The Bitcoin-Boom and Bust

Posted in Finance Articles, Total Reads: 4685 , Published on 04 January 2014
Advertisements

Introduction to Bitcoins

Bitcoin is a one of the first and most prominent cryptocurrency – a type of alternative digital currency that relies on cryptography (the practice and study of techniques for secure communication in the presence of third parties) to create and manage the currency. Cryptocurrencies are peer-to-peer and are not controlled by any central authority. They are generally designed to have no inflation (once all the currency has been produced), in order to keep scarcity and hence value. They can be ‘mined’ through use of hardware resources to perform resource intensive calculations or, be bought from the various exchanges prevalent globally.



Recent Spike in Bitcoin Prices

Bitcoin has grown tremendously in value since the start of this year, with a single Bitcoin rising from $13.5 to over $1,200. It hit the all-time high value of $ 1,242 on November 29. 2013 on Tokyo-based Mt. Gox, the world's best-known Bitcoin trading platform.

However, most of this gain has been observed in November 2013 where its value has surged from around $200 to over $1200. The biggest contributor to this rally was China.


Factors and Indicators of the Bitcoin Boom

The price of Bitcoin rose to $266 in early April 2013 when people were worried that banks in Cyprus may default which would lead to a huge Euro disaster. There were stories of investors stocking up on Bitcoins and shops, traders and professional service providers had started accepting payment via Bitcoins. However, the Cyprus crisis was ultimately averted and the value of Bitcoin quickly plunged to $54 from $266.

China recently became the hub of majority of Bitcoin trading. As per Bitcoin Average, an independent pricing site, China now accounts for 62 percent of volume of Bitcoins traded across global market. This surge in Chinese demand has recently led China-based BTC China to become the world’s largest Bitcoin exchange in terms of volumes traded. BTC China targets trades in Chinese currency – Renminbi, or Yuan.

Around 1.8 million Bitcoins were traded on BTC China in November 2013. Prior to this,

Mt. Gox, was the exchange with most trading volumes. However, in November 2013, only 700,000 Bitcoins traded against 1.8 million Bitcoins on BTC China, as per bitcoincharts.com. Bitcoin became popular amongst people of China in April 2013, when movie star Jet Li's One Foundation received a donation of several hundred Bitcoins towards rehabilitation efforts for the quake-stricken Sichuan Province.

The reason for surge in Chinese demand can be attributed to the following:

• Inflation in China resulting in devaluation of the Renminbi

• China does not allow the Renminbi’s value to float freely

• The difficulty in getting/sending money out of China

• China has prior exposure to digital currency – Tencent’s Q Coin


Towards the end of November 2013, Yi Gang, the Deputy Governor of the People's Bank of China, mentioned at an economic forum that the central bank would find it extremely difficult to recognize Bitcoins as a legitimate financial instrument in the near future. However, he said that people were free to take part in the Bitcoin market, which has been observed by many as a tacit approval.


Ben Bernanke, chairman of the Federal Reserve, recently said the following to the Senate committee regarding Bitcoins: "While these types of innovations may pose risks related to law enforcement and supervisory matters, there are also areas in which they may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system."

The Winklevoss twins - Cameron and Tyler Winklevoss, of Facebook fame, have made heavy investments in Bitcoins and have lodged a filing with the U.S. Securities and Exchange Commission to establish the first ever Bitcoin exchange-traded fund, or E.T.F., that will track the Bitcoin markets.

Sir Richard Branson, the founder of Virgin Group, recently told CNBC's "Squawk Box" of his intent to accept Bitcoins as a mode of payment for his space travel endeavor - Virgin Galactic.

A documentary - “The Rise and Rise of Bitcoin“, which follows the journey of 35-year-old computer programmer Daniel Mross , as he explores the merchants, entrepreneurs and others in the Bitcoin community all across the world, is slated to be released in early 2014.

Popular online portals like Wordpress.com and Reddit have started accepting Bitcoin.

In first week of December, Windows Phone Central Store also started accepting Bitcoin.

ATM-maker Robocoin recently set up the first Bitcoin ATM machine in Vancouver, Canada.

The University of Nicosia, the largest university of Cyprus has decided to accept Bitcoins as payment for tuition and other school fees. It has also decided to offer a master's degree in digital currency to increase understanding of "the technical underpinnings of digital currency."

In August 2013, the German Finance Ministry recognized Bitcoin as a "unit of account", which allows it to be used for tax and trading purposes in the country.

Emergence of other Cryptocurrencies

The buzz surrounding Bitcoins and the concerns regarding its limitations have led to the emergence of many alternative cryptocurrencies, the most popular one being Litecoin. Litecoin is designed to offer faster transactions by processing a block every 2.5 minutes rather than Bitcoin’s 10 minutes and prevent the race for hardware resources amongst miners to get the most number of coins.

Peercoin, unlike Bitcoins, has no upper limit on the the number of coins to be generated. Instead, it has an in-built inflation rate of 1% and has a more energy-efficient process of mining.

