History is full of fringe investments that occasionally make the news following a rapid, and oftentimes inexplicable and indefensible, price increase. Bitcoin is only the latest, leaving even casual investors asking “what is it, and should I be buying some?”
Bitcoin is an unregulated cryptocurrency created in 2009. A cryptocurrency is a digital asset designed to work as a medium of exchange using cryptography to secure the transactions, to control the creation of additional units, and to verify the transfer of assets.
Among the first digital currencies produced, Bitcoin has also become the most well-known. Thousands of others have been introduced, many of which have since died. The market value of cryptocurrencies is growing and is currently estimated at $200 – $300 billion, depending on how Bitcoin trades from day to day, compared to the trillions represented by other currencies. Bitcoin remains the biggest cryptocurrency, but its lead has been eroded by technological improvements of other competitors. That is one problem with trying to back the right digital currency, there is no barrier to entry for the competition. All it takes is a computer and some skills to improve. If that doesn’t work, try again.
Much has changed in the last several years for cryptocurrencies, including a growing awareness by investors, regulators, and currency traders. The latter has a particular interest in the promotion of cryptocurrency trading due to the expected growth of the market and potential profits. While broad acceptance remains small, we may have seen a turning point with the recent announcement by Paypal that they would be accepting Bitcoin transactions. Nevertheless, the idea of using Bitcoin as a digital currency is suffering from three primary challenges: its value is too unstable, transaction processing speed is too slow, and transaction fees are too high.
Bitcoin is an unreliable store of value. Bitcoin’s value routinely changes daily by 1-3%, which, when seen over a month or a year, can be substantial. By comparison, the exchange rate between the U.S. dollar and the euro has an average daily change of less than 1% and a monthly change of less than 3%. And the value of a Bitcoin can go down hard too. See the chart below. After hitting a high of $1,150 in November 2013, the price of one Bitcoin dropped to $500 by mid-December and didn’t recover for four years. It touched $19,000 in late 2017, only to drop 83%, back to $3,200 twelve months later. As of November 30, 2020, it reached a new high of more than $19,000.
People don’t want investments or debts denominated in a currency where price swings are that dramatic, though speculators might. If I purchase one Bitcoin now for $20,000 and it doubles to $40,000, I may feel good for a moment. But if the value of my Bitcoin drops to $5,000 instead, the items I wish to purchase with that currency now cost a whole lot more.
Slow Processing Speed
Processing speed is another drawback. To protect the security of the blockchain technology that makes digital currency so secure, the processing is slow. As a result, there are practical limits on the number of daily transactions which can cause even simple transactions to take days. The blockchain network processes about seven transactions per second. As users increase, so too will wait times. By comparison, one large credit card company processes close to 150 million transactions per day, or about 1,700 per second, with more capacity available. The slow processing speed of digital currency transactions is a significant roadblock to scalability.
Transaction Fees are too High
Transaction fees were not part of the original system. As Bitcoin has grown over the last decade, users must wait longer for their transactions to be added to the blockchain. Transaction fees were introduced as an incentive mechanism to allow users to move to the head of the line. While this may benefit a lucky few, it does nothing to address the problem of processing speed and the massive amount of power required for blockchain transactions generally. Furthermore, while the fees may help prioritize some deals over others, the costs alone could make most transactions impractical.
Because of these drawbacks, very few owners of Bitcoin use it as currency. Rather, they are using them to speculate that the price of a non-income producing asset will continue to rise. They may also hold them to shield transactions from others, such as authorities or regulators.
There are fewer doubts about whether digital currencies will play a larger role in economic activity, it is a question of when. Even central banks are paying attention. According to a survey by the Bank for International Settlements, 10% of all central banks expect to issue their own digital currencies within the next three years. Even the Federal Reserve is studying the idea.
Bitcoin may eventually gain traction in ways that match its original vision of creating a global currency, independent of interference by banks or government. For now, however, Bitcoin is less a currency than simply an asset whose price has been bid up again. And a rather unreliable asset that produces no income. If you insist on buying Bitcoin or any other digital currency, do so with money you can afford to lose, and know that its value could disappear as easily as the bits and bytes that support its creation.
Disclosure: This is for informational purposes only and is not a recommendation to buy or sell Bitcoins.