December 21, 2017 12:46 pm JST
Stephen Grenville

Bitcoin bubble to burst

Asian regulators right to impose curbs, more warnings needed

The excitement generated by an epic technological adventure surrounding bitcoin is similar to the thrill of being the first to buy the latest iPhone. © Reuters

Bitcoin is not a substitute or alternative for conventional currency, and cannot become one. It cannot operate as an effective medium of exchange, unit of account, or store of value. Its use in crowdfunding is a gimmick. Like the 17th century Dutch tulip mania and other bubbles, this will burst sooner or later and the adventure will be over.

Those Asian central bankers and other regulators who have imposed curbs have been wise to do so. With China and South Korea leading the way, these authorities will find their prudence justified when the inevitable disaster strikes. Officials in the U.S., Japan and other jurisdictions who have stood to one side in the face of the advancing wave of speculation should put on the record an unambiguous opinion that this is a bubble which will end badly.

An effective medium of exchange must have widespread acceptance, convenience of use and credible stable purchasing power. Bitcoin's acceptance has not gone beyond novelty value. The blockchain technology and deadweight cost of the problem-solving competition between miners give it intrinsically high processing costs. And its value fluctuates wildly. Lack of stable purchasing power also makes bitcoin unusable as a unit of account. You do not want your home-loan contract denominated in a currency which gyrates wildly. After starting the year at $1,019, bitcoin hit a high of $19,966 this month before falling back to around $17,000.

Gamblers and believers

Almost everyone who bought and held bitcoin has done well so far. But that does not make it a good store of value, even if many idiosyncratic objects (rare postage stamps and Rembrandt paintings, for example) perform this function.

To be a reliable store of value, an asset should have an assured stable price over time, low safe-storage costs and a liquid market. Bitcoin has none of these attributes.

Why has bitcoin's price continued to rise? Most Silicon Valley startups are being constantly evaluated by sharp-pencil investors who are assessing the narrative of the startup's business plan. Bitcoin has managed to maintain its narrative, because it has a different set of investors: gamblers; those relying on the "greater fool" theory of investment; and true believers.

Linked to the undoubtedly revolutionary blockchain technology, investors are participants in an epic technological adventure. The excitement generated is akin to the thrill of being at the head of the queue to buy the latest iPhone.

Could bitcoin morph into a more useful form? Some startup tech companies offer their investors a version of cyber-currency instead of a share script. More than a thousand cryptocurrencies now exist, mostly as a result of these initial coin offerings (ICOs). But this is just a gimmick to associate the funding transaction with the ephemeral excitement of cyber-currencies. Crowdfunding may well develop as an important form of informal unregulated financing. But issuing ownership certification in the form of a useless cyber-currency will go out of fashion as soon as the bitcoin bubble bursts.

Nor can bitcoin find even a limited niche serving those who have compelling reasons to keep their transactions secret. Anyone using bitcoin has to interface with the conventional payments system when the bitcoins are initially bought and when the owner wants to get general purchasing power by selling bitcoin.

Does any of this excitement require a more active policy response? Most countries regard bitcoin as legitimate for citizens to hold and exchange among themselves domestically, while ensuring that their regulated financial institutions do not get involved.

Only a few countries have outright bans on bitcoin holdings -- Bangladesh for example. But many central banks have signaled their strong concerns about risks to investors and are alert to the potential use of bitcoin for tax evasion, money laundering or other illegal purposes. China has banned crowdfunding ICOs and has made regulation of bitcoin exchanges so tight that some have ceased operations. Hong Kong's securities watchdog is contemplating action. South Korean authorities, already discouraging of bitcoin use, will stiffen their attitude further after another hacking attack forced one of its bitcoin exchanges into bankruptcy this week. Singapore has taken measures to ensure that transactions do not remain anonymous.

"Act with extreme caution"

A People's Bank of China official said "it's scary to think about" what might have happened if China had not taken action. Just this week, the Monetary Authority of Singapore reminded its citizens that cryptocurrencies are not legal tender and "advises the public to act with extreme caution and understand the significant risks they take on if they choose to invest in cryptocurrencies." The Bank of Thailand and the Reserve Bank of India have been explicit in their warnings that bitcoin is not a currency and has inherent risks.

The U.S. and Japan have a more relaxed laissez-faire attitude, perhaps hoping for useful spinoffs, such as boosting venture capital and wider use of blockchain technology. The Japanese authorities maintain a low-profile watching brief on bitcoin developments. The U.S. Commodities Futures Trading Commission has endorsed trading bitcoin futures on two central counterparty exchanges, which exposes these exchanges to counterparty risk, although the margins are large and the transactions, so far, modest.

Some spinoffs are already proving useful. Blockchain will be used for the Australian Securities Exchange registry. Banks everywhere are working on blockchain applications and one Singapore bank will use this technology for migrant transfers. Outside blockchain, niche products in the payments system (such as PayPal) are providing some limited competition to bank-based transactions. Crowdfunding also has a place in the financial system. But bitcoin investment is something else: pure speculation without foundation.

How painful will it be when the bubble bursts? The holders who bought their bitcoins at low price should think "easy come, easy go." Others might have acquired their holdings via the various hacking scams that have occurred, so might have no grounds for complaint.

For those still holding bitcoin when the bubble bursts, a digital printout of their holdings can decorate their wall, alongside their pre-1949 Chinese government bonds and German Reichsbank notes from the inflation years of the Weimar period, as a worthless memento of their selfless contribution to the advance of blockchain technology and a reminder of the "madness of crowds."

Stephen Grenville is a non-resident visiting fellow at the Lowy Institute in Sydney and former deputy governor at the Reserve Bank of Australia

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