Not Quite the Economist

Bad money drives out good. But does virtual money drives out real?

That sounds a laughable idea at first: why would people want to pay real dollars for virtual currencies at all? And albeit Bitcoin’s “monetary supply” is determined by strict rules, which require super-computer to solve processor-intensive equations so that the supply of Bitcoin would not grow too quickly, there is hardly any guarantee that the rules will be adhered in the future (or faster computers be created). That means Bitcoin hyperinflation is always a remote possibility. There is, of course, nothing close to a deposit insurance for Bitcoin, too, should the Bitcoin “bank” close down one day.

What is more perplexing to most people then, is that the first Bitcoin exchange-traded fund (ETF) – the Winklevoss Bitcoin Trust – is introduced this week. And the “Winklevoss” name can hardly give a sense of credibility to the whole idea. To quote the Wall Street Journal:

If the Winklevoss name rings a bell, that means you probably saw the movie “The Social Network,” or know enough about the origins of Facebook to know that Cameron and Tyler Winklevoss — twins who attended Harvard and rowed in the 2008 Olympic Games in Beijing — claimed that Mark Zuckerberg essentially stole their idea for the business. The twins walked away with a settlement worth $20 million in cash, and Facebook shares worth, conservatively, 10 times more.

It is also interesting to note that China has emerged as a big centre of Bitcoin users. The graph from FT below shows that China has the second-biggest numbers of downloads of Bitcoin wallet downloads (a proxy to measure the popularity of Bitcoin), after the US. And the jump was especially significant since March 2013.

Sources: Sourceforge.net

So why would people want to convert their hard-earned “real money” into Bitcoins? For some, Bitcoin is just another way to escape the formal financial system to launder monies. Terrorists and organized crime networks have longed hoarded cash (i.e. banknotes) so that they leave no trace to the regulators. Bitcoin, despite its illiquidity, may still be a better and easier way for these criminals to wire money to each other.

But Bitcoin may gain its popularity because of its volatile price. In the last year alone, Bitcoins are traded between US$13 and US$266. The value of the currency is determined by nothing more than speculation. For investors awash with liquidity, especially in closed economies like China, hot money would naturally find its way into real assets. Bitcoin is hardly a “real” asset, but it is still something that people can invest in. That, however, doesn’t fit in with the credit crunch in China stories that have worried the investment world.

Despite its ambition to be a digital currency, Bitcoin is hardly money in an economic sense. It would only merely fulfill the first of the three functions of money: (i) an unit of account, (ii) a medium of exchange, and (iii) a store of value. Bitcoin is at best an investable commodity. But sadly, there seems to be a bubble that is about to pop too.