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The Future of Bitcoin

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  • Bitcoin’s value has risen sharply on balance in recent months
  • Opinion is completely divided on the future of this cryptocurrency
  • Economists often take a different view on Bitcoin than people in the crypto world
  • In this special, I discuss the various arguments as objectively as I possibly can
  • Bitcoin could still increase in value, but it could just as easily go the other way

Introduction

In recent months the price of Bitcoin has risen sharply on balance, despite some fluctuations. The largest cryptocurrency’s latest price spike is prompting talk about Bitcoin’s future. Pressing questions are coming up. Is Bitcoin money or not? Why is Bitcoin valuable? And what does the future hold?

Skeptics anticipate a collapse at some point, while true crypto believers see Bitcoin as the currency of the future. The discussions about Bitcoin are very broad and opinion is divided on even its most basic aspects. For example, Bitcoin was designed to be a payment method, but more and more people have come to view it mainly as a new investment category. The likely future of Bitcoin is also the subject of debate; will it replace the existing system, or will it eventually become “just” another new financial product that exists alongside the ones we already know?

In this special, I will attempt to answer some of the pressing questions about Bitcoin, without the least intention of even trying to settle them definitively. The main perspective I take here is that of an economist. Because regardless of all the innovation unleashed by the arrival of Bitcoin which appears set to cause permanent changes to the financial system, some of the economic claims being thrown about deserve, at the very least, closer consideration. Some of them are just plain wrong. And it is not easy to verify claims and news. I will subject a few such news facts to further scrutiny in this special.[1]

First Things First: Is Bitcoin Really Money?

A Common Definition of Money

Money is frequently defined as follows: something is money if it is generally accepted within a specific society as a unit of account, a payment medium, or a store of wealth. This definition is not entirely adequate, since in a developed economy, money can be used not only as a unit of account, as a means to pay for goods and services and to accrue savings, but one should also be able to use it for borrowing money or issuing a bond.

If we take this definition of money as our starting point, we can review the various elements. Bitcoin can be used as a payment medium, but its overall acceptance is limited to Bitcoin believers. This group can be likened to a sort of society that is spread across the world and has become pretty big. But it does not overlap with a real Bitcoin economy. In fact, there hardly is one. In this light, Bitcoin is not unlike a foreign currency, but one without an economy to support it. This feature makes Bitcoin and other cryptocurrencies fairly unique.

There are relatively few companies that accept payments in Bitcoin. In early February 2021, Elon Musk announced that soon, you would be able to buy a Tesla with Bitcoin, but the next person that the same news item interviewed was a Tesla dealer who strongly denied that his business would accept such payments. On March 23, Musk put his Bitcoin where his mouth is. For the meantime only in the U.S., Tesla will indeed be allowing payments in Bitcoin. To begin with Tesla will not accept other cryptos, but that could very well change. Musk’s move raises several interesting questions that I will address in Box 2.

On March 20, 2021, the Dutch newspaper NRC reported that approximately 200 companies in the Netherlands accept Bitcoin as a means of payment, noting that, for many, this above all is related to marketing campaigns. In practice, they only execute a few transactions a year. Public acceptance of Bitcoin still has a long way to go, even if several million people across the globe have their own so-called wallet. Therefore, Bitcoin definitely has value (see below, too) but to turn that value into cash, which is undifferentiated purchasing power, it first has to be converted into regular money, like dollars or euros. As a unit of account, Bitcoin only works if valued in a regular currency. Whether or not inflation occurs in the Bitcoin world is an open question. No information exists on the subject. Bitcoin prices do not exist within a Bitcoin economy as an allocation mechanism, or at least not perceptibly, on which more later.

Bitcoin as an Asset Class (store of wealth)

It takes some effort to see Bitcoin as a regular investment asset too. With “regular” currencies like the euro, people can make money by investing it in a profitable business. The profit generates a return, and if the amount of money grows in line with real economic activity, investors can cash in on it. The most important point here is that one party’s gain is not necessarily another’s loss. Simultaneously, it’s also possible to borrow money to invest at a predictable interest rate and to, over time, pay the interest and loan repayments from the generated income.

