Confused about Bitcoin and other Cryptocurrencies? Do They Matter to Me?

Parker College of Business

Bitcoin is the first and most popular digital currency based on a protocol outlined in a white paper (2008, pdf) under the pseudonym of Satoshi Nakamoto. Is bitcoin a viable currency or asset? The views on the matter are not unanimous but highly controversial. Some describe bitcoin as “noxious poison” (Charlie Munger) or “Avoid bitcoin like the plague” (Jack Bogle). Others describe it as “digital gold” (David Markus, Facebook) while Jack Dorsey (Twitter) said that “the internet will have a native currency” and thinks that it will be bitcoin.

What is the importance of bitcoin? One can answer this question by examining bitcoin as a technology, currency or asset. As a technology, the decentralized payments mechanism through the distributed ledger, the blockchain, represents an important technological innovation that may result in a potential disruption in the payments system and reconfigure industries. It could lead to the development of central bank digital currencies (see the attempt to introduce the global stablecoin Libra by Facebook in 2019). The decentralized web already has applications in smart contracts, banking, retailing and other areas. Many technologists agree that the blockchain technology will be transformative.

Does bitcoin qualify as a currency? Bitcoin is not backed by any authority (it is not a liability of any individual or institution). So far, it is accepted by a small number of companies and thus has a very limited use as a medium of exchange. Also, its function as a store of value is problematic given the tremendous volatility of bitcoin prices on the exchanges. It follows that presently bitcoin does not meet the criteria for currency.

How much is bitcoin worth as an investment asset? As bitcoin does not generate any cash flows, its intrinsic value should be zero. However, it has recorded the largest price bubble in financial market history. Bitcoin prices may be driven by speculative fervor on the expectation that other investors would be willing to pay a higher price in the future (greater fool theory). Should an investor speculate in bitcoin? Given the substantial legal and regulatory risks, there is a clear danger of a sizable permanent loss in the bitcoin value. The time integral, short- versus long-term horizon, is an important consideration in the decision to speculate in bitcoin. On the positive side, research shows that bitcoin offers portfolio diversification benefits. If investors want to speculate in cryptocurrencies, they should allocate a small percentage of their funds (less than 5%) toward that purpose. Finally, if blockchain is a foundational transformational technology, investing in blockchain technology companies has merit.

— John Barkoulas, Ph.D., Professor, Department of Finance