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The rise and rise of bitcoin! The name Bitcoin evokes a sense of enigma, curiosity, and a possible peep into the future of money.   

Origins of bitcoin can be traced to a blockchain built under an anonymous name – Satoshi Nakamoto. Satoshi was the first to solve the problem of double-spending using peer to peer network. The identity of the brilliant mind who authored the white paper on Bitcoin remains unknown to this day however!

Bitcoin blockchain is a public ledger that records all bitcoin transactions. It is recorded as an addition to the block of transactions without overwriting the earlier blocks. New bitcoins are mined every 10 minutes by generating a code or nonce. Mining of bitcoins refers to solving a computational puzzle and people who solve the puzzle are rewarded with new bitcoins.

Bitcoin has seen a dramatic rise in 2020 – a year marked by events unprecedented both in the real economy and in financial markets. Bitcoin has given a staggering return of 340% in 2020 and 570% from the lows of March 20. Financial markets had a roller coaster ride in 2020 and Bitcoin has been a stellar outperformer beating all asset classes by miles. 

Given the powerful rally and rising investments in the cryptocurrency from traditional investors, there is a growing view that the fair value of one bitcoin will be upwards of 1 mn USD if only 2% of investor wealth in currencies is invested in the cryptocurrency.

Given the advantages of borderless and seamless transactions at nil transaction costs in real-time, a huge influx of liquidity by Federal Reserve in the aftermath of COVID 19, audit trail of all transactions, flawless code with complete transparency of the mining process, added cushion of eventual scarcity in the supply of bitcoins coupled with a rally in the cryptocurrency, the argument that it will gradually replace the hard currencies of today seems a more realistic and likely scenario than it was anytime earlier.

We have attempted to put together our thoughts on whether bitcoin will pass the basic tests for being the next currency of the future or it will fade with the eventual rise of digital currencies backed by sovereign nations –

  • Popularity of bitcoin is partly because it is not regulated by the Federal Reserve or the Central bank of any country. These are free-flowing transactions that are not subject to review and/or approval of any competent authority. What has however led to the popularity of bitcoin is also an obstacle to its adoption and acceptability by a much wider audience. Submission to a sovereign regulation imparts legitimacy and trust to a currency. Higher the trust in the Central bank of a country, more are the savings and funds deposited in that currency. This explains why US dollar despite its flaws is the preferred currency in which Sovereign funds, pension funds, and individuals park their savings. This is the single biggest reason why bitcoin may never be able to become the alternative currency or replace any major currency.  
  • One of the basic features of a good currency is low volatility in its exchange rate. This explains why a lot of currencies are pegged to the dollar or a basket of currencies. Central banks of countries like India who have chosen not to peg their currency maintain huge forex reserves and intervene in money markets regularly to manage volatility. Reserve Bank of India has a plethora of instruments in its arsenal such as Repo rate, swap arrangements, and other policy tools to manage currency volatility. There is no Central Authority that exists to manage volatility in Bitcoin which partly explains the highs and lows in its chart. Banks, businesses, and ordinary people are unlikely to park their savings in a currency that runs a risk of 30% overnight fall in its value/purchasing power.     
  • Existing currencies enable different mediums of payment ranging from online transactions, credit card payments, withdrawal from ATM, and payment of currency notes and coins. Basic feature of a currency is to enable transactions across all these mediums and dimensions. Bitcoin while having certain advantages is not designed for payment via credit card/withdrawal by ATM etc. Though some Bitcoin Credit cards are available, their usage is quite limited due to the limitations cited above.  
  • Deposits in all currencies earn interest which is largely regulated by the Central bank based on inflation, growth rate, etc. One of the basic functions of currency is to drive economic activity by giving loans to consumers, businesses to invest in capacity expansion, etc. Businesses issue Bonds for different terms and a free debt market determines the interest rate or yield based on the credit worthiness of borrower, risk free rate and rates at which comparable bonds are traded in debt market. Bitcoin resembles a dematerialized asset class that earns no interest and has no underlying cash flows to support the high valuations. There is no regulatory authority which can act as an oversight for issuing loans and / or provide a legal recourse to enforce debt servicing in Bitcoin.
  • Bitcoin is also referred as Gold 2.0 with the potential to replace and/or complement the traditional yellow metal as a store of value. Until the Bretton wood system was abolished by President Nixon in 1971, US dollar was redeemable in Gold. Gold has been the store of value for centuries across civilizations as it indicates trust, low volatility, and hedge against inflation. It is extremely unlikely that people would change their mindset or behavior shaped by wisdom passed over several generations to abandon gold in any reasonable measure in favor of bitcoin. 

Buoyancy in financial markets, partly driven by the money printing machine of the Federal Reserve in the aftermath of COVID 19 has led to a rally in cryptocurrencies. In a discussion on cryptocurrencies on a business channel a few weeks ago, an “analyst” expressed the fear that economic growth may be impacted as Indians with 20% of the world population own less than 1% of bitcoins. I would not want to debate such comments but cannot resist drawing similarities to the views expressed by analysts in the build up to dot.com boom who suggested companies should be valued based on the number of clicks and that era of valuing companies based on cash flows is passe. 

Buoyancy in financial markets is a more recent phenomenon. So, what explains the success of bitcoin? For one, it is a Technological Leap. Secondly, it can be explained by the psychology of human nature. We are fascinated by the future and want to be early adopters of new technology. If our forecast of future on the adoption of cryptocurrency turns out to be correct, we would be handsomely rewarded financially and would also stand out among our peers as the ones who “out called” the future. We get carried away by our fascination for the future and in the process overlook that most forecasts are inherently off the mark!