Bitcoin works differently. We have seen that Bitcoin can increase or decrease strongly in value, but it is a closed system. In part, this is because of the deflationary characteristics of Bitcoin. How much Bitcoin is available is predetermined and ultimately limited. Therefore, the ROI of Bitcoin is only related to the price of the Bitcoin itself, expressed in regular currency.

Because there’s hardly anywhere that they can make a payment in Bitcoin, Bitcoin investors can only claim their return if another user is prepared to invest that amount into Bitcoin at a higher level, in exchange for regular currency, of course. This is perhaps one important reason why speculation about Bitcoin’s further upward potential is rife at the exact time that the price of Bitcoin has soared. Without the inflow of new money, investors in Bitcoin cannot reap their return in regular currency. In this, Bitcoin shares some resemblance to a pyramid scheme. At the same time, commentators regularly point out that price manipulation can occur in the Bitcoin system, when a few big parties manipulate the price for their own gain. The market for Bitcoin is relatively illiquid compared to the traditional financial markets, which means, unfortunately, that it lends itself well to such manipulation.

Of course, the same can be said of an asset class like precious metals, too. They often have only limited value in regular economic activity, even though they have industrial applications and can be used to make jewelry.

Cowrie shells and Rai stones cannot even make this claim and just like Bitcoin, their value can plummet to zero. Nonetheless, it’s a cold hard fact that these two means of payment have been in use for thousands of years, even if their significance has declined considerably. Even gold was pushed from its pedestal temporarily in the 19th century by the advent of aluminum. Early perspectives on aluminum considered it an exceptionally remarkable new metal. Napoleon III even replaced the golden tableware he used at state banquets temporarily with the new-fangled aluminum. The hype was short-lived; aluminum cutlery soon became part of soldiers’ standard equipment and disappeared even sooner from the royal court. Gold and silver have traditionally played an important role as safe investments that are relatively easy to exchange for currency. They still do.

Box 1: Paying Taxes in Bitcoin

If the government backs a currency as a means of payment, in a normal economy, it greatly helps to increase general acceptance. So the news that taxes could be paid in Bitcoin and Ethereum in Switzerland was welcomed in crypto circles.

Closer examination, however, reveals that this news is less spectacular than it first appears. It was the canton of Zug that opened the possibility of paying taxes in Bitcoin, something that was already possible in a few Swiss cities. But the tax assessment simply reads in Swiss francs. And the tax authorities just want to be paid in francs. However, people can convert their cryptos into francs through a designated crypto company with which the tax assessment can be paid. After all, local governments keep their books in the national currency.

Not so spectacular, then. At any time people can decide to convert illiquid assets, such as gold, stocks, real estate, or cryptos, into regular money to pay a bill. That has now been made a little easier for Bitcoin users.

Can You Get a Loan in Bitcoin?

The fact that Bitcoin also has some characteristics of a zero-sum game, limits its use in day-to-day-transactions.  Regular money can be used for more than just payments, it can at the same time be borrowed or invested. With Bitcoin, it is the price that ultimately determines the return, positive and negative.

By definition, then, the fate of the person who takes out a loan in Bitcoin is the opposite of the investor’s. A great deal of attention is going to those people who got into Bitcoin in early 2020; they can now collect a profit thanks to the current, much higher price. But someone who, say, took out a mortgage loan in Bitcoin would have seen their debt explode in terms of regular money and would likely now be bankrupt. Incidentally, I am unaware whether many people have taken out Bitcoin loans.

The underlying problem, therefore, is that there is no underlying Bitcoin economy in all costs and revenues are in Bitcoin. As long as people’s daily incomes and expenditures take place in regular money, Bitcoin (or any other random crypto) will, at best, be ill-prepared to serve the same function as money.

That said, Bitcoin fulfills the function as a store of wealth rather well, but its high volatility also makes it high risk. Therefore the most important possible role that Bitcoin could have in the future financial system is as an asset class. 

Bitcoin Only Exists Virtually. Why Does Bitcoin Have Value?

Things are as valuable as the worth we attach to them. This may seem like a lazy definition, but it is not. Clearly, some goods exist that are considered valuable because they are useful. Early money standards, for example in Egypt, were based on grain. In Virginia, the money system was based on tobacco for centuries. The intrinsic value of metal coins depends on which metal is used to mint it, like copper, iron, silver, and gold. But most money has no practical application other than fulfilling the role of money.

