Published Editorial

Don’t invest in Bitcoins yet

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by

Neville Dumasia
Partner & Leader
Risk Advisory Services, EY

Contributed by:

Nikhil Pandey
Associate Director
Risk Advisory Services, EY

Virtual currencies such as Bitcoin are attracting greater attention and scrutiny as more and more interest is getting generated. Bitcoin was launched in 2009 by a person (or group of persons) known by the pseudonym of Satoshi Nakamato. The idea behind the launch of Bitcoin was to have a digital currency that can be used for payments across various e-commerce platforms without the relying on financial intermediaries, and that will not be affected by supply-side problems—which is of printing more and more of such currencies—currently affecting fiat money. In essence, Bitcoin is a decentralized peer to peer payments network and a virtual currency that essentially operates as online cash. Unlike traditional currencies, which are issued by central banks, Bitcoin has no central monetary authority.

The first question which comes to mind while using Bitcoin is why should one use Bitcoin when one can use fiat currencies such as rupee, dollar or euro? Bitcoin is still a new and fluctuating currency that is not accepted by many merchants, so the use of Bitcoin may seem mostly experimental. But using Bitcoins has advantages—it is a truly global currency, the transaction costs are lower and it provides liquidity in times of capital controls and high inflation.

Like all digital currencies and platforms that try to keep transactions to be used across the Internet anonymous, Bitcoins, too, have disadvantages such as online theft and hacking, criminal uses and volatility.
Historically, money had two functions—to act as a medium of exchange and a store of value.
After the advent of banking and financial institutions in the medieval period, money added a third function as well—credit creation, i.e., the transfer of money from one who has it to one who needs it. This has been made possible by the evolution and innovations in banking, which include:

a) Cashless intra-bank and inter-bank transactions, thus reducing the need for coins and other such resources.
b) Fractional reserve banking (the policy to hold a fraction of loans as reserves against loss-making provision).
c) Central bank monopoly on note creation, as this induced faith in the currency in use and imparted stability in the system and thus has made fractional reserve banking possible.

In modern times, credit creation has become a very important aspect of monetary phenomenon, as is evident from the way Marshallian K is increasing (it is a ratio of monetary base to nominal gross domestic product).
For any virtual currency like Bitcoin to establish itself as an alternative to fiat currencies, all three functions of money are equally important.

Policy concerns

Historically, human life has been mostly affected by technological evolution from hunter gatherers to agricultural settlers to an industrial society and now to an ever connected society via Internet and other means of communication. This makes it impossible for regulators and other governing authorities to ignore virtual currencies such as Bitcoin, which, for the first time, make it possible to have a unified medium of exchange on Internet.

Such virtual currencies can and will greatly influence people’s behaviour, both socially as well as economically, in the future in the same way as introduction of physical money had done in the past. Therefore, it is imperative for governments and policymakers to have a critical examination and study of virtual currencies, their impact on greater economy and society, and to be prepared for any eventuality brought by technological disruptions. This will be the first step in understanding and providing the stewardship for ushering the society into the next age.

The idea of virtual currencies like Bitcoin is catching up. However, the legal status of Bitcoin is unclear, as is evident from the fact that recently big governments have started to warn people against the use of digital currencies, since money is an integral part of how a society operates and a stable monetary system is one of the pillars of functioning of a stable society. At the same time, given the technological evolution, the idea of a virtual currency that can be used in a virtual economy, in which the current human generation is moving, has also got a fundamental case in its favor.

Bitcoin itself may go bust due to resistance from various governments and technological flaws but the chances are that some form of digital money will make a lasting impression on the financial landscape. Given the socioeconomic impact and implications, this calls for a greater understanding and development of necessary frameworks and institutions on part of policymakers and governments to deal with this phenomenon.
As of now, Bitcoin has weathered quite a number of significant price adjustments since 2011. These adjustments resemble traditional speculative bubbles: overoptimistic coverage of Bitcoin prompts waves of novice investors to pump up Bitcoin prices. The exuberance reaches a tipping point, and the value eventually plummets.

Newcomer investors who are eager to participate run the risk of overvaluing the currency and then losing their money in a crash. The fluctuating value makes holding Bitcoins tough for people who want to use this particular virtual currency as a store of value.