Should I get bitcoins?

Bonjour,

Bitcoins are everywhere in the news at the moment. The value of a bitcoin is above $800 (they were just $500 when I started thinking of this article), the Winklevoss brothers are launching a fund trading in bitcoins, a Canadian miner is paying with them .

I thought it would be time to have a look at it using two angles: first a pros and cons approach and then trying to check whether it passes the “money” test.

Pros and cons (not necessarily exhaustive)

1)      Pros

·         The number of bitcoins in circulation is predictable and will reach a ceiling, supporting its value, especially against global currencies

·         Fraud looks impossible unlike for banknotes or coins

·         It enables cheaper international transactions because there are no commissions or FX fees

·         The peer-to-peer model enables faster transactions at lower costs

·         It is convertible in any world currency without needing a dollar or euro backing. Which means there could be arbitraging opportunities across currencies

2)      Cons

o   Bitcoins can be stolen from your digital wallet if you are hacked

o   Like gold, bitcoins are deflationary (their value goes up with time since their supply is constrained)

o   Which means that many bitcoins users hoard them, hoping to see them appreciate. That way, bitcoins are not exchanged as intended and this “currency” will struggle to achieve sufficient velocity to be adopted by the mass

o   It remains to be seen whether it will become a truly accepted means of payment (see below)

The money test

According to many theories, money has 6 to 7 characteristics.

1.       It must be durable, which is why we don’t use wheat or corn or rice

=> Bitcoins are virtual and therefore durable. Test passed.

2.       It must be divisible, which is why we don’t use art work.

=>  Bitcoins can be divided down to 8 decimal places. Test passed.

3.       It must be convenient, which is why we don’t use lead or copper.

=>   Bitcoins are virtual and therefore convenient. Test passed.

4.       It must be consistent, which is why we don’t use real estate.

 Market value of bitcoins in linear scale since inception

Market value of bitcoins in logarithmic scale since inception

We can see that consistency is not present with massive swings. For instance, the value of bitcoins can drop 70% in a few weeks before tripling thereafter. This is not a predictable move. Test failed.

5.       It must be limited in the quantity that is available, which is why we don’t use aluminum or iron.

            =>  Bitcoins are “mined” according to a formula which implies that the number of bitcoins in circulation will increase at an increasingly slower pace going forward. Test passed.

6.       It should have a long history of acceptance, which is why we don’t use molybdenum or rhodium.

            =>Bitcoins were introduced in 2008 only and have become a headline subject this year really. Can a currency be judged over 5 years? This sounds unlikely and therefore this test is failed.

Until Amazon and large banks accept it on a regular basis, this will remain a financial product.

The last condition is often cited by monetarists and is overlooked by a number of economists. It tends to argue that only precious metals can be characterised as money.

7.       It must possess value in itself, which is why we don’t use paper.

            => Bitcoins fail this test but so do bank notes or coins.

Overall, out of 7 tests, 4 were passed. Out of the mainstreet 6 tests, 4 were passed.

I do not believe this makes it a money yet.

Conclusion

To me, bitcoins are a symptom of some fatigue with the current currencies such as high transaction costs, slow devaluation (due to the central banks quantitative easing) and a willingness to create a new world currency to replace the dollar.

Those points are not enough to make it a currency yet. However, this could prompt financial institutions to lower transaction costs to regain the initiative. In that sense, the bitcoins will have been useful to lower costs for the economic system.

With bitcoins buying institutionalised, bitcoins are losing their initial purpose. I would expect the bitcoin “mania” to ease progressively as financial institutions offer new transaction products.