A version of this article appeared in Business Times.
“I think the fact that within the bitcoin universe an algorithm replaces the functions of [the government] … is actually pretty cool. I am a big fan of Bitcoin” - Al Gore, 45th Vice President of the United States
Similar effusive sentiments were expressed by several well-known (and well meaning) commentators and influencers about Bitcoin a few years back.
Circa 2017. Jamie Dimon, one of the most respected and influential bankers in recent times, who has been credited with steering J P Morgan out of the financial crisis of 2008, commented that Bitcoin is a ‘fraud’.
Not limiting it to just calling it a ‘fraud’, one of the columnists in the respected newspaper Financial Times termed it as a ‘Ponzi scheme’ perpetuated by those who had benefitted immensely from the explosive upside seen in the price of Bitcoin. It was implied that it was in the interest of these early investors to keep perpetuating the myth so that they could get the next larger and less informed group of investors interested so that the price action could then create a ‘Domino effect’.
Couple these with the recent actions in China where the government banned the Bitcoin exchanges and Initial Coin Offerings (ICO). This stringent regulatory action, coming from one of the largest markets for Bitcoin, makes one contemplate if the narrative has changed track.
Has it - is the big question occupying many minds?
What the final course is – only time shall tell. As with other bubbles in the past, parts of this too (Blockchain – the technology underpinning the Bitcoin being the most likely candidate) are most likely to survive and grow. However, this final outcome is expected to unfold after undergoing the ‘big churn’ of regulatory scrutiny, iterative discovery and immense pain (and pleasure) for some.
In this entire episode, an important and fundamental aspect which is being inadequately debated is whether Bitcoin is a currency.
What is a currency?
Without going into the textbook definition of a currency, in the very broadest sense a currency tends to demonstrate the following characteristics;
Issuer: Being legal tender, it is issued by an entity who has authority to issue it over a certain geography which could range from being as large as a number of countries (e.g. the EURO) or it could be as small as a local council. However, it could become popular and gain acceptance over a wider geography, as is the case with the US Dollar. While it is not necessary for this entity to be a government, it normally tends to be of that nature.
Purpose of creation: The issuing entity acts like an intermediary (akin to a stock exchange between the buyer and seller of shares) and eliminates the trust deficit between the counterparties who may or may not know each other. The acceptance of the currency is an expression of trust in the issuer. The alternative to this intermediation process would have been to find a barter in goods and services acceptable to both sides.
Store of fiat (officially sanctioned) value: Since currency is issued as legal tender in the form of a promissory note (‘I promise to pay the bearer’ or ‘this note is legal tender for all debts, public and private), both the counterparties need to accept the authority of the issuing entity and the stored value sanctioned by it. The physical currency itself i.e., the metal or paper etc., does not possess any intrinsic value. For an issuer, the nomination as legal tender that they possess the authority as well as the economic strength to honor the promise. There have been many instances wherein the currencies issued by sovereigns have lost value (hyperinflation) because the issuer was unable to preserve value in their currency. In essence, the currency is as good as the faith reposed in it by the buyers and sellers of goods and services. While value could be attributed vide a fiat from the issuer, whose writ all buyers and sellers accept, it could also be perceived in other ‘non fiat’ situations when a group of people perceive value in an asset. Examples of these non fiat value could be commodities like gold and other precious metals, real estate, art, fine wine and others. In these cases, the imbued value is as perceived by a private group with no official sanction. These possess value however are not currencies.
Quantity of issuance not defined: The limit to the amount of currency that the issuer creates is mostly determined by the trade in goods and services that they undertake which determines the demand and supply as well as the value of the currency. Swings toward both sides, excess and deficit, can be detrimental to the economy of the geography. Hence, the amount of currency is not cast in stone and even if it is, it is never made public. This is to eliminate a situation wherein speculative elements can reap enormous benefits due to a perceived scarcity creating a supply demand mismatch. A deficit also exacerbates price movements by creating extreme price swings which are detrimental to underlying trade and commerce, which is the fundamental reason for the currency to exist.
