Bitcoin basics: why it won't replace currencies

By: Tim Bennett
Does Bitcoin spell the end for conventional currencies? This week I explain why I think not.

Bitcoin basics: why it won’t replace currencies

Fans of Bitcoin and its many rivals, claim that it is a currency that will one day take over from the world’s dominant reserve currency, the US dollar. But while Bitcoin is important, this is a claim too far – there are too many features of the cryptocurrency in its current form that makes it a poor substitute.

What’s in a name?

The language that surrounds Bitcoin is certainly confusing. It is often referred to as a type of currency (see below) and yet it doesn’t share any of a traditional currency’s characteristics. As such, it is more of a digital asset.

What money is, and is not

To be fair to Bitcoin, it does do a number of the things that money is supposed to. The left hand side of the slide below summarises these. However, in order to join the ranks of, say, the US dollar, euro or sterling, it would also need to fulfil a few more key functions

·         As a medium of exchange

·         As a store of value

·         As a price inflator

As things stand, it rather fails on at least two of these three counts.

A medium of exchange

This is one of the three criteria on which Bitcoin scores most highly. The process of buying, storing and then using Bitcoin is relatively fast, secure and cheap. The list of goods and services that Bitcoin can be swapped for is growing and its anonymity adds to its appeal as a way of getting transactions done.
There are quite a few challenges remaining here, however, prime amongst which are the fact that it still cannot be swapped for many existing goods and services and transaction costs can be variable when it comes to converting cryptocurrencies back into conventions ones. On top of that, Bitcoin may be the dominant medium in this space but new potential rivals are spring up all the time.

A store of value

Here, I am afraid, the wheels come off pretty spectacularly. Whilst it has some attributes that look promising (see slide below), the main problem is that with the price spiralling and simultaneously volatile, no-one trusts it. Many buyers are happy to speculate on the value rising, rather than spending their “currency”, whilst sellers are wary of committing to cryptocurrency prices and typically price in a reference currency, such as the US dollar. Moreover, few workers will want to be paid in it for fear of their wages being immediately devalued in terms of what they can buy.

A price inflator

Inflation has traditionally been seen as a good thing, provided it is kept under control. The reason is that it stimulates spending, rather than saving, which in turn is thought to be good for overall economic growth.
The problem with Bitcoin is that it is deflationary, both because the price keeps rising (so goods and services priced in it get cheaper and cheaper) and the supply is limited (to 21m Bitcoins). Without a central source of liquidity, this supply constraint could push prices even higher. Couple that with the fact that it is technically possible to permanently lose Bitcoins, if say your PC crashes and takes all of your hard drive data with it, and the size of the problem becomes clear unless you believe that cryptocurrencies are about to rewrite economics.

A target for criminals

Whilst it is clearly going too far, as some commentators have, to suggest that Bitcoin is solely the preserve of underworld operators, the fact it is unregulated and anonymous makes it an easy target for fraudsters and money launderers. The lack of investor protection will worry few people while the price is rocketing but makes it unsuitable for use as a widely accepted form of money in the same way as say US dollars until some sort of framework is agreed.

A way to go yet

In summary, don’t be fooled by the various labels that suggest Bitcoin is a currency. It fans like to label it as such but the functional reality is rather different.