The anonymous little Bitcoin has been getting a lot of press recently. For an internet currency that has been around since 2009 it is suddenly very popular – and worth a lot of real actual money. Bitcoins are a brilliant technical concept designed to create a new, digital currency that essentially cuts out the middleman—values of Bitcoins are established online, peer to peer. There are no central banks, and at least for now, there is no government involvement. Like standard currency, Bitcoins can be traded or used for purchases, but only with those sellers who will accept them.
This is where it starts to get a little weird. Unlike traditional currency, that’s backed up by something, (be it gold, silver, or a central bank), Bitcoins are generated out of thin air. Through a process called “mining,” a little app sits on your computer and slowly—very slowly—creates new Bitcoins in exchange for providing the computational power to process transactions. When a new batch of coins is ready, they’re distributed in probabilistic accordance to whomever had the highest computing power in the mining process. The system is rigged so that no more than 21 million BitCoins will ever exist—so the mining process will yield less and less as time goes on, and more people sign up. This makes the whole system a lot sweeter for early adopters.
Just like you can trade in yen for dollars, you can swap your BitCoins with other users for several “real world” currencies. And right now, the BitCoin is trading very high! When we first published this post in May 2011, one Bitcoin was worth $7.50. Today it’s over $250. And climbing. And climbing and climbing. Not too shabby—the world is starting to see its first Bitcoin millionaires.
But like any bubble—or perhaps more so than most bubbles—the digital coin rush could collapse at any moment, leaving a lot of people with a lot of virtual nothing. And there is more and more talk that this sudden surge in Bitcoin value is more than another bubble. The one fundamental truism of investing, and the one most often ignored, is this: the higher the returns, the higher the risk.
Put simply, despite all the hullaballoo, Bitcoins are not a currency, at least in any traditional sense of the word. Rather, they have transformed more into an investment, like a stock. I could certainly purchase items with shares of Google Inc.—I would just have to find a seller willing to accept them—but no one would rationally say that makes stock into a currency rather than an investment.
The essence of a currency is a rational expectation of relatively stable valuation. Yes, values can collapse or soar, but those circumstances relate to unusual events and, for the most part, are widely predictable ahead of time. Outside of those circumstances, the values of valid currencies tend to fluctuate within a reasonable range. There are several reasons for this, including the existence of central banks, which can act to preserve the integrity of their national currency. But more important is the rich and liquid markets for nationally backed currencies, with traders buying and selling based on floating exchange rates. When one currency—say the yen—rises in value against the dollar, a trader might sell it for a profit, then purchase the now cheaper dollar. Or, if, say, the dollar were to start collapsing, the Fed could intervene in the market and purchase quantities of the currency to stabilize it. But it is almost incomprehensible to imagine that 100 yen would be worth $1 on Monday and then be worth $5 on Tuesday. That is the kind of daily value change seen in stocks.
What caused the unprecedented jump in value seen in the chart above? The general consensus is that the financial crisis in Cyprus, which led to proposals to raid domestic bank accounts, set off a panic among Spaniards, who feared that the tumult would cross the Mediterranean and put their savings at risk. So large numbers of them converted their euros into digital Bitcoins.
Hoarding has become a common feature of the Bitcoin market, as purchasers hold on to the investment in hopes that the prices will keep rising. One comprehensive study released last October found that more than three-quarters of all Bitcoins—78 percent—had been stuffed into virtual mattresses and taken out of circulation. In other words, in a system where supply and demand dictate prices, the available supply in the market is far less than might be imagined.
In essence, the market is a fantasy. Once the hoarders stop buying, what buyers will step up to the plate to take their place? My bet? No one. There will be, at some point, a time when some hoarder decides to unload. Prices will drop. Other hoarders will get scared and start to sell. Prices will drop further. Before long, there will be a mass rush to the exits. And at that point, the illiquidity of the Bitcoin market will be apparent.
This entire scenario that has unfolded over the past month does fit the model of one of the most famous investment bubbles in history, the tulip-and-bulb craze. It took place from 1634 to 1637, a few decades after tulips were brought from Turkey to the Dutch. A virus changed the colors of the tulips, making them very popular. Prices began to rise as people bought more and more tulips. Hoarders (the tulip-bulb centers) began loading up on them, driving up the prices as demand increased and supply dropped. Then tulip investors who had huge paper profits decided to lock them in by selling. And the price dropped. Which led to more sales, larger price drops, and on and on. By the time the downward spiral ended, tulips were back to being flowers—not investments—and the bulb investors were wiped out.
In essence, the tulip-bulb bubble was based only on the fact that buyers and sellers decided—peer to peer—that these flowers had ridiculous values. It was nothing more than an agreement in thought. Bitcoin fans admit that the currency has value only because the users in the Bitcoin market think it does but say that that is no different than in the markets for dollars, yen, and other national currencies. And that is absurd. There is no country, no national bank, nothing standing behind the Bitcoin valuations other than other Bitcoin investors. If the dollar falls, the Fed will jump in. And if the Bitcoin falls? Well, on to the next big thing.