Are Crypto Currencies here to stay? The invention of a digital currency is certainly a fantastic development. There are significant pluses to a market for new breeds of currencies. Bitcoin is the most established so far. Listed below (at the end of this post) are two articles that help define the mechanics and utility of using bitcoin, the most advanced digital currency in terms of participation. Yet, questions remain regarding the various motivations for owning a digital currency such as Bitcoin.
Considering diving into the Crypto market? Here are the key areas to examine:
- Why is there so much volatility in the price of Bitcoin relative to the US dollar?
- Will the limitations on supply hold together for Bitcoin, and what about other newly developing digital currencies?
- Is Bitcoin a good hedge against rising inflation? Really?
- Is Bitcoin a substitute for traditional cash? It has utility value, but is this enough?
- Does block chain computing provide the assurances that make Bitcoin a transparent marketplace?
VOLATILITY:
Volatility can be useful for trading desks established to leverage the crypto craze. But if you are a pedestrian in this market, volatility is not a friend. Why so much volatility?
Back to microeconomics. If supply is limited or fixed and does not respond to more creation due to higher prices, we call this highly elastic. And a small change in demand makes for a large increase in the price. Miners do not create more bitcoin in response to higher prices. This is a plus and a negative at the same time. Knowing the supply helps investors hold on to the value, but it also creates liquidity issues in the market. A steady supply helps defend against the traditional currencies’ behavior as central banks create money for promotion of economic activity. Currencies can weaken relative to other currencies which helps promote trade but at the expense of other countries with stronger currencies.
LIMITED BITCOIN SUPPLY AND OTHER ENTRIES:
The rules are that no more than 21 million Bitcoin will exist in total. Currently, there are 18 million in existence. The limit is enforced by a rule in the source code. Who is in charge of this and will there be potential for some alteration of the rules by a future conglomerate is a current topic of speculation. As miners run out of supply, they will be incentivized to continue to support the market by earning a fee for transactions. Their computing power is a large part of the market. So, even with the limitation on Bitcoin supply, future scarcity is a big motivation for investing in this market. However, there may be other new digital currency entries competing with fresh supply of their own digital currency. This bears watching! It is worth mentioning that Bitcoin will not change in price due to a trade war motivating a country to weaken its currency, despite the Bretton Woods agreement. Bitcoin will hold its value as other currencies face policy decisions.
INFLATION HEDGE OR NOT?
The whole idea of a hedge against inflation stems from owning an asset that is limited in supply and will richen relative to other assets that reflect a decrease in purchasing power. So, if the dollar-based economy experiences by example, 5% inflation, the dollar will lose 5% of its purchasing power. Bitcoin however, will not as it rises 5% to offset the dollar inflation. Limited supply does the work. Gold has been a traditional inflation hedge asset, and still works as such. There is about 10 times more gold supply than Bitcoin at this time. Bitcoin is more “precious” given its relative supply. By the way, diamond miners would only release small quantities into the market as their primary issuance in order to preserve the marginal cost of buying a diamond for your loved one. “A Diamond is Forever” advertising kept the existing supply off the secondary market. Clever! See similarities? Trouble is, that the volatility of price swings, mostly trending to higher prices due to evolving inelasticity of supply, swamps the price changes reflecting inflation expectations in other currencies.
BITCOIN AS CASH:
Cash is what Cash does. Years ago, our dollar bill values were backed by gold as assurance that the paper money was good. Soon we went past that constraint in order to work with enough cash to keep the economy moving. Faith and credit of the US Government backs the paper money these days. Digital currencies have no backing such as gold except the demand for a cash-like asset that supposedly enables easy and transparent transactions. A day will come when enough selling occurs that the faith in this derivative will falter with no central bank or government as a backer. It can happen.
The transferability of crypto currencies around the world with just a few clicks is fantastic. There is no institution to go through to make these transactions. That makes Bitcoin a nice version of cash. I used to work on a funding desk at Chase in my early career. There is a market for money and cash equivalents, where you buy money by paying interest or sell it to receive interest. It was exciting stuff, buying money to fulfil the bank’s needs. The Federal Reserve was a standby money supplier, if need be, and they would also feed the economy extra cash through open market operations. There is no such protective process in a digital currency. Instead of interest to be paid for a short while to attract enough cash equivalency, the price fluctuates as the demand in a digital currency rises due to demand for cash equivalency. Your need to pay in dollars converting from Bitcoin can catch one of these upticks in price and may or may not change the willingness to use a digital currency as cash. It’s like cash in transaction mode, but it’s not in the sense of certainty in value.
As mentioned above, the US dollar left the gold standard in order to continue to facilitate cash needs as we outgrew the limited supply and challenges of moving gold around. Are we going back to a gold standard with Bitcoin? Like the gold standard, there was virtue in a limited supply. And there was faith that gold would hold its value as a backer of the paper money. Bitcoin is similar to a return to the gold standard in that it is a precious asset supply-wise. On the other hand, Bitcoin is a form of cash that does not receive the full faith and credit of the US government which can sell trillions of dollars of bonds to demonstrate the extraordinary faith the world has in the US government’s ability to pay it’ debt. The faith in Bitcoin as an asset is a floating variable.
BLOCK CHAIN:
Given the sheer computing power needed for the world to see every transaction, the miners have a role in producing bitcoins. They require a huge computing engine to capture cumulative ordinary transactions. Block chain computing is enormous and is a reliable limitation on the primary issuance while proving a picture of the market as a huge single ledger and therefore transparent. You get to see every transaction and prices reflect more perfect information than routine financial markets, I believe. Transactions list an account, but you do not necessarily see the person or entity doing the transaction. Bitcoin or perhaps other digital currencies grew from the movement of monies out of the sight of regulators or Justice Departments. This nefarious activity footed the beginning of the Bitcoin craze and may well continue to this day. It was not long ago that managers of money and the bank relationships they held began to be required to adhere to KYC rules, a crypto verification process overseeing crypto companies. They had to know the client and demonstrate it through reporting. I recall one interested investor actually asking if we would manage some money from entities such as North Korea. We said a quick no, a goodbye and moved on. Can you know your client in Bitcoin? Maybe not always. Should you? Yes.
Fantastic as it is, there is more to be proven with crypto currencies and perhaps other future products.
https://www.investopedia.com/tech/what-happens-bitcoin-after-21-million-mined/
https://www.coinbase.com/learn/crypto-basics/what-is-cryptocurrency