Does Bitcoin Need a Central Bank?


If one could describe the digital currency in human terms, Bitcoin would probably be labeled the rock star of the currency world. Of late, digital currency, or Cryptocurrency as some fans like to call it, has become the rising star of the currency world, skyrocketing akin to lightning speed, despite being plagued by scandal.

Now FX investors ask, is this digital currency worth considering as an investment despite all the scandals? Or is it just a transient phenomenon that could disappear as quickly as it came, with future dreams of a digital currency sinking into the abyss? For the answer to those questions, we first must understand why Bitcoin gravitated in value in the first place, what problems it now faces and how they could be tackled?

Bitcoin as a Concept

For many, Bitcoin is a way to invest in the future of digital business and hence the reason they are drawn to it. However, the origin of the attraction to Bitcoin started as a parallel banking system to the one we traditionally use. With many freelancers and other individuals working for people located all across the globe, the Bitcoin system allows them to make international money transfers with ridiculously low costs, enabling those who are engaged in international trade to avoid often hefty fees charged by traditional banks.

Indeed, it is a significant factor to consider, a shadow banking system with almost no fees, meshing seemingly perfectly to the digital age where all payments and services are done internationally and online.

Bitcoin as a Currency

While Bitcoin’s allure as an alternative banking system seems clear, Bitcoin as an FX investment is far from promising and prospects seem rather shaky. To start with, Bitcoin has no ties to any economic cycle whatsoever, meaning there is no economic supply and demand cycles which drive demand as it does for traditional currencies like the U.S. Dollar or the Euro.

Even commodities such as Oil or Copper are tied to the cycles in the global economy. Bitcoin, however, is tied to one thing and one thing only only and that is how much investors are willing to pay for it. The currency is programmed in a way that eventually only 21 million will be “minted,” and as more Bitcoins come into circulation the process will require more and more processing power, making it harder to mint more Bitcoins.

For many, the limited number of Bitcoins and the fact that it becomes harder to mint them with each additional Bitcoin in circulation makes Bitcoin a currency destined for constant appreciation. Indeed, this process of minting Bitcoins where it is harder and harder to increase circulation is, in monetary terms, the reverse of quantitative easing, thus ensuring that the digital currency is in a constant state of tightening.

Adult Supervision Required

So what would balance the bubbly and regulation risk ? A Central bank for Bitcoins. Why? Because, otherwise, the currency will keep its exuberant appreciation until the bubble bursts and then the Bitcoin market, now composed of fans and investors, will become only a crowd of sellers.

One of the most effective ways to illustrate how Bitcoin has entered into a bubbly territory due to its constant monetary tightening is the chart below. So why do we think of Bitcoin’s meteoric rise from a little more than $107 back in July to more than $900 today as a bubble? Let’s take a look at the average U.S. household income in Bitcoins (rather than U.S. Dollars) since last July (mind you, a mere six months). As you can see, the results are astounding.

While the average U.S. household income was equivalent to 476 Bitcoins in July, it tumbled today to barely 56 Bitcoins – again in a space of only six months – clearly a staggering collapse of purchasing power and catastrophic deflation, thus risking massive liquidation of the currency due to its unrealistic value. What could save us from that possibly imminent burst? The answer is a central bank for Bitcoins that would enable Bitcoin circulation to increase under certain conditions and moderate its appreciation.

Moreover, with the currency collapsing over China’s ban of it and the growing threat that India’s government does likewise, then only a central authority, like a Bitcoin central bank, could curb regulatory concerns, maintain value over time and avert the catastrophic collapse of the currency, especially if it keeps appreciating exponentially without a backstop. While Bitcoin as a concept for a new banking system may very well work, the currency without a central bank may be doomed and destined to become yet another boom and bust.

This is not to say investment in Bitcoins won’t yield, just that without a central bank it’s a risky investment in a revolutionary startup, not a future currency as some of Cryptocurrency fans would like to think. Just some food for thought before you jump aboard the Bitcoin wagon.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Forex and Currencies , Economy , Investing Ideas

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Lior Alkalay

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