One very old money standard was based on massive stones (Rai), while the longest functioning money standard throughout a large geographical area was based on Cowry shells. Besides dental crowns and jewels, gold has few practical applications and paper money is completely worthless the minute that no-one will accept it.

Traditional fiat money has no physical form. The same is true for Bitcoin. As long as enough people believe in Bitcoin and are prepared to pay regular money for it, Bitcoin has value. If people stop believing in it, Bitcoin becomes worthless. As noted, Bitcoin shares this characteristic with other types of fiduciary money, like the aforementioned Rai, shells, or currency and fiat money.

It is also true that as long as people trust in the government, regular money’s status as legal tender enjoys some protection. However, that trust in money can be revoked if, during times of hyperinflation, trust in the government is utterly destroyed, as in Zimbabwe in 2008 (see Figure 1) or, more recently, in Venezuela.

Figure 1: Hyperinflation Money in Zimbabwe
Figure 1: Hyperinflation Money in ZimbabweSource: Reserve Bank of Zimbabwe

How High Can the Value of Bitcoin Rise?

Some people anticipate that the value of Bitcoin can rise much, much higher, to a million dollars even. If asked whether this is possible, I can only say: yes, it could. The value of Bitcoin could even rise to as much as two million dollars, or more. But it might not, because the chance that the value of Bitcoin could suddenly crash, even to zero, is arguably just as likely. As I have explained, the value of Bitcoin is completely determined by the value its enthusiasts attach to it. Hypes can go very far, though. Back in the 17th century when Tulip Mania was sweeping the Netherlands, there was one type of tulip bulb that was worth so much you could trade it for a fine canal house in Amsterdam. Relatively speaking, the hype surrounding Bitcoin is not so bad, although with a much larger international reach.

Bitcoin and Inflation

Bitcoin advocates regularly point out that Bitcoin is not affected by inflation. They draw attention to the fact that there is a limited amount of Bitcoin, a situation they compare to the regular money circuit, where in principle central banks can introduce an infinite amount of money to the market. While it is true that this tells us something about the amount of Bitcoin, it tells us nothing about the rate of inflation, which is measured in terms of price development rather than the development of the amount of money. So the example tells us nothing about inflation. In order to make any claims about inflation in the world of Bitcoin, you would need to identify exactly which goods and services were being traded in Bitcoin globally, how large a share each individual product has of purchases in Bitcoin, and what the price development of every product (in Bitcoin) is over time. Only then can a price index be constructed for Bitcoin to measure its progression over time. But that information does not exist and will not be made available. Because that would require far-reaching transparency throughout the Bitcoin world, to an extent that would undermine the core philosophy of Bitcoin, which privileges privacy and pseudonymity over transparency. The claim that Bitcoin is not affected by inflation, therefore, is unfounded.

The Scarcity of Bitcoin: Advantage or Handicap?

A related factor is that Bitcoin is not suited to functioning like money in a normal economy. In this respect, the predetermined, fixed amount of Bitcoin is a great handicap. To maintain a stable price level, it is important for the amount of money to be able to grow more or less in line with economic activity. This is not entirely a one-to-one relationship, because the rate at which money is exchanged between owners (the so-called velocity of money) also plays a role (Boonstra & Van Goor, 2021). If the amount of money cannot grow in relation to economic activity, it can only be accommodated by either an ever-increasing velocity of money or a structural decline in prices. A problem arises when people begin to expect structural price decline, in that the velocity of money is more likely to decrease instead of go up. This could land the economy in a serious depression. The same problem, among others, affected the gold standard, eventually leading to its being given up. As a result, fiduciary money became far more common during the last few decades of the gold standard, for example, debased currency, bank notes, and fiat money.

