Bitcoin's Existential Crisis

Forget ETFs, Bitcoin needs a reason to live.
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It’s not every day that new asset classes aimed at retail investors come along, as Bitcoin has in recent years. But Bitcoin in particular, and crypto-currency in general, suffered a set-back when the SEC rejected the first Bitcoin ETF last week due to a lack of regulation in the underlying Bitcoin markets.

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Given that reputation, does Bitcoin have a future?

To answer that question we need to separate out two distinct uses of Bitcoin. Some holders of Bitcoin are treating it as a speculative investment, while others see it as a form of money.

There is little doubt that Bitcoin can be used for speculation, and it does not need to have any regulatory legitimacy or investment value in such a role. As a parallel, think about penny stocks trading on the OTCBB and Pink Sheets. These penny stocks are used for speculation all the time, yet in the vast majority of cases, they are at best risky and at worst downright fraudulent. (The obvious exception to this is certain foreign stocks of large companies that trade on the pink sheets or OTCBB – no one would suggest that Volkswagen’s pink sheet stock is a scam, though it is risky due to illiquidity.)

The point here is that whatever else happens to Bitcoin, there is no reason that it cannot continue to be used as a speculative gamble in the future. Even if Bitcoin has zero intrinsic value, like most penny stocks, that won’t stop people from gambling on its future.

To move beyond the seedy underbelly of the investing world, though, Bitcoin must show that it has intrinsic value. And like any currency, that means it must be used as a form of money.

All money serves three basic functions: (1) a store of value, (2) a medium of exchange, and (3) a unit of account.

The store of value function means that an individual must be able to put their wealth into the money and then have that money retain its value in the future. Money does not have to be able to store value perfectly – most of the time inflation erodes the store of value, but the better the money keeps its value, the more widely it will be used. That’s part of why the U.S. Dollar is the dominant currency around the globe.

While bitcoin does not have the inflation problems associated with traditional currency, its value thus far has been anything but stable. As a result, it’s hard to imagine someone wanting their paycheck paid out in Bitcoin or wanting to use Bitcoin to save money to buy a house or get married. On the store of value front, Bitcoin fails – at least for now, and until its value stabilizes.

Bitcoin’s bigger problem probably comes from the most important function that money serves: acting as a medium of exchange. The real purpose of money in the economy is not to give people something to speculate on, but to facilitate transactions. Dollar bills work because anyone can go to a restaurant, grocery store, or auto shop and trade their own labor for goods and services through the use of green pieces of paper (or plastic that represents that paper).

Though there are a few notable exceptions, a vanishingly small percentage of businesses don't accept Bitcoin. A person could have 1 million Bitcoins and still starve to death if they weren't willing to trade them for USD first. Further, there is no sign that Bitcoin is gaining significantly wider acceptance. Instead, it seems to be viewed as a stranger and less stable form of gold.

Both gold and Bitcoin can serve the third function of money: as a unit of account. In theory, we could price any service or good in either Bitcoins or gold. The problem is that at present, people still do this using USD. For example, if I wanted to sell a car for $10,000 and I was willing to accept gold or Bitcoin, I would first look at the conversion rate between those commodities and USD, then set the appropriate “price.” In other words, Bitcoin’s ability to serve as a unit of account depends on its link to the USD.

All of this suggests that Bitcoin is not a form of money at present, nor is it likely to become one anytime soon. Some would argue that rather than being thought of as currency, Bitcoin should be seen as a commodity. But all other commodities – even gold – have some use or practical purpose, from feeding animals (corn and soybeans) to making jewelry (gold and silver). Bitcoin has no practical purpose.

Without a practical purpose and without the ability to serve as a form of money, Bitcoin is likely doomed to remain merely a tool of speculators lacking any intrinsic value. Until Bitcoin proponents solve this problem, the “currency” will continue to be eschewed by investors and advisors regardless of whether a Bitcoin ETF is ever approved.

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