existing currencies issued by central banks rather than a wholesale switch to bitcoin.
It is always tempting to try to jump on a bandwagon, especially when you see prices rising so quickly. A phrase to remember is that ‘if you see the bandwagon coming to town – then you’ve missed it’. It is exactly at this point you should be most wary and where there is most risk in jumping in late. Get rich quick schemes rarely work out and our advice to investors is to stay focused on long-term market fundamentals and financial objectives and avoid being distracted by a sideshow, albeit a very interesting one.
If you would like to discuss your own investment strategy in more detail, then please contact us and one of our Wealth Strategists would be pleased to speak with you.