When Bitcoin was launched, commentators (for example, The Economist in 2011) quickly noted the coin’s structurally deflationary nature. The artificial scarcity of Bitcoin is an advantage for Bitcoin investors as long as enthusiasm for Bitcoin continues to grow: rising demand with inelastic supply by definition leads to a higher price. In this sense, Bitcoin resembles gold. But from a monetary perspective, it severely handicaps Bitcoin’s potential to become a serious currency. Price stability requires the amount of money to retain some elasticity so that it can grow in line with the economy. The gold standard proved untenable for a reason. Once the economy “outgrew” the gold supply, fiduciary money became increasingly important.

The same thing could happen to cryptocurrency, too. Since the introduction of Bitcoin, a great many new cryptocurrencies have been created. As the deflationary character of Bitcoin becomes a bigger handicap to its successfully fulfilling the payment function of money, other cryptos may well step in to play that role. It’s what happened when paper money and later, fiat money, gradually replaced precious metals as a means of payment. In this scenario, it is imaginable that Bitcoin would increasingly become an investment category. History provides an analogy with precious metals here, as well. Considering the fact that the amount of some newer cryptocurrencies is not limited in advance, unlike Bitcoin, the crypto world is neither more nor less inflationary than the regular money market.

Bitcoin and Sustainability

It is well known that the "mining" of Bitcoins is a very energy-intensive process. A recent publication by PWC calculated that one transaction in the Bitcoin network consumes 750 kilowatts of energy. By comparison, 450,000 Visa transactions can be carried out for the same amount of energy. It is equivalent to approximately the electricity consumption of a Dutch family in about 75 days. Not exactly what you call an attractive sustainability track record. The total usage, according to another article, is around 121 terawatt hours per year. That is more than the energy consumption of the whole of the Netherlands and is about thirty times the annual energy production of the Dutch nuclear power plant in Borssele. The authors of the latter article point out that the annual costs of gold mining are even higher. But whether that is true depends entirely on the Bitcoin price. The comparison used in that study is based on the amount of energy per value unit. At its current price, Bitcoin’s energy consumption is not unfavorable, but a year ago it was a different story. Relative to other payment methods, like cash or fiat money, Bitcoin is extremely energy intensive. There are also newer cryptos that consume far less energy.

Some Bitcoin adepts argue that Bitcoin’s high energy consumption should be accepted without complaint simply because Bitcoin is such an innovative application. Here the crypto devotees seem to be confusing the Bitcoin blockchain with the "currency." Because as a means of payment, Bitcoin adds no real functionality compared to regular fiat money. On the other hand, the distributed ledger technology it uses is a distinct innovation compared to the regular system.

Is Bitcoin a Suitable Means of Payment? And How Fast is the Blockchain?

According to the PWC report mentioned above, the blockchain, the distributed ledger technology (DLT) behind Bitcoin, can handle approximately 180,000 transactions per day. That seems like a lot, but the Dutch giro-based payment system can handle that volume in a few minutes. The existing Chinese giro payment system can handle it in two seconds; the new Digital Currency Electronic Payment (DCEP) system is even designed for 300,000 transactions per second. Compared to regular currencies, then, Bitcoin is clearly lagging behind as a means of payment. To put it bluntly, for the time being, the speed of the blockchain is to regular payments what a handcar is to an F16 at top speed.

That could all change, of course. A so-called lightning network has been under construction since 2015, but it is still in an experimental stage of development. But in fact, this “second-layer” solution is actually nothing more or less than temporarily bypassing the blockchain. It can even make the Bitcoin market more opaque. The tragedy of Bitcoin can be boiled down to the fact that it came with a completely new, revolutionary technology, the DLT. Now there are other cryptocurrencies that have their own networks; some are much faster than the blockchain, with a number of them almost capable of matching the processing speed of the regular payment system.

DLT is a technology that is rapidly gaining a foothold in the mainstream financial system. But the same is not automatically true for Bitcoin. It can be compared to the impact of the internet on banking. Twenty years ago, many trend watchers predicted that new internet banks, i.e. banks without branches only accessible via the web, would rapidly replace the existing banking system. In 2021 almost every bank (also) offers its services via internet banking. Many a pure internet bank, however, has ingloriously been absorbed into an old-fashioned bank. Egg Bank, the first real internet bank, is now part of the Yorkshire Building Society. Anyone searching the internet for "Egg Bank" today has a good chance of ending up on the websites of companies offering women the opportunity to have their eggs frozen.

