It's only a matter of time before cryptocurrency prices start to fall
Making a success out of investing is as much about what you don't do as what you do. The recent dramatic appearance and strong price rises of a plethora of digital currencies (cryptocurrencies) is a case in point. Who wouldn't want to own a digital currency that has gone from a few cents on the dollar just a few years ago to $6,500 today - like the bitcoin has?
As far back as 330BC, Aristotle defined the five characteristics of good money as durable, divisible, convenient, consistent, and something which has use value in and of itself. Not much has changed in the intervening 2,000-plus years.
Bitcoin and other cryptocurrencies are probably durable. They are certainly divisible, consistent and they are convenient as long as you have Internet access and others are willing to transact in bitcoins with you. The key question is: have bitcoins any use value in and of themselves?
By way of comparison, gold has been accepted as money for thousands of years. Gold is durable, divisible, convenient, consistent and has use value. There is a base demand for jewellery and industrial uses. It costs between $820 and $850 to get an ounce of gold out of the ground. Add in the miner's profit and it is easy to understand why gold might have a base value of $1,100 an ounce and currently changes hands at $1,300 an ounce.
Over the millennia, due principally to the fact that new supplies are limited, the gold price has matched inflation. Yet, as the supply of gold cannot be increased at the same pace that trade expands, there has never been enough of it to facilitate the settlement of faster expanding global trade. Gold is an excellent store of value, but it has never been an ideal medium of exchange.
Bitcoin and cryptocurrencies in general have good potential as new mediums of exchange in global trade. All we are debating here is their value. Supporters of bitcoins and cryptocurrencies will argue that paper currencies have no use value in and of themselves. That's correct in a narrow sense, but completely misses the bigger picture.
Bank deposits and paper money represent 'sound money' most of the time. Money in a trusted banking system is both a medium of exchange and a store of value. Yes, in 2008, that trust was broken, but a country's banking system is supported by its central bank which, in turn, is supported by its Government. The value of a country's currency is underpinned by a Government's ability to raise revenue through taxes - not just today, but into the indefinite future.
In contrast, bitcoins are created and earned by those who verify transactions using blockchain technology over the Internet, so one might suggest that a base intrinsic value for a bitcoin is the value of the programmer's time and any other costs associated with transactions.
Supporters also argue that like gold, bitcoin transactions settle outside the bank system. So what? Most likely, we are simply witnessing a speculative development where the limited supply of bitcoins is leading to higher prices as the demand multiplies, particularly for use in illegal anonymous transactions. Higher prices lure more speculators who drive the price still higher.
If bitcoin is a novel way to settle trades outside the banking system, why limit the supply? This, in our view, is the central point and one which supporters cannot answer. If the supply is increased, as we think inevitable (there'll be no shortage of new digital currencies), then prices will eventually gravitate back to their intrinsic value, which in bitcoin's case is far below today's price.
Rory Gillen is the founder of GillenMarkets.com, the investment training and asset management business
Sunday Indo Business