Bitcoin also runs the inherent risk of a clampdown by regulatory authorities should a terror attack be financed by underlying transactions in cryptocurrency or if authorities decide to clamp down on the dark web which is a source of illicit transactions. As per a study, 1548 cryptocurrencies are in vogue today with transactions running into billions of dollars. It is similar to euphoria before the meltdown!!

US economy has been the most dominant economy since the end of World war 2. US dollar continues to be the store of value and haven for investors in times of risk aversion. 61% of the Forex reserves of countries are invested in dollar-denominated assets and 40% of world debt is denominated in the US Dollar, as per IMF

US dollar was created by the Act of Federal reserve in 1913. At the time, the US had overtaken Britain as the largest economy though Britain continued to hold its sway in the world economy and most transactions continued to be done in Pounds. US dollar was pegged to Gold as were all the major currencies of the world. The US was the major supplier of military equipment during world war and imported huge quantities of gold creating the largest reservoir on the planet. Bretton wood agreement put the seal on the US dollar as the reserve currency in 1944 when all major countries linked their currency to US Dollar while the Federal reserve re-affirmed its commitment to redeem the dollar for the value of gold.

In 1971, stagflation in the US economy prompted a run on the US dollar when the demand for redemption of the dollar against gold created the risk of the US losing out on precious gold reserves. After a round of devaluation of the US dollar against gold, President Richard Nixon delinked the US dollar to gold standard. This effectively removed any limit on the supply of dollars by the Federal Reserve. The devaluation of the dollar also made US exports more competitive giving a boost to domestic manufacturing. 

Petrodollar 

OPEC imposed an oil embargo on the US in 1973 as a protest to its support to Israel in the Yom Kippur war. This created long ques at the fuel stations and effectively brought the oil guzzler economy to a grinding halt. In 1979, US entered into an agreement with Saudi Arabia and oil-exporting countries wherein they agreed to sell oil only against dollars. It created an unending appetite for US Dollar by oil-importing countries like India, China

In return, US agreed to protect the House of Sauds against all acts of internal and external aggression. OPEC countries also pegged their currencies to Dollar or a basket of currencies dominated by the dollar. It helped in insulating the economies of OPEC countries from wide swings of inflation as they were importing most of the goods also in US dollar.

Current status of US Dollar and Covid 19

  1. US dollar continues to be the preferred currency of exchange and US continues to be the largest economy. It is noteworthy that personal consumption as a share of US GDP has risen from less than 58% in 1967 to over 70% today. Unlike other countries, US borrows its way to consumption by issuing US treasury bills which are lapped up by Central banks, Hedge Funds, etc around the world. US redeems Treasury Bills by printing currency since there is no limit on the supply of dollars after the abandonment of the gold standard. Ironically, the holder of reserve currency runs the largest trade deficit in the world at USD 616.8 Bn in 2019. US today has become akin to a consumer that maintains its momentum of consumption by increasing its debt and meeting it by printing currency. Rest of the world is also playing the game as it keeps its factories up and running, needs dollars to buy oil, and gives it the fallacy of increasing foreign exchange reserves denominated in a currency issued by a country that has an unending supply of notes. The question that we need to ask is that is it sustainable?
  2. Total debt carried by US has risen from USD 10 Tn in 2008 to a staggering USD 24 Tn as per Congressional Budget Office. Daily interest cost of the debt is a staggering 1 Bn USD and the debt per person in US is USD73K. As a percent to GDP, it stands at 106.9% up from 68% in 2008 when financial markets were on the brink of collapse. Further, it is 106.9.% of GDP of a country where consumption contributes 70% of the GDP funded by the largest trade deficit in the world. Debt is invariably a pre cursor to a financial crisis and the world is not a pretty place today. 
  3. US has been at the fag end of the curve in the manner in which it is responding to the pandemic. As of the date of writing, US has 7.2 Mn cases of infections with more than 200K deaths. Different countries have followed different approaches in responding to the pandemic. While we are yet to see any meaningful analysis in terms of what would be the most optimum approach in dealing with the pandemic, US has been the worst hit. It may not be an understatement to say that the US is heading into a catastrophe that is both human and economical. 
  4. This crisis is inherently different from the housing crisis of 2008. In 2008, the cash flows of Subprime bonds rated AAA by rating agencies around the world trickled down to zero with the collapse of the housing market. AIG which sold insurance against the default of Subprime bonds through Credit Default Swap (CDS) was staring at losses running into billions of dollars. It was bailed out by US govt which invested a staggering USD 180 Bn to prevent the collapse of the systemically important institution along with investments in major US banks to prevent their collapse. Companies today have created global supply chains to optimize on the sourcing, manufacturing and logistics costs. Covid 19 has disrupted the global supply chain in a manner that was not hitherto imagined. US has reacted to the existing crisis like how it was able to successfully manage the housing crisis of 2008. It has unleashed a Quantitative easing program for a staggering USD 2 Tn. Economists have been pleasantly surprised with the return of demand at Pre-Covid levels in some sectors but the distribution of demand is far from uniform. Companies have been responding to the loss of demand with automation and digitization initiatives which would not help in restoring employment to Pre-Covid levels for quite some time. Supply chain disruptions due to Covid-19 will not help the matters either. The huge influx of liquidity in the world economy may keep financial markets afloat for some time but will lead to inflation and devaluation of US Dollar which has been in an era of unlimited supply. 

The world order is changing in ways that have not been seen earlier. It will be too early to hazard a guess on the world order post the pandemic but will essentially depend on how various countries around the world respond to it. If US fails to respond in time before it’s too late, it may impact the world order and the greenback leading to a crisis of confidence in currencies. Gold may come back in limelight and so may the cryptocurrencies. Time is yet to cast its dice!