How Transparant Is The Blockchain?

People who are deeply enthusiastic about Bitcoin like to draw attention to the network's transparency. After all, every individual transaction is visible on the blockchain. But this is not the whole story. It is true that every web address is visible, but it is often not known who is behind it. This is because of pseudonymity. The creators of Bitcoin and similar crypto currencies and their supporters are mostly strongly committed to privacy. There is nothing wrong with that in itself, but it also makes cryptos very attractive for the financial settlement of criminal transactions. Even in the case of computer hacks, as was the case recently at Maastricht University, the hackers often have to be paid off in Bitcoins. If such a transaction were concluded through an ordinary bank account, the police would probably be on the criminals' doorstep within minutes. But when criminal transactions are conducted via the blockchain, tracking down the criminals requires much more law enforcement effort, although gradually the police are becoming more effective in tracing Bitcoin transactions Incidentally, the number of criminal transactions completed in Bitcoin accounts for less than 1 percent of the total number of Bitcoin transactions, I recently heard on a radio interview. Nevertheless, that says nothing about the amounts of money that could supposedly be involved.

Box 2: Tesla Now Accepts Payments in Bitcoin

In early February 2021, Elon Musk announced that Tesla would be accepting payments in Bitcoin. It was also announced at the same time that Tesla had purchased USD 1.5 billion of Bitcoin, the equivalent of 3 percent of Tesla's balance sheet total and about 8 percent of its liquid assets. On March 23, Musk reiterated his commitment and made it more concrete. It will not be long before a Tesla in the U.S. can be paid for with Bitcoin, with the rest of the world to follow later, according to the plan. Unlike the Swiss canton of Zug, Tesla does not use a crypto company as an intermediary. You can pay directly in Bitcoin. At first glance, this is a big step forward in the general acceptance of Bitcoin. But a lot is still unclear.

The key question is which currency will be used to set the price of a Tesla. Currently, in the U.S., this is still done in dollars. If customers can then pay in Bitcoin, the daily price of a Tesla expressed in Bitcoin will constantly fluctuate with the USD-Bitcoin exchange rate. Then, as with the Swiss canton of Zug, it's a nice publicity stunt, but it's not really material. On its own, this would be a logical choice for Tesla, especially since the cost side of the business is in regular currency. If Tesla were to lock in the Bitcoin price of a car for an extended period of time, the company would run the risk of making its dollar-denominated operating income increasingly dependent on fluctuations in the price of Bitcoin. That would be a risky gamble. Only if Tesla started paying its suppliers and employees in Bitcoin could it afford to receive (a large portion of) its revenues in Bitcoin, because that would shift the risks to employees and suppliers.

In practice, it is likely that Tesla will invoice a portion of its automobiles in Bitcoin and a portion in regular money. This is like treating Bitcoin as a foreign currency, which is difficult to hedge against. The impact on the operating result would be limited, but would still depend mainly on whether the prevailing price is the dollar price or the Bitcoin price. The former is the most likely, and would be in Tesla's own favor, according to a recent article on CoinDesk, which also reveals that Tesla has another surprise in store for buyers. In the United States, when people buy a car, if the product is defective they are entitled to return the car to the factory and get a refund of the purchase price. The legislation on this is known as lemon law. If someone buys a Tesla worth USD 50,000 and pays in Bitcoin, doesn't like the product, and is entitled to a refund, Tesla will refund the purchase price. But it will only do this in Bitcoin if it has fallen in value. If Bitcoin has continued to rise since the vehicle was purchased, however, Tesla will refund the amount owed in dollars. The terms and conditions show this. Thus considered, it is better to pay for a Tesla in dollars or, should people want to monetize their holdings of Bitcoins to buy a Tesla, they should simply do so through a crypto exchange and pay for the new car with the dollar amount released in the process.