Anoncoin and Zerocoin offer complete anonymity in transactions which is not offered by Bitcoin.

Cautionary Remarks and the Bitcoin Bust

On December 5, 2013, the People’s Bank of China, China's central bank, warned that financial institutions should not trade or offer services in Bitcoin, saying that while it does not yet pose a threat to China's financial system, it carries risks the most prominent of them being money laundering.

One of the biggest boosts to Bitcoin was the positive comments from the U.S. Federal Authorities during the mid-November meeting post which, Bitcoin which was trading around $600 crossed the $1,200 mark. But by December 5, 2013, it seemed to be receding back. Former Federal Bank Chairman Alan Greenspan may also have been influential in the Bitcoin fall-back. In an interview published by Bloomberg News on December 4, 2013, he warned that Bitcoin prices are unsustainably high: “It’s a bubble. It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.” Expanding on just how baffled he was, Greenspan said this: “I do not understand where the backing of Bitcoin is coming from. There is no fundamental issue of capabilities of repaying it in anything which is universally acceptable, which is either intrinsic value of the currency or the credit or trust of the individual who is issuing the money, whether it’s a government or an individual.”

Even the Bank of France followed up with: "Even if Bitcoin is not currently a credible investment vehicle and therefore do not pose a significant risk to financial stability, they represent a financial risk for those who hold them.

A similar cautionary message came from the Netherland’s central bank, which stated that there is no central authority that can held liable for Bitcoin, and no guarantee of deposits in the event of failure of Bitcoin banks. A former head of the Dutch bank went on to compare the Bitcoin bubble to the Netherlands' Tulip mania that occurred in the 17th century. According to him, when that bubble burst, investors were atleast left with tulips at the end which might not be the case with Bitcoins.

On December 18, 2013, BTC China was forced to stop accepting deposits in the Chinese currency following new restrictions imposed by the People’s Bank of China. This news was followed by almost a 50% crash in Bitcoin prices from its 24-hour high point.

On December 24, 2013, The Reserve Bank of India warned the public against the use of virtual currencies such as Bitcoin, due to the “potential financial, operational, legal, customer protection and security-related risks they are exposing themselves to”. It added that “The absence of information of counterparties in such peer-to-peer anonymous/ pseudonymous systems could subject the users to unintentional breaches of anti-money laundering and combating the financing of terrorism.”

Concerns

The primary hurdle to Bitcoin’s ongoing success is that right now Bitcoins are mostly being used for speculations. People are buying Bitcoins, but if they just hoard it and do not use them for transactions, it goes against the ideology behind the creation of cryptocurrencies by leading to fluctuations in values. Unlike gold, which has a physical value and market controls that lend it some stability, Bitcoin investors could lose almost all their digital fortunes in a jiffy, leading to mass panic and sell-off. Also, if Bitcoins continue to be predominantly used for buying other currencies, as against to buy goods and services, then its potential for growth is very much lower than what is currently being projected. The security and stability of the system are questionable. If the system is hacked, one will be left with no Bitcoins, no bank guarantee and no authority to complain to.

The only people who would still be interested, will be those who want to but things anonymously, which again is not completely ensured by Bitcoins. The developers of Bitcoin may not have created a perfect replacement currency or a safe investment opportunity. They have created a clever peer-to-peer transaction system that which in its current state enables fraud, tax avoidance, drug dealing and other illicit uses which the governments may not allow in the future.


Way Forward

Bitcoin is slowly gaining acceptance across the globe. The important step now is for the Bitcoin community, the traders and the buyers to establish the necessary infrastructure and controls to make Bitcoin a safe and reliable option. The Bitcoin exchange platforms have been slowly moving towards quality from their initial emphasis on quantity by becoming better backed and offering safer and more secure infrastructure. The open public discussions along with the attention of the regulatory authorities and joint measures to make the currency safer may help in legitimizing Bitcoin. However, this will be challenging considering the issues raised by the central banks, governments and other regulatory bodies. The success or failure in dealing with these challenges will ultimately determine the sustainability of Bitcoins and other cryptocurrencies in the financial system.


The article has been authored by Agraj Shah, JBIMS, Mumbai

References:

• http://www.economist.com/news/leaders/21590901-it-looks-overvalued-even-if-digital-currency-crashes-others-will-follow-bitcoin

• http://www.theguardian.com/technology/2013/dec/05/bitcoin-price-tumbles-chinese-central-bank-warning

• http://www.nbcnews.com/business/bitcoin-tops-1-200-does-its-fate-rest-chinas-hands-2D11673316

• https://blockchain.info/charts

• http://bitcoincharts.com/

• http://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30247

• http://articles.timesofindia.indiatimes.com/2013-12-18/internet/45336745_1_virtual-currency-bitcoin-bitcoin-foundation-satoshi-nakamoto

• http://www.moneynews.com/StreetTalk/Greenspan-Bitcoin-Currency-Bubble/2013/12/04/id/540062



Advertisements


If you are interested in writing articles for us, Submit Here