What is Bitcoin?
Bitcoin was created to be a digital currency (we shall use the term ‘currency’ here for the purpose of convenience) with the objective of by-passing the boundaries of the sovereign state. As there is no single issuer hence the trust required in a currency is to be reposed in the faceless mathematical algorithm and the ‘miners’ who create the bitcoin.
The algorithm for bitcoin also stipulates that the maximum number of bitcoins that can be mined at 21 million of which roughly 16-17 million have already been mined.
If we agree upon the above mentioned attributes of currencies, then Bitcoin does not qualify to be a currency on most parameters. It does not possess the status of a legal tender since it has neither been issued by an entity with the authority nor does it carry any absolute intrinsic value.
As currencies are intermediaries for exchange of value, they need to move in an orderly manner (there are aberrations of course) and would not witness the kind of extreme swings that we have experienced in the Bitcoin and other cryptocurrencies over the last few weeks. These swings are essentially reflecting the limited liquidity and no controlling authority in the Bitcoin market.
The fact that bitcoin is not issued by any singular entity militates against the conventional understanding of a currency. Not being a legal tender, it cannot be a universal store of value since its perceived value shall be confined to a private group akin to one of the alternative assets like precious metals, a painting or a bottle of fine wine.
Is Bitcoin just another asset class?
Bitcoin is better understood as a ‘commodity’ or another ‘asset class’ as it demonstrates all their features.
Let us just use the example of art or fine wine. Each of these is created using ‘proprietary algorithms’, has a niche private acceptance, exists in limited quantities and therefore possesses scarcity value. They are almost borderless.
Hence, they can experience extremely wild price swings due to mismatches in demand and supply.
The major difference is that these exist in physical and discrete formats unlike the Bitcoin which exists in a digital format and therefore can be easily traded in units even much smaller than a single unit. Being digital, a bitcoin can be broken down into infinitely small units and lends itself to the argument that even though there is an upper ceiling in the bitcoin algorithm, there is never a scarcity. All the demand can be reflected in the price of the bitcoin which will keep rising resulting into people buying small fractions of one bitcoin. When viewed in this manner, the bitcoin starts fulfilling one of the requirements of a currency.
As a comparison, one can even create a fractional interest in either art or fine wine by participating in their price action through a fund structure. When viewed through this prism, Bitcoin very much is very much a commodity or an alternate asset class.
Which judicial system will be responsible for the redressal of a dispute?
Where bitcoin starts deviating from a currency is in the event of a dispute between the buyer and the seller. If the underlying transaction has been undertaken using fiat currencies (which themselves are regulated), a dispute between the counterparties falls under the ambit of the law of the land and hence undergoes a well-defined settlement mechanism. However, in the event one purchased something using Bitcoin, it is akin to a barter (and hence no value can be assigned to the trade) and would be construed as a private trade in the event of a dispute. Given that Bitcoin has not been authorized as currency, in theory it is a barter. It is in theory equivalent to exchanging a crate of fine wine for a small painting. Should either of the parties to the transaction be dissatisfied, how would the legal systems judge the dispute?
Digital currency v/s digitization of currencies
Many of the benefits offered by the digital currencies like Bitcoin can get offset if the world is successful in digitizing the existing currencies. One of the benefits sought to be offered by cryptocurrencies is the ease and time in undertaking a cross border movement. Subject to the exchange control laws of a country, if the existing fiat currencies are digitized, their movement becomes instantaneous as well. Try doing a PayPal funds transfer or availing the services of many banks who now offer such services. I have personally experienced this with the bank that I bank with. The limitation of time is more embedded in governance than in technology.
Having said all of the above, there is no certainty in how this supposed bubble shall unfold. It could very well be as Oscar Wilde said ‘Illusion is the first of all pleasures’.