A second important question is what Tesla will do with the Bitcoin it obtains. The company could add it to the Bitcoins it already holds, or it could choose to dispose of them directly. Some analysts point out that if Tesla keeps a large amount of Bitcoin in its portfolio, there is a chance that its share price could become increasingly correlated with the price of Bitcoin. Considering the small share of the balance sheet that Tesla currently holds in Bitcoin (around 3 percent), this seems to be a non-issue for the time being. Remarkably, since Musk's first announcement, the price of Bitcoin has risen by about 50 percent, but Tesla's share price has fallen by about 20 percent. This has evaporated about USD 200 billion worth of stock market value. But it is still too early to conclude whether the drop in Tesla's share price has anything to do with Musk's announcement. Some skeptics say that not only Bitcoin, but also Tesla shares (still with a price-to-earnings ratio of around 990) are a bubble. Time will tell.

Are There Any More Disadvantages to the Blockchain?

The absence of a central regulator for the blockchain is good for privacy, as explained above, but it also means that if anything goes wrong, no central authority can be called upon to fix it. Human error is responsible for almost all payment transactions gone wrong. People occasionally mistakenly transfer money to the wrong account. They can be tricked into transferring money to a fake account (spoofing). A third example: people sometimes pay the incorrect amount. In many if not most cases like these, banks can resolve payment errors. Even when, through no fault of the account holder, an account is hacked by an outside party, banks often (partly) compensate the account holder’s damages. Not so in the blockchain. If a payment goes wrong or a wallet is hacked and emptied, users can’t do anything to fix it. Another vulnerability is that losing the password for a Bitcoin wallet is just as bad as losing an actual wallet (see below).

What To Do If You Forget Your Wallet Password

Given the current price spike, losing your Bitcoin wallet password is very similar to losing a winning lottery ticket. The solution? Cry your eyes out and try again. Some (difficult to verify) accounts maintain that roughly 20 percent of all wallets can no longer be accessed by their owners. The contents of these wallets can be huge sums, especially those belonging to people who bought a few hundred dollars in Bitcoin for just a few cents per Bitcoin. The internet has stories to tell about lost passwords, people who deleted passwords while reformatting their hard drives, and people who discarded old computers only to realize their wallet had literally ended up on the garbage belt with it. The lesson is simple: pay better attention. Because there is no central regulator protecting Bitcoin users.

But, of course, you could also argue that the people who choose to hold (part of) their assets in Bitcoin are aware of this. It is the risk you inevitably run in exchange for far-reaching privacy and the absence of central supervision. Whether every enthusiastic Bitcoin follower who has recently jumped in realizes this is an open question.

Convergence with the Regular Financial System

By now, the reader can surely recognize some convergence between existing financial institutions and the world of cryptos. Among other things, banks provide custodian services to Bitcoin investors, which may actually help to solve some of the problems mentioned above. There are now also numerous other financial service providers offering investment products in Bitcoin and other cryptocurrencies. In many cases, these parties do not include Bitcoins on their own balance sheets. Unfortunately, it is generally difficult to obtain precise insight into which services they are actually offering. Often, they do not have an annual report with core data, balance sheet data, and a profit and loss statement. In the Netherlands, if crypto companies want to have a banking relationship with a regular bank, they must provide comprehensive disclosure to their bank. Banks must require this under supervisory legislation, which demands that they know their customers. Some crypto companies believe that the regulator is too strict and have even filed a lawsuit on this issue. It illustrates the inherent tension between, on the one hand, the high degree of privacy that many Bitcoin users see as a huge advantage and, on the other hand, the fear on the part of the regulator that this degree of privacy makes it all too easy for criminals to conduct illegal transactions through Bitcoin.

Distributed ledger technology is finding more and more applications away from Bitcoin in existing institutions, for example in transnational payments or expediting international letters of credit. In these places, DLT is adding significant value. Some central banks are considering introducing a central bank digital currency (CBDC) which will be based on DLT, although DLT appears to be more feasible for (wholesale) central bank applications rather than retail. (Terpstra et al., 2021). The Chinese central bank is also considering using DLT for the central settlement of DCBC, but as far as we know there is not yet a definitive decision.

