Bitcoin: a pocketful of cryptonite
With the price of a bitcoin reaching record highs of more than $10 000, more and more people are considering investing in the cryptocurrency. But the recent price surge comes with tremendous risks: investors should be prepared for the possibility that they could lose their entire investment.
Bitcoin was launched in 2008 by an anonymous author under the name of Satoshi Nakamoto as a way of transacting among participants without the need for intermediaries. Since the beginning of this year, the price of a bitcoin has increased by 1 300% as more and more consumers flock to it hoping to profit off its increasing popularity and the associated increase in value.
Cryptocurrencies are not currencies. As the Financial Times explains, bitcoin is a string of computer codes, which means new bitcoins can be created — in its case, up to an agreed limit — by computers that gain the right to do so by solving complex puzzles. Transactions are recorded in a database called a blockchain.
Bitcoin, like other assets such as gold, doesn’t yield income. You have to sell it to realise any value. And, like gold and other currencies, it can be transferred peer to peer.
Part of the nervousness about bitcoin is that it, and other cryptocurrencies, challenge the traditional role of banks and central banks. In the classical world, banks act as intermediaries by providing loans out of the deposits they take and from funding from the central bank. The central bank uses the rate at which it provides this funding as a lever to ensure price stability. The introduction of cryptocurrencies threatens this model because banks are no longer necessary to intermediate funds and there is no central bank to ensure that prices are stable.
The more immediate fears about bitcoin centre on the recent dramatic rise in its value. There’s nervousness in the market that a flash crash might be imminent after the cryptocurrency tumbled by more than $1 300 in minutes on bitcoin exchange Bitfinex, although it recovered to levels above $10 800.
The flash crash echoes long-standing warnings that the bitcoin party will end in tears. Most recently, Jamie Dimon, the chief executive of JPMorgan, one of the world’s largest investment banks, declared that he would fire any employee trading in bitcoin for being stupid.
In a highly unusual alliance, his words were echoed by economics Nobel laureate Joseph Stiglitz, who has gone even further, arguing that bitcoin ought to be outlawed.
These are clear warning signs that the professionals do not trust the lofty promises of crypto enthusiasts.
The blockchain factor
There is no doubt that bitcoin — and in particular the blockchain technology behind it — has the potential to revolutionise the financial services industry.
A blockchain functions as a transparent and incorruptible digital ledger of economic transactions, recorded in chronological order, which operates on a peer-to-peer network. Fundamentally, the technology allows exchange of value to occur in an environment of peers with conflicting interests without the need for trusted intermediaries. That, in effect, wipes out the need for banks or financial services companies, which fulfil this role.
The use of the technology is not limited to financial transactions. Virtually anything of value can be traded on a blockchain. But no matter how useful the blockchain technology is, or how widely it can be applied, there are real and substantial risks involved in bitcoin.
Volatility versus returns
The first and most significant risk is that, compared with any currency, share or gold, bitcoin is extremely volatile. Its volatility to the US dollar is almost six times the volatility of the rand to the dollar. Although this is great in good times, it is potentially devastating for investors in bad times.
When professional investors decide on which assets to hold, they look at both the return and the volatility of the asset. Only investors with a healthy appetite for risk are willing to invest in risky, volatile assets. Usually these are finance professionals, for example in large investment banks or hedge funds.
Investors with a lower risk appetite, such as asset managers or pension funds, prefer less volatile assets with a somewhat lower return.
The rule of thumb is that the sophistication of an investor increases with the volatility of the asset she invests in.
But with bitcoin this rule of thumb doesn’t hold true. More and more private investors have been flocking to bitcoin “exchanges” that have sprung up on the internet and are being aggressively advertised on social media.
There is a huge risk that bitcoin is already overvalued.
The practical uses of bitcoin are limited. It doesn’t enable enough transactions to take place per second to be used as a replacement for a modern payment system. And it doesn’t offer any functionality other than pseudonymous transactions, which hides the true identity of the counterparties.
Bitcoin is favoured by pyramid schemes, including the infamous MMM pyramid scheme in Nigeria. In a recent article, the Financial Times described bitcoin as a pyramid scheme, much to the dismay of crypto enthusiasts. (A pyramid scheme is usually an illegal operation in which participants pay to join and profit mainly from payments made by subsequent participants. If no new people come in, it collapses.)
The third and possibly biggest risk is regulatory. In September, the Chinese government outlawed bitcoin exchanges, sending the price of bitcoin tumbling.
Despite the claim that bitcoin is a “global currency”, the reality is that 58% of all bitcoin mining happens in China. If at any point the Chinese government should decide to make bitcoin mining illegal the price is likely to plunge.
Other countries have also voiced concern. The Russian Central Bank recently issued a warning to investors about the risks of investing in cryptocurrencies, citing concerns about a bubble. This suggests that there might be a crackdown.
Cryptocurrencies are banned in India because their use is a violation of foreign exchange rules. The Australian Reserve Bank has taken a different approach. It monitors the cryptocurrency market in a bid to understand the underlying technology.
The South African Reserve Bank has expressed its openness to blockchain technologies but it has highlighted potential risks to consumers.
A classic bubble
There are real risks that many consumers investing in cryptocurrency don’t fully understand. Adverts promise it can make you rich fast. And social media is alive with stories about people who have made a lot of money with bitcoin.
These cases are real, and those who invested early can reap large benefits. But this is true in every bubble — from Dotcom to tulip mania. It’s also true in every pyramid scheme.
Investors should be extremely wary with any scheme that promises quick returns. — The Conversation
Co-Pierre Georg is a lecturer at the African Institute for Financial Markets and Risk Management at the University of Cape Town. Qobolwakhe Dube is a PhD candidate at UCT