As the debate rages on whether bitcoin is a legitimate currency or just imaginary money, one Wall Street analyst stripped down the argument to three simple parameters — safety, liquidity and return.
These attributes are the hallmarks of reserve currencies like the U.S. dollar, the euro or gold, according to Bank of America Merrill Lynch’s head of global commodities and derivatives research, Francisco Blanch.
For now, bitcoin
falls short in making the cut even though it is gaining in popularity among a certain class of investors who believe the cryptocurrency will soon come out of the shadows and claim its rightful place as a legal tender.
Of the three criteria, safety remains the biggest problem as the absence of a central governing authority not only makes the digital currency more vulnerable to chaos but also susceptible to hacking, identity theft and fraud, according to Blanch.
“Other issues more specific to the functioning of cryptocurrencies, such as finding an agreement regarding the adoption of certain protocols, are also worth mentioning. For example, should bitcoin split into two digital tokens because miners cannot find common ground, a collapse in confidence and value could follow,” writes Blanch.
Bitcoin’s value nose-dived earlier in July on fears that a possible split could result in multiple versions. That event was averted last week, but investors are now bracing for what is known as a hard fork, which will lead to a splinter blockchain.
The volatile nature of the cryptocurrency also undermines its credibility.
“Volatility is the key parameter to understand the concept of safety in a reserve currency, in our view,” he said. “In that regard, bitcoin’s score has improved in recent years as volatility has continued to drop.”
Even compared to emerging market currencies, bitcoin is viewed as extremely volatile. Some of that, according to Blanch, may be due to the fact that many of these countries — China, Malaysia, Pakistan, Philippines and India — have repressive capital controls in place.
Nonetheless, as the chart shows, on at least two occasions last year, bitcoin’s volatility fell below silver, which was for some 400 years the world’s currency.
Interest in digital currencies has soared recently with daily trading volume in the cryptomarket jumping to $2 billion today from $400 million in 2012.
“For a digital token to become a currency, it must build to a certain scale,” said Blanch. “In some ways, this is exactly what has been happening in recent quarters, with the total market value of digital tokens growing exponentially from $1.5 billion to around $87 billion at present. Put differently, cryptocurrencies have built scale rapidly and are now accepted as a means of payment by some corporations and individuals.”
Unlike reserve currencies, bitcoin does not have an interest rate that is set by a central bank so it is difficult to quantify its returns. It also does not offer much in the way of diversification given its lack of correlation to other major currencies, precious metals, bonds or equities.
Still, bitcoin has offered phenomenal returns in terms of absolute value that few assets can come close to matching.
But exceptional returns do not make for a fiat currency and bitcoin’s ultimate test will be whether banks will capitulate and accept it as collateral.
“Most regulated financial institutions allow their clients to borrow against financial or physical assets, but we are not aware of any major institution that takes cryptocurrency as collateral at the moment. Thus, in our view, a key step for bitcoin would be for it to become pledgeable collateral,” said Blanch.
In other words, bitcoin still has a long way to go.