Bitcoin Versus Cash

Paying with Bitcoin is in many ways similar to paying with cash. Law-abiding citizens use cash without any bad intentions, but it too, unfortunately, is also highly attractive to people with more questionable intentions. There is strong evidence that cash payments, especially banknotes in large denominations, play a significant role in the criminal world. For that reason, some economists advocate a reduction in the use of cash money (Rogoff, 2016). Over the past few decades, the central bank in Sweden conducted a large-scale cash purge, which has lessened the importance of large banknotes considerably. This article describes the process. The ECB has also taken some cautious, early steps to this end, but it’s a sensitive matter. In some countries, like Germany and Austria, people place a lot of value on cash. These countries have always considered privacy important where money is concerned, which is not to say that German and Austrian citizens are involved in large-scale tax evasion. It is more a question of culture, as illustrated by the saying Nur Bahres ist Wahres,which basically means that many people only consider a payment complete if it’s done in cash. It Modern methods of payment are widely available there, as shown in the advertisement in the following photo, taken in Vienna in 2018 (Figure 2). Contactless payments are also possible in Germany and Austria, but it is not as popular there as it is in the Netherlands.

Figure 2: Recent Advertisement Promoting Card Payments in Vienna
Figure 2: Recent Advertisement Promoting Card Payments in ViennaSource: Author’s Archive

For the prospects of Bitcoin, it is important that central (and private) banks want to have oversight of payment behavior in order to detect criminal transactions. Indeed, this is legally required. Many customers like the idea of being able to turn to their bank to rectify a transaction that they can prove is wrong. In addition, some governments are slowly but surely working to further reduce the attractiveness of cash for payment transactions. Against this backdrop, it is highly unlikely that regulators would tolerate opaque crypto networks undoing their efforts. To the extent that large-scale use of DLT is permitted, at some point central banks will likely demand that they be given access to the transactions and the parties behind them. Incidentally, this discussion is also currently playing out in the design of digital central bank money). In China, for example, the PBoC will soon be able to see exactly what is happening in the DCEP network (the Chinese version of CBDC).

Could Bitcoin Become a Global Currency?

No, Bitcoin cannot do that. Nor can any crypto or regular currency. The whole concept of a global currency is flawed. The theory of optimal currency areas teaches that currency areas have an optimal size. Whether a currency area may be called an optimum currency area (OCA) depends on the economic and political cohesion in that area and, in the words of Nobel laureate Robert Mundell, “the optimum currency area is not the world” (Mundell, 1961). Monetary autonomy is also important. Policymakers of particular currency areas want to be able to influence the money supply within their economy so that there is not excessive inflation or deflation. In Europe, we have the EMU, a currency area in which political integration is not yet complete. Given how hard it is to achieve political cohesion in a group of about twenty countries that are similar in many ways, the chances that it could be achieved on a global scale are zero.

Could Bitcoin Become a Global Currency Anchor?

No. The system is neither fast enough nor transparent enough. Moreover, creating a global currency anchor is a highly political process. It would enormously influence the way the international financial system is organized and could place restrictions on national monetary sovereignty. The stakes are extremely high. Policy makers would never allow an untransparent system like Bitcoin to fulfill that role.

That doesn't diminish the fact that intelligently designed crypto currencies may well play a role here. In 2019, for example, a consortium led by Facebook announced plans for a new digital currency, the Libra (later renamed Diem). There are many differences between Libra/Diem and Bitcoin, and of course the most important is that the Diem does not exist yet. But the design of the Diem is economically very sound. It is flexible, the consortium behind the Diem wants to cooperate with supervisors to prevent use of the Diem for illegal transactions and the Diem is a so-called stablecoin. This means that all Diem are in principle backed by high-quality, highly liquid assets. It all remains to be seen, but the authorities immediately recognized that the Diem has the potential to become much bigger than Bitcoin, thus affecting the monetary autonomy of central banks. It is probably the main reason why central banks have greatly increased their efforts to introduce CBDC in recent years.

Earlier, I stated that the Libra/Diem could serve as a global currency anchor with a few adjustments. The composition of the Diem would need to be like the SDR, the International Monetary Fund’s basket of currencies which is comprised of the most important currencies in the world. The IMF would have to supervise this basket, but the Bank for International Settlements (BIS) would manage the currency on a day-to-day basis. That would vastly improve the global financial infrastructure and simultaneously make the global economy more stable.

The Diem does not exist yet, but if one day it does, in its original version, possibly supplemented with various national stable coins (and if it is successful), then it is not at all clear what the added value of Bitcoin will be as an international payment means. But maybe it could still play a role as an asset class.

