Bitcoin is defined as digital money within a decentralized peer-to-peer payment network. It is a hybrid between fiat currency and commodity currency without intrinsic value and independent of any government or monetary authority. Bitcoin is a peer-to-peer electronic cash system which allows online payments to be sent directly from one party to another without going through a financial institution. This definition suggests that Bitcoin is mainly used as an alternative currency. However, Bitcoin can also be used as an asset and thus would serve a different purpose. Whilst currency be characterized as a medium of exchange, a unit of account and a store of value, an asset does generally not possess the first two features and can be clearly distinguished from a currency.
If Bit coin is mainly used as a currency to pay for goods and services it will compete with fiat currency such as the US dollar and thus influence its value and ultimately monetary policy. If, on the other hand it will mainly be used as an investment, it will compete with other assets such as government bonds, stocks and commodities among others and potentially influencing the financial system and financial stability. Whether it is currency or an asset, the potential to influence the economy as a whole depends on the success of Bitcoin or similar alternatives compared to existing currencies and financial assets.
Bitcoins are mainly used as a speculative investment despite or due to its high volatility and larger returns. Interestingly, Bitcoin returns are essentially uncorrelated with all major asset classes which offer large diversification benefits. This low correlation, if stable and constant over time would also imply low risk from a macro perspective. For example, if Bitcoins showed bubble – like characteristics, significant fall in the value of Bitcoins could be an isolated event if the correlation remained at zero and thus no other assets would be affected. If, on the other hand, Bitcoin investments were debt-financed, a significant fall in the value could lead to margin calls and then also affect other assets.
Bitcoin can be defined as synthetic commodity money sharing features with both commodity monies such as gold and fiat monies such as the US dollar. Whilst commodity money is naturally scarce and has a use other than being a medium of exchange, fiat money is not naturally scarce but issued by a central bank and its main purpose is that of being a medium of exchange. In addition, both types of money can be used as a store of value.
Bitcoin is a hybrid of commodity money and fiat money. Bitcoin is scarce by design, i.e. its scarcity is determined by an automatic, deterministic rule fulfilled by competitive mining similar but not equal to commodity money (e.g. gold) but its value is better characterized by fiat money as Bitcoins have no “intrinsic” value. Another important similarity of Bitcoin with gold is its non-centrality. When evaluating the potential future use and acceptance of Bitcoin, it is important to analyze the growth path of Bitcoin supply. The supply of Bitcoins is perfectly predictable and will continue to increase in decreasing steps until 2040 and remain at the 2040 level ad infinitum. This has strong implications for the value of Bitcoins and the potential deflationary effects it may entail. Since the demand for Bitcoins, in contrast to its supply, is unpredictable both in the near future and beyond 2040, it is difficult to forecast the future value and usage of Bitcoins.
However, the deflationary effects that are built into the Bitcoin system make it more likely that Bitcoins will be used as an investment than as a medium of exchange. If Bitcoins are not viewed as an alternative currency and not used as a medium of exchange, it will not compete with fiat currency and thus not affect the effectiveness of monetary policy. If on the other hand, Bitcoins are seen as a stable money benchmark and thus a medium of exchange, it may influence the value of fiat currency and ultimately monetary policy. Given the potential influence of Bitcoins on fiat money and thus on monetary policy, central banks and regulatory authorities carefully monitor the future developments of Bitcoin and other “virtual currencies”.
Bitcoin’s intended purpose is as a medium of exchange but it may also be used as an asset and investment. Bitcoin return properties are very different from traditional asset classes and thus offer great diversification benefits. Analyzing we find about a third of Bitcoins are held by investors, particularly users that only receive Bitcoin and never send to others. A minority of users, both in number and Bitcoin balances, appear to use Bitcoin as a medium of exchange. This suggests that at present Bitcoins are held for investment purposes rather than being used for transactions. Whether the evidence towards investment rather than currency and thus a medium of exchange is due to the volatility of Bitcoin is a matter for future research.
Since the size of Bitcoin investments and transactions can be characterized as small relative to other assets we do not see an immediate risk or even threat for financial or monetary stability. However, we believe it is important to emphasize that this conclusion is based on its size. If the acceptance of Bitcoin or similar ‘virtual currencies’ increased significantly on a global level, it could affect the behavior of consumers and producers and as a consequence change the relevance of monetary policy. Given Bitcoin’s global decentralized nature and independence from any central bank or supranational authority, regulatory oversight may be difficult and challenging.
By: Sourabh Tiwari, CIO/ IT Head, Overseas Infrastructure Alliance