In regular financial markets the value of a country’s currency is a great marker for how well it’s doing in economic terms. The surge in value of the Australian currency over the past 2 years demonstrates how strong our economy was in comparison to the rest of the world, mostly thanks to our strong capitalization of our banks couple with some pocket change from the mining and resources boom. However there’s one particular exchange rate where the value of the currency is actually irrelevant to the strength of the underlying economy and a high trading price actually signals that there’s something going horribly wrong. The economy I’m referring to is the one of the online cryptocurrency BitCoin.
Long time readers will know that I was very skeptical about the idea at first as it harked back to the days of other online currencies that were ripe for exploitation and all of which inevitably fell down, sometimes with catastrophic consequences. My concerns were mainly centred around the immense amount of wealth that that was concentrated in the hands of the early adopters but over time it shifted to the crazy exchange rates that BitCoins were attracting which inevitably lead to the price crash that happened in the middle of last year. Since then I’ve been more bullish on the idea of BitCoins because the price has remained steady whilst transaction volumes have started to rise, showing that BitCoins can actually function as a proper currency and not a speculative investment vehicle.
However over the last month or so BitCoin’s exchange rate has been creeping up steadily and the last week alone has seen massive gains in the current trading price:
As you can see for the past 6 months or so the price of BitCoins has been relatively steady, trading at around $5 for a good length of time. However just over a month ago the value started to slowly tick upwards and the last two weeks have seen that value explode in some rapid gains, culminating in a massive jump of almost 20% in under a week. Whilst it’s nothing like the speculative bubble of last year it does raise concerns that the stability of the BitCoin currency was short lived and the speculators have come back to the market looking to derive some more short term gains from the market they successfully pillaged last year.
Increases like this remind us of the unfortunate fact that at its current size the BitCoin market is still volatile as there are strong correlations between large transaction volumes and huge swings in the exchange rate. This is not a desirable attribute for a currency and is much more amenable to speculative trading, something which has burned BitCoin users in the past. Indeed a rising BitCoin value should cause a rational actor to hold off using is as a currency as they would instead want to hold onto them for as long as possible in order to extract the maximum amount of gain out of them. Such thinking is what lead to the BitCoin price to reach such dizzying heights last year and this last bump in the price has the potential to do it all over again.
For BitCoin’s sake I hope this isn’t the case as there are many innovative companies betting their core business on the BitCoin idea and a volatile market could easily spell the end for them. It’s quite possible that these latest bumps are just blips on the radar but the steady rise over the last month or so really has me worried about a repeat of the speculative bubble that happened last year. Can the BitCoin market correct for this kind of behaviour? Will passionate BitCoiners get roped back into the idea that their BitCoins are investment and not a wealth transfer vehicle? I don’t have straight answers to these questions but the next couple months will show if the BitCoin market can learn from the mistakes of its past and hopefully overcome them to become the real virtual currency it has always strived to be.
My opinion hasn’t changed much in the month since I wrote my first post on how I think BitCoin is a pyramid scheme, ultimately destined to unravel unceremoniously when all the speculative investors decide to pull the plug and cash out of the BitCoin market. Still the discussion that that post spawned was quite enlightening, forcing me to clarify many points both in my own head and here on my blog. Since then there’s been a deluge of other blogs and press chiming in with similar opinions about BitCoin and how its intended purpose is far from its reality. There’s been enough noise about BitCoin’s issues that last week saw the first major dip in the exchange rate, and it hasn’t been smooth sailing since.
The image above is the historic trading price for BitCoins to USD on the biggest BitCoin exchange Mt.Gox. The BitCoin “Black Friday” can be seen as the first dip following the massive peak at around $30. Since that day BitCoin has been shedding value constantly with the latest bid offers hovering around the $18 mark. This is not the kind of volatility you see in something you’d class as a currency where single percentage changes are cause for concern and usually government intervention. In the space of a week BitCoin has shed almost half of its peak value which in any sane market would have seen suspension of trade to prevent a fire sale of the asset. The market isn’t showing any signs of recovering either as the market depth report from Mt.Gox shows:
There’s a very large discrepancy between the majority of seller’s idea of how much BitCoin is worth and what the market is willing to pay for it. The vast majority of sellers are looking to cash out at the mid-twenties range when the highest buy offer doesn’t even break the $20 mark. Any rational actor in this sort of market would be looking to get out before the market wipes out all of their value completely and for what its worth I believe the main speculators have probably already withdrawn from the market which is what triggered the initial dip in price. Liquidity in the BitCoin market is fast drying up and that will only serve to drive the price back to (or even below) its initial stable equilibrium.
On the surface this would appear to be the beginning of the end for BitCoin since confidence in the currency is rapidly disappearing with all the accumulated wealth that’s being lost to the diving market. However whilst many who were hoping to make their riches with a nascent currency might be finding themselves short changed the diving price of BitCoins means that those who were working against the currencies intentions, I.E. those who were using it as a speculative investment vehicle, are more likely to leave the market alone now that it’s been pumped and dumped. Once the price retreats back to more stable levels BitCoin could then start functioning as it is supposed to, as a vehicle for wealth that has no central authority regulating it.
It’s not going to be an easy road for BitCoin and its adopters though as confidence in the currency has been dashed with even some of its earliest supporters withdrawing from it. Mining will then no longer be a profit driven enterprise, instead run by those who support the idea and large companies like Mt.Gox who run exchanges. Once the idea that BitCoin’s value would ever be increasing has dissipated we may finally see a point where BitCoins are primarily used as a vehicle for value transfer and not speculative investment. It will probably be another month or two before we reach a new stable equilibrium in the BitCoin market but after that I might finally stop harping on about it being an elaborate (though probably unintentional) scheme.
This still doesn’t detract from the concentration of wealth for early adopters in the BitCoin ecosystem but once their incentive to hoard currency has vanished then the impact of their vast BitCoin stashes means a whole lot less than it did during the speculative price explosion. This will encourage them to put those BitCoins into circulation adding much needed liquidity to the market and hopefully restoring some more faith in the system. Time will tell if this works out however as with market volumes so low on the BitCoin exchanges price manipulation is bound to happen from time to time and realistically can only be solved by having wider adoption. I’m still not convinced that BitCoin is a safe place for any of my wealth currently but once its recovered from this rapidly bursting bubble I may revisit it, should the want arise.