Buying bitcoins is going long bitcoin deflation

Buying bitcoins as an investment means going long bitcoin deflation. That’s it. Let me explain.

Bitcoin is a cryptocurrency, a digital currency made hard to forge using cryptography, and also a payment platform such as those used by Visa, ATMs and if you’ve done wire transfers, the Swift system.

The bitcoin technology platform is not new, it was first released in 2009. The cryptography is older, having first been developed in the early 1990’s. The payment systems are decades old.

So what do I know about this? As a former Head of Treasury at Union National Bank I of course needed to understand currencies and currency market. Also the Swift system is managed out of the treasury’s back office. Furthermore I was a director of the board of VISA International CEMEA Region. For the technology, in the mid-1990’s Moti Yung, a former student of my graduate adviser, tried to lure me away from computational finance research back into mainstream theoretical computer science by explaining to me the uses of distributed databases and how they can be used for secure payment systems. Although I didn’t switch it was interesting enough that we would chat about it once in a while. Today, distributed databases have acquired a sexier name: blockchains.

I tell you all this so that you understand the following – there is no innovation here, not in the theory nor in the application. Even if there was, actually buying a bitcoin does not give one economic exposure to any technology, simply to the supply and demand forces acting on the bitcoin currency. So we can narrow our discussion simply to analysing the currency markets.

What makes a conventional currency price move? A simple but not so useful answer is the supply and demand of that currency. So let’s go one step further. There are in general two markets for a security, the primary market when the security is first offered, such as an IPO, and the secondary market, a trading market like Abu Dhabi’s ADX, London’s LSE or New York’s NYSE.

For a currency, the primary market is usually via the central bank’s monetary policy which injects currency into the financial system, as the US’ Fed has been doing in huge amounts under a programme called quantitative easing, or it can withdraw it. On the other hand bitcoins are only added following a certain protocol which limits the total number of bitcoins to 21 million. As of this month there are about 16 million bitcoins in circulation. So the long-term effect of changes in the primary supply is zero. This means we should look solely at the secondary market.

There is no consensus on the main determinants of currency price fluctuation so I’ll offer my personal view:

1. Current account deficit: This basically measures the value in trade between a country and its trading partners. If it is a deficit then the country is importing more than it is exporting, so it has to buy foreign currency and sell its own currency to pay for the trade deficit. This would lead to a decrease in the value of the local currency.

2. GDP differentials: An economy that is doing better than other economies will attract investment. This investment in turn will lead to an increase in demand for the local currency and therefore an increase in its value.

3. Interest rate differentials: All other things being equal, a country with a higher interest rate will attract investors, leading to an increase in the value of the local currency. Please note that this means one has to first adjust for other factors, such as those listed here.

4. Inflation differentials: An economy with higher relative inflation will see the value of its currency evaporate. On the other hand, negative inflation, known as deflation, increases the value of the currency relative to other currencies.

5. Public debt: Similar to company debt, if public debt becomes too high the interest payments on that debt choke off government spending, which is bad for the economy and leads to a decrease in the value of the local currency.

6. Speculators: They look at all the other factors, rationally and irrationally, such as economic forecast, political climate, public perception, how others might be trading, etc.

We can see from this that when looking at bitcoins only inflation and speculators matter in terms of affecting the price as all of the factors do not exist for bitcoins as they are not backed by an economy. You might think that interest rates do matter but as it is not at the national level as set by a central bank then it does not affect the bitcoin economy. Interest provided for bitcoin deposits is simply a return provided for lending to a particular borrower. This is not a currency return but a lending or credit return.

This means that if you buy bitcoins as an investment you are basically betting that either there is deflation or speculators will drive the price up. This is not an investment. This is not a trade. I’m not sure if it is even a gambling bet.

This article was originally published in The National.

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