Though valuable, bitcoin unlikely to replace traditional currencies

Though valuable, bitcoin unlikely to replace traditional currencies
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What’s the future of Bitcoin? That has become an increasingly critical question for investors and observers as bitcoin’s value rose past $16,000 in early December.

The best-known cryptocurrency has had a great deal of expectation surrounding it since it was first created in 2009. For many, the hope was that bitcoin would replace conventional currency forms — paper and coin-based — altogether, becoming a go-to global payment tool.

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But my observation of bitcoin’s trends and dynamics suggests otherwise: Rather than supplanting other payment forms, bitcoin and potentially other cryptocurrencies may likely become investment tools, representing a new asset class that can help diversify the portfolios of individual and institutional investors alike.

 

Thus, bitcoin may ultimately become a way to keep and grow value, rather than a means of transacting value between parties.

I base this prediction largely on the growing barriers I see to bitcoin’s emergence as a payment tool, obstacles that revolve around the two issues described below. 

First, for bitcoin to become a standard payment tool, the cryptocurrency must be able to handle a very large number of transactions at any given second, as is the case for conventional currencies.

The challenge is that bitcoin was created with blockchain technology, a digital, block-based ledger in which individual, encrypted transactions are shared across and authenticated by a vast network of users/computers (known as bitcoin miners), to promote greater security than typical digital transactions might offer, while removing the need for paper.

While this increases security/flexibility, it can limit transaction volume dramatically. Specifically, for bitcoin, the size of each blockchain digital “block” is fixed — each currently holds up to 1 megabyte (MB) of information — which limits the number of transactions a given block can hold.

Moreover, there’s an imposed limit to how fast each block can be approved, to avoid the possibility that two discrepant blocks would be approved simultaneously.

In short, these security-focused measures built into bitcoin’s underlying technology limit the speed and volume of associated transactions. As a stark illustration, Visa can handle 24,000 transactions per second to bitcoin’s seven.

This is a well-known limitation of bitcoin, one that led to the spinoff bitcoin Cash, which uses 8-MB blocks to allow for higher transaction volume. But bitcoin purists disapprove of any such protocol modifications.

The second, related barrier to bitcoin becoming a digital payment tool involves the economics of bitcoin mining; specifically, how compensation for those who authenticate bitcoin transactions affects related supply and demand.

Currently, miners are mainly compensated by the bitcoin reward that comes along with each block approved (they receive a set number of bitcoins for being the first to “mine” a block), but the currency is fast approaching the original limit set to the number of bitcoins that can be mined.

If miners can no longer be paid in mint bitcoin, they will require payment in fees. In fact, miners already receive some transaction fees, for example, to prioritize authentication of a given transaction ahead of earlier ones.

As we near the point where all miner compensation is fee-based, it will be interesting to watch cyclical patterns of supply and demand for miners. As fees rise with demand for transaction authorization, more miners will enter the market to compete; but the growing number of them will result in lower fees, shifting the situation from one of excess demand for miners to excess supply of them.

If fees move toward zero (miners incur high energy costs and should always be at least compensated for their costs), many miners will exit the market, slowing transaction volumes even further, hampering bitcoin’s use as a payment tool.

Such congestion due to low miner numbers happened as recently as last month, highlighting the potential inconsistency and unreliability of bitcoin as a go-to payment form.

While these issues may prevent bitcoin from becoming the ubiquitous payment currency envisioned earlier, they don’t stop its use as an investment tool. In fact, because the price of bitcoin is not well-correlated with those of other asset classes, it can be a strong source of diversification for individual and institutional investors.

The Chicago Mercantile Exchange and CBOE are already betting on the value of bitcoin in the investment domain, by creating a futures market for it. The CME, for example, is studying multiple exchanges that offer bitcoin to determine its average price.

The legitimacy conferred to bitcoin by such developments and greater regulation should pique the interest of a wider range of investors.

But that warrants a concluding note of caution: The price of bitcoin is affected significantly by the larger exchanges that trade it, such as Bitfinex, which may manipulate bitcoin’s value out of self-interest, without sufficient reserves to cover a high volume of cashouts.

If that happens even on one exchange, it can create a ripple effect leaving many bitcoin investors with worthless holdings, as was the case when the Mt. Gox exchange collapsed in 2014.

Bitcoin may not become the payment tool many hoped for, but it likely remains a viable investment asset — one best approached cautiously as its dynamics and economics continue to emerge.

Sarit Markovich is a clinical associate professor in the strategy department at the Kellogg School of Management at Northwestern University.