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Kristina Hooper | December 12, 2017

Bitcoin: Digital currency or digital tulip?

Now, for the first time, investors are able to purchase futures on bitcoin, the digital currency. The Chicago Board Options Exchange just began offering derivatives contracts which provide the ability to bet on the future price of this cryptocurrency. The CME Group will also be offering derivatives contracts on bitcoin in the coming week. Investors seem to be excited about this opportunity, sending the price of a single bitcoin thousands of dollars higher in the past several weeks in anticipation of the launch of these futures contracts.

Opinions are split on bitcoin

Opinions differ dramatically on the potential of bitcoin. Some argue that it will become ubiquitous – the currency of choice for the world – while others argue that it is yet another fad, akin to the tulip mania that hit Holland in the 1600s, or even the Pet Rock craze of the 1970s. There certainly is some support for both arguments. Proponents of bitcoin point to it as “the people’s currency” because it is a peer-to-peer system that doesn’t involve any central banks or third-party administrators. In fact, it was launched in early 2009 as a swift response to the global financial crisis and the loss of trust in institutions. It is also touted as being virtually “fraud-proof” because transactions are recorded in a distributed ledger; in other words, when a transaction occurs, it is verified and then copied, encrypted and transmitted to other computers.

However, there is also validity to some of the criticisms of bitcoin. Lack of control by a central bank means that bitcoin could present risks to markets that would be more difficult to address. China is becoming increasingly concerned about this, which is why it announced the shutdown of its cryptocurrency exchanges back in September. Bitcoin can also enable criminal activity because of the anonymity of its system. Anecdotally, I have heard of many entities, including police departments, being asked to pay “ransom” in bitcoin to their hackers.

Bitcoin critics may recall that this is not the first foray into some form of digital currency. Some may remember back in the late 1990s, an “Internet currency” was developed called Flooz. It was created expressly for e-commerce purchases – the idea was to create a currency unique to Internet merchants. It received significant attention at its inception, with Whoopi Goldberg featured as a pitchwoman in its commercials. Interestingly, but perhaps not surprisingly, Flooz became the currency of choice for some criminals, particularly a Russian organized crime syndicate. Flooz ceased to exist in August 2001, a victim of the bust and its role as an unwitting conduit for criminal activity. In addition, there is growing criticism that the energy used to “mine” a bitcoin is very large – and growing. There is also the potential for investors to move away from bitcoin and instead focus on a different cryptocurrency such as ethereum once futures contracts are offered on it as well. Finally, bitcoin might face serious competition from a central bank-created cryptocurrency; the Fed has talked about the possibility of launching a digital currency such as “Fedcoin.”

Is bitcoin in a bubble?

Whether one is positive or negative on bitcoin, many are likely to agree that it is not really a currency. Merriam-Webster defines a currency as “something (such as coins, Treasury notes and banknotes) that is in circulation as a medium of exchange.” It is difficult for bitcoin to be used as a medium of exchange given the dramatic price fluctuations it experiences. After all, why buy a pizza or a car or anything else with bitcoin if one is not sure whether the price of bitcoin will go up significantly in the next week?

I would argue that bitcoin has characteristics that make it less like a currency and more like gold. Like gold, bitcoin has to be “mined,” an increasingly labourious digital process that unleashes blocks on a blockchain (the digitized ledger of all cryptocurrency transactions). Like gold, bitcoin has no intrinsic value; its value is dictated by the laws of supply and demand – how much traders are willing to pay for it. However, it is important to note that gold has some distinct advantages over bitcoin, particularly its use by central banks as a way to support the value of their respective currencies. In fact, central banks are one of the largest buyers of gold. Some have even argued that gold is like a “reserve currency” in that it is accepted by virtually all countries. In addition, gold plays a role as a “safe haven” investment – a hedge for some “worst case” scenarios. In those kinds of scenarios, the tangibility of gold over bitcoin would arguably make it far more popular. So one can argue that while gold can be considered a speculative investment, bitcoin can be considered a far more speculative investment.

And, if bitcoin is a speculative investment, we must then ask if it is in a bubble. If we were to apply the Kindleberger framework for the five phases of a bubble, we certainly haven’t seen them all yet, but we are well on our way with bitcoin, in my view.

  • The first stage, displacement, occurred almost a decade ago when bitcoin was created in response to the global financial crisis.
  • The second stage, the boom, has already occurred as investors have become excited about an alternative to traditional currencies, a prospect that carries with it the possibility for very significant change (just as we saw when investors became electrified by internet stocks in the late 1990s or when Dutch investors became excited about rare tulip bulbs in the 1600s and purchased futures contracts on them).
  • The third phase, euphoria, is arguably where we are at today. In this phase, people become aware that money is being made through investments in bitcoin and become convinced they will make a lot of money as well; this is evidenced by the price of one bitcoin rising thousands of dollars in the course of a few days.

I believe we will need to tread lightly with bitcoin, given the next two phases – profit-taking and panic – are a lot uglier. The reality is that bitcoin is not realizing the rationale for its creation, which was to provide an alternative currency not subject to the vagaries of central bank decisions or profligate government spending, but that doesn’t mean it won’t have staying power as a speculative investment.

It may just be that, behaviourally, humans are prone to getting caught up in a speculative investment craze once every generation. We can put bitcoin into perspective by revisiting the parabolic rise in the price of gold in the late 1970s – or the enormous run-up in internet stocks in the late 1990s. Gold and internet stocks (or at least some internet stocks) are still around today, so it wouldn’t surprise me if bitcoin has staying power as well. However, I think we will continue to see wild price swings in 2018. Some have already made fortunes with bitcoin, and there may be more fortunes to come; however, there will likely be many who experience significant losses with bitcoin as well.

Key takeaway

In short, I believe bitcoin is less a digital currency and more of a digital tulip. In other words, I believe bitcoin and other cryptocurrencies will remain popular, but they are a very risky investment. Given their popularity, I expect we will see far more regulation of them going forward. There may be a time when cryptocurrencies will make sense as a non-correlated asset class in an investor’s portfolio, falling into the “alternatives” bucket. However, that day is certainly not upon us now, and I don’t believe that it will be any time soon.

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Tulip mania refers to the time in 1600s Holland when the prices of tulips soared to extreme highs, then crashed.

Charles Kindleberger was a retired MIT professor who wrote the book “Manias, Panics and Crashes”.

Cryptocurrencies are digital currencies that use cryptography for security and are not controlled by a central authority, such as a central bank.

Bitcoins are considered a highly speculative investment due to their lack of guaranteed value and limited track record. Because of their digital nature, they pose risk from hackers, malware, fraud, and operational glitches. Bitcoins are not legal tender and are operated by a decentralized authority, unlike government-issued currencies. Bitcoin exchanges and Bitcoin accounts are not backed or insured by any type of federal or government program or bank.

Fluctuations in the price of gold and precious metals may affect the profitability of companies in the gold and precious metals sector. Changes in the political or economic conditions of countries where companies in the gold and precious metals sector are located may have a direct effect on the price of gold and precious metals.

Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

The opinions referenced above are those of Kristina Hooper as at December 11, 2017. These comments should not be construed as recommendations but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

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