History is full of fringe investments that occasionally make the news following a rapid, often 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, control the creation of additional units, and verify the transfer of assets.
Bitcoin has become the most well-known among the first digital currencies produced. Developers introduced thousands of others, some as a joke, many of which have since died. Following recent market declines, the market value of cryptocurrencies is just over $1 trillion, depending on how Bitcoin trades from day to day, compared to the multiple trillions represented by other currencies. Bitcoin remains the most significant cryptocurrency, but technological improvements of other competitors have eroded its lead. One problem with trying to back the correct 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 institutional brokers, regulators, and currency traders. The latter has a particular interest in promoting cryptocurrency trading due to the expected growth of the market and potential profits. While broad acceptance remains small, more examples arise of vendors and even countries announcing 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.
- Transaction fees are too high.
Bitcoin is an unreliable store of value. Bitcoin’s value routinely changes daily by 1-3%, which can be substantial when seen over a month or a year. 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.
- In April 2021, it reached $63,000 and bottomed at $29,000 in July
- In November 2021, it peaked at $67,000 and now sits around $31,000
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 my Bitcoin drops to $5,000 instead, my purchases with that currency now cost substantially more.
Slow processing speed
Processing speed is another drawback. The processing is slow to protect the security of the blockchain technology that makes digital currency so secure. As a result, there are practical limits on the number of daily transactions, causing even simple transactions to take days. Blockchain networks process about seven transactions per second. As users increase, so too will wait times. 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. And Bitcoin is slower than others.
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 to add their transactions to the blockchain. Transaction fees arose 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, the costs alone could make most transactions impractical.
Because of these drawbacks, very few owners of Bitcoin use it as currency. Instead, they are holding them in the belief that the price of a non-income producing asset will continue to rise. They are speculating, not investing. They may also use them to shield transactions from others, such as authorities or regulators. But recent arrest announcements based on the ability to track cryptocurrency payments are quickly discounting that belief.
There are fewer doubts about whether digital currencies will play a growing role in economic activity. It is a question of when. Even central banks are paying attention. According to the Bank for International Settlements survey, 10% of all central banks expect to issue 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 fluctuates wildly. 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.