Will Bitcoin Ever Be Fully Integrated into the Mainstream System?

As explained above, this is already happening to some degree. For example, some banks are already acting as custodians for Bitcoin companies. However, this does not necessarily mean that they take Bitcoins on their balance sheet themselves; trading at their own risk is now largely prohibited for most banks. They would also have to hold a lot of equity against it, given Bitcoin's volatility. But when banks offer services to Bitcoin companies, they immediately provide a means for the regulator to get a better handle on them. After all, banks need to know their customers well, which means they need to have a good understanding of what their customers are doing. The customers behind the wallets may very well have to reveal their real identity to the custodian. Many parties are entering this market with additional financial services in cryptocurrency. Although some of these companies are starting to look like banks in many ways, they rarely are, which makes sense, as they would be directly subject to banking supervision. For Bitcoin to be fully integrated into the system, its pseudonymity will have to be largely abandoned.

Can We All Get Rich on Bitcoin Overnight?

No, we cannot. At least, not all at once. As it is, there is no real Bitcoin economy. So if a Bitcoin investor has made a nice profit in Bitcoins then, in order to collect this profit, they must find someone else to take the Bitcoins from them. As long as money flows into Bitcoin from the dollar or euro sphere, the Bitcoin price can remain high or even continue to rise. If that flow dries up, sentiment can also shift very quickly. Of course, there are people who can make a lot of money investing in Bitcoin, but there are also many who cannot. In that respect, it's a bit like a lottery or going to a casino. You have a chance to make a nice return on your investment, but you also know that most people just lose their money. So getting rich in our sleep while Bitcoin does its "work" is unfortunately not possible, at least no more possible than it is with any other investments. No matter how much many of us would like that. In the end, goods and services have to be produced somewhere.

What Will Happen If Bitcoin Becomes Regulated?

The fact that Bitcoin is used to settle illegal activities also gives Bitcoin investing a bit of a sour aftertaste. It is, of course, conceivable that the blockchain will be modified in such a way that a certain degree of transparency for a central regulator will replace pseudonymity. And that a market regulator will henceforth oversee whether price manipulation is taking place and whether Bitcoin investors are being provided with good, objectively accurate information. Who could object to that?

Nevertheless, the possibility remains that such measures, which regulators are bound to lean toward sooner or later, will subsequently cause Bitcoin's light to burn out quickly. Criminals are then likely to retreat from Bitcoin in a hurry. If it were to emerge that, despite the small number of false transactions mentioned above, a great deal of money is involved, the price could fall rapidly.

What Is the Biggest Threat to Bitcoin?

Bitcoin faces a slightly contradictory threat, namely, that it could become too successful. Central banks will not allow an uncontrollable type of alternative money to take away their control of domestic monetary developments. The same is true with stablecoins: central banks are now working hard on CBDC themselves, with the preservation of monetary sovereignty as the main reason. Bitcoin or any crypto should not become systemically important. Regulators have worked hard in recent years to strengthen the stability of the banking system and won't be happy to see it now eroded by shadow banking.

Overall, I get the sense that the DLT, the real innovation behind crypto currencies, is likely to become a permanent fixture in the financial system. However, the prospects of Bitcoin as a currency, like those of other crypto currencies, are a lot less certain.

Caveat Emptor!

References

Mundell, R.A. (1961), A Theory of Optimum Currency Areas, American Economic Review, Vol. 51 (4), Sep. 1961, pp. 657–665.

Rogoff, K.S. (2016), The Curse of Cash, Princeton Press.

Footnote

[1] I am grateful to my colleagues Jarl Nieuwenhuizen, Claudia Terpstra, Wouter van Eijkelenburg, and Maartje Wijffelaars for their comments on this article. Jarl and Claudia’s innovation insight in particular helped me find my way in the world of cryptocurrency and blockchain. I learned a lot from that journey, but whether it was enough is up to the reader to decide. I take full responsibility for any inaccuracies. I must also point out that I am not an investment adviser, and that this article offers neither purchase nor investment recommendations.

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Wim Boonstra
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 5128 1405

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