This first of a two-part series about bitcoin examines its viability as a potential global currency. Part 2 looks at the impact of China’s recent bitcoin ban.
In 2009, bitcoin became the first cryptocurrency, or digital medium of exchange, to begin trading. Is it currency or a commodity? Is it a potential peer or a threat to existing currencies? Let’s take a closer look.
Bitcoin basics
Here’s a quick summary of the basics:
- Bitcoins are used to make payments between people sharing the online Bitcoin network. Users pay for products and services via a personal computer, mobile device or Web service.
- Transactions transfer ownership of the currency from one user’s account to another.
- Merchants have incentive to accept bitcoins because transaction fees are lower than the 2% to 3% typically imposed by credit card processors.
- Bitcoins are generated, or “mined,” online according to algorithms, and their supply is finite. They can be converted into other currencies, such as dollars, based on prices that are set in online trading.
- Bitcoins are created and traded independently; they are not associated with any world government or any bank.
- Speculators accumulate bitcoins on the chance their price will rise.
- Public key cryptography is used for security.
There’s a flip side to bitcoins, however — their use in illicit activity and theft of the currency have been covered extensively in the media and drawn scrutiny from law enforcement agencies. But illicit or otherwise, the use of bitcoins in commerce is currently small compared with their use by speculators, which has fueled price volatility.
Commodity or a currency?
Bitcoin is a type of privately created currency, which has often existed during different eras around the world. As economist and Nobel Prize winner Milton Friedman pointed out, it’s hard to name a commodity that hasn’t been used as money at some point. What differentiates bitcoins from earlier types of private currencies — such as rice, cowrie shells or tobacco — is that they’re a digital, or virtual, currency.
Potential global currency or threat?
Major currencies, such as the US dollar or the euro, meet the three minimum criteria for “money” because they:
- Can be used as an effective medium of exchange for a very wide range of transactions.
- Can feasibly be used as a unit of account, such as to measure income or wealth.
- Act as a stable store of value for savings and investment or for long-term contracts.
Bitcoin doesn’t measure up to these three standards because it’s not a stable store of value. In fact, measured in terms of these three key criteria, while bitcoins have started to be used as a medium of exchange (criterion 1), they are never likely to be used seriously as a unit of account (criterion 2). In addition, as we’ve seen in recent weeks since China banned the currency in early December — which I address in Part 2 of this series — bitcoins are highly unstable in value (criterion 3).
In my view, bitcoins aren’t a serious threat to any major convertible currencies because these currencies can each be used for all types of payments at home within their country of origin. Moreover, they can also be converted at free market prices without restriction into foreign currency for the purpose of making payments abroad. In my judgement, it never looked likely that bitcoins could become established as anything other than a speculative vehicle for a small minority of adventurous investors.
Important information
An investment in new technologies such as cryptocurrencies may be extremely volatile and not appropriate for all investors. Additionally, cryptocurrencies and cryptocurrency exchanges are not regulated and offer little to no protections to investors.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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