Bitcoin's Contentious Bid for Legitimacy
(Bloomberg View) -- Instead of bringing clarity, an impressive price surge last week accentuated the differences within the financial industry about the future of the bitcoins. Opinions range from those asserting that we are witnessing the birth and maturation of a new global currency to those who argue that the phenomenon is a “fraud,” with a large middle either reserving judgment or arguing that it will last but currently may risk being in the midst of a speculative price bubble.
Your position in this debate will depend to a significant extent on where you come out on the following three issues.
- The number of dedicated holders versus the number of momentum and speculative investors:
Bitcoins have loyal followers who believe that the future of mediums of exchange and stores of value is in currency constructs that are outside the purview of governments and central banks. They also have confidence that the technological underpinnings of cryptocurrencies give these a unique and lasting advantage.
There are no firm indicators of how large this base of dedicated holders is relative to traders who are temporarily -- and, until now, very profitably -- on the bitcoin bandwagon. The smaller the dedicated base, the greater bitcoins’ vulnerability to a speculative bubble that will eventually pop, delaying the structural and secular maturation of cryptocurrencies.
- The prospects for widespread adoption:
The answer to the first question will depend in part on where you come out on the issue of how fast bitcoins will be adopted by a broader population of users, whether for transactions or as a saving vehicle. Here, again, opinions are varied.
The optimists believe it is just a matter of time. They are encouraged by signals of greater interest and adoption, including the announcement last week that CME Group Inc. would offer bitcoin future contracts and Japan's decision last month to recognize the cryptocurrency as legal tender.
Detractors argue that the adoption process is fundamentally challenged by the high likelihood that governments and central banks will crack down on bitcoins sooner or later. After all, they argue, authorities will resist strongly a phenomenon that takes away their seignorage privileges, enables malfeasance and illicit payments, erodes their influence on economic and inflation outcomes, and lacks adequate consumer protection. They point to China’s crackdown as an indication of what is ahead.
- Financial engineering:
Holders of bitcoins have benefited from the difficulties that detractors, particularly certain hedge funds, face in trying to short the cryptocurrency. It is very hard to “borrow” the currency and there are no straightforward highly correlated assets to construct adequate proxies that then influence its pricing. As a result, the market is structurally, and very heavily, tilted in favor of the longs.
In the past, such dynamics have stimulated considerable interest in creating new tools, particularly some types of synthetics, to balance some markets. Already, there is chatter that the emergence of futures trading, in addition to developing a fuller universe of pricing and exchange, will open the way for shorts to participate actively.
These three factors will likely play an important role in determining bitcoins’ prospects, both in the short- and longer-term.
You should come to your own conclusions, but my view is that:
The technology underlying cryptocurrencies is here to stay, including in improving cost-effective payments systems and reducing their security vulnerabilities. Yet the bitcoin adoption rate may prove slower and bumpier than the predicted by the strong believers, whose overall number is probably still relatively small compared with speculators and short-term momentum players. In addition, shorting facilities will eventually emerge.
As a result, current holders could face a significant risk of sharp price corrections in the context of greater two-way price volatility. But then again, I held the same view a few weeks ago when bitcoins were trading at around half their current level.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."
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