The bitcoin bubble may well get much larger until there is clarity on its use as a currency.
On Tuesday, the Reserve Bank of India (RBI) issued its third warning about trading in virtual currencies such as bitcoin. On Wednesday, the price of one bitcoin hit a new high of $12,000 in the US.
Not that anyone expected RBI’s warnings to cause a dent in appetite for bitcoins. China went much further and banned cryptocurrency exchanges earlier this year, but trading moved to over-the-counter platforms, and the ban caused only a temporary blip in the bitcoin rally.
The irony is that the more bitcoin rallies, the more people it draws into the rally, regardless of the fact that heavyweights such as investor Warren Buffett and Nobel laureate Robert Shiller have called it a bubble. Supporters of virtual currencies are betting that they will ultimately be accepted as alternative currencies, making them immensely valuable, especially since supply of the currency is limited by design. The bitcoin bubble may well get much larger until there is clarity on its use as a currency.
For now, multiple hacks, thefts and scams haven’t taken away anything from the charm of trading in bitcoins. The number of new users is doubling every three-four months on Indian trading platforms. In fact, in India, the rush for bitcoins has outpaced supply by a wide margin. As a result, there is a mark-up of around 15-20% to the international price; the price of one bitcoin hovered around Rs9 lakh on the Coinsecure platform on Wednesday at the time of writing.
Given the stupendous rise in the price of bitcoin this year—it was at less than $1,000 at the start of the year—even staunch supporters now use the following caveat, “Only invest money you can afford to lose”. In other words, risks associated with this form of investment are very high.
Nitin Sharma, an angel and crypto investor, says “There are a few different reasons why the average investor should not overexpose himself to cryptocurrencies. One, compared to even other high-risk asset classes, they are esoteric and one needs time to develop an appreciation for the underlying technology and the fundamental need for such tokens or currencies. As the saying goes, one shouldn’t invest in something you don’t understand, at least at a basic level.” Sharma, who was formally a founding member of venture capital firm Lightbox, says it took him about four months studying and building that understanding before investing. On the other hand, a large majority of new participants are just chasing the price rise, which is a classic feature of a bubble.
The fact that regulation is not clear is another risk. Bitcoin purchases and sales in India are undertaken under the premise that they are allowed because they aren’t explicitly disallowed. Do provisions of RBI’s Foreign Exchange Management Act (FEMA) apply to bitcoin bought overseas and later sold onshore? Perhaps not, some lawyers argue, because FEMA doesn’t talk about virtual currencies specifically. In short, it’s all grey. If Indian policymakers worry, as China did, about the multiple Ponzi schemes that have spawned alongside the bitcoin rally, and ban trading of bitcoin platforms, traders could be in trouble.
But on the other hand, with people such as the head of the International Monetary Fund making positive statements about digital currencies and with a large economy such as Japan giving bitcoin official sanction, an outright ban may not happen. Still, investors should appreciate the regulatory risks that are associated, especially given the lack of clarity from Indian regulators.
Another feature they need to appreciate is that cryptocurrencies are difficult to value. “While I am bullish on the possibilities that decentralization opens up, it is hard to think about valuation of these new crypto assets. For bitcoin, depending on whether it is thought of as ‘digital gold’ (a store of value) or a currency to pay for purchases (a medium of exchange), you can arrive at vastly different estimates of what it can be worth in the future. Right now, it’s just guesswork,” says Sharma.
Kunal Nandwani, CEO at uTrade Solutions, a fintech firm, worries about the mainstreaming of bitcoin, with the impending launch of futures trading on large platforms such as CBoE and CME in the US. “Bitcoin was meant to be used as a peer-to-peer decentralized currency. The whole idea was decentralization away from regulated and centralized financial systems. While there may be reason to cheer the bitcoin futures launch as validation of its credibility, are we losing the whole point of why Bitcoin was invented?” he asks.
In fact, other commentators have argued that the rapid rise in the virtual currency potentially defeats its use as a currency; people may just prefer to hold it for appreciation, rather than use it for buying goods and services. Of course, this begs the question—if it isn’t being viewed as a currency by the majority of buyers, then what is the logic behind the price rise?
But while there are multiple risks, bitcoin has also given some traders the thrill of earning returns of 1600% in the past year. This appears to be the fastest appreciation per unit of time for any major investment opportunity; with that sort of return, it’s little wonder people are ignoring the warnings all around them.