They say the best disinfectant is sunlight and the People's Bank of China just opened the shades on bitcoin. According to multiple news reports, the PBoC will conduct ongoing examinations of bitcoin exchanges - this has caused the price of bitcoin to crash 14 percent on Wednesday after a 22 percent drop earlier in January.
Interestingly, despite bitcoin's low volatility in 2016, such declines are not unusual in the history of this emerging currency. Furthermore, increased oversight should be welcomed by those, like me, who view bitcoin as one of many digital assets in the fin-tech investing category.
The Chinese exchanges matter because that is where the majority of the trading takes place. Bitcoin trades more dollar volume on a daily basis than the Gold ETF (GLD) and 95 percent plus of that volume is traded in China. China is important to bitcoin and by extension the PBoC is very important to bitcoin.
Presumably the bank's action is a response to speculation that bitcoin has been used as a tool for capital flight from China and I suspect they will find evidence of that activity.
But it should be put into perspective - the total value of all the bitcoin in existence is $12.9 billion, last year official currency outflow from China was $320 billion - so any capital flight that was taking place via bitcoin was/is tiny.
Of course, it had an impact on the price of bitcoin, but it's not where the majority of capital flight is occurring. In fact, there are currently 16 million bitcoin in circulation and the population of Shanghai is 24 million - if every person in Shanghai wanted to buy just one bitcoin (current value of $780) they could not.
The point being, if the PBoC finds that capital flight occurred it will be small and result in a cleansing of the system. What's more, because institutional investors are becoming more interested in bitcoin, the price drop could move bitcoin from weak hands to strong hands.
It's tough to make predictions, especially when they are about the future – so said the infamous Yogi Berra. But it's a new year and the price of bitcoin has been volatile, so it's a good time to look at what the future may hold for the digital currency.
In the long run, the financial revolution that was started by bitcoin will yield a better, faster and stronger financial system but over the next year there are three things that I view as high probability events for bitcoin.
- Bitcoin will go back to being a currency
- Bitcoin will become a new asset class for investors
- Bitcoin will become a hedge for global currency turmoil
Bitcoin was designed as an alternative currency, similar to gold but infinitely more usable due to its digital nature. Gold has a long history as a currency, but try buying booking a hotel room at Expedia with an ounce of gold…it is impossible. But not with bitcoin. In fact, I have booked hotel rooms with bitcoin on Expdeia and found it to be easier and more secure than my credit cards. A few clicks of a button and my bitcoin was transferred, I did not need to provide personal information that could be hacked. My credit card remained securely in my wallet.
Bitcoin sparked a financial technology (fintech) revolution when it was created in 2009. The technology behind bitcoin - called blockchain – became the darling of the fintech world. Interestingly, blockchain technology went beyond financial use cases and has made forays into inventory tracking, healthcare and identify theft. It is being used in healthcare to track sensitive patient information, it is being used by WalMart to trace pork from farm to store, and it being used as a solution to the identify theft problem by creating a secure online indentity.
But at its core bitcoin is a currency, it was designed to function as a currency and currently that is its highest and best use. In fact, most of the run-up in the price of bitcoin was due to Chinese buying as the Renminbi weakened. For the last two years it was easy to observe the strong relationship between Renminbi weakness and higher bitcoin prices. Trading volume in China surged and made China the epicenter of bitcoin trading. It has become so popular as a currency hedge that the daily bitcoin volume in China is greater than the volume of the Gold ETF (GLD) in the US. This popularity has begun to attract institutional investors.
In my view, digital currencies and assets will become an entirely new asset class for investors similar to how foreign exchange and futures grew over the last few decades. Institutional investors are beginning to share this view especially when one considers that currency turmoil could be the new normal.
The President-elect's plan to bring money back to the U.S. to boost the economy is laudable but comes with a major risk. Capital flowing into the U.S. means it is flowing out of developing markets like China. For decades, capital inflow was the fuel for GDP growth that consistently hit well over 10 percent. Corporations, investors and Chinese citizens were able to amass vast piles of debt as the economy grew, but that could all be reversing.
The reversal in capital flows has the potential to be incredibly destabilizing and could result in rolling currency crises, especially in Asia. This could serve as a continued catalyst that brings institutional investors into bitcoin. Moreover, the citizens impacted by destabilizing currency moves will be able to use bitcoin as an alternative. Recent volatility notwithstanding, over the last two years bitcoin has outperformed gold while also begin less volatile.
It's not hard to imagine that a currency more useful than gold that can serve as a hedge to global currency turmoil will continue to gain in popularity. That is not to say that bitcoin is exempt from the normal highs and lows that are the hallmarks of all financial markets. As much as I believe bitcoin to be a revolution, I am cognizant that the digital currency is subject to the same human emotions as all markets - fear, greed, euphoria, and depression are the catalysts that drive human action to buy or sell – and the recent bitcoin price swings appear to be a result of euphoria.
As more investors, traders and end user enter the ecosystem the volatility will once again subside and bitcoin will resemble its paper currency cousins…with one very important distinction. As more companies begin to explore the use of bitcoin and blockchain, the demand for this asset should rise at the same time that supply is severely constricted. The total supply of bitcoin is capped at 21 million coins, currently 16 million coins are traded freely leaving only 5 million coins in additional supply. The remaining 5 million coins will be metered out by the bitcoin software over the next 100 years…yes a century.
One does not need a PhD in economics to understand that when increasing demand meets decreasing supply the price goes up. So no, it's not too late to buy bitcoin, but like any investment it is better to buy low and sell high.
Since reaching a multi-year peak on January 4, 2017, the price of bitcoin has crashed 33 percent as a result of China examining bitcoin exchanges. This price drop has obscured the positive developments that have occurred during the same period. Regulating, monitoring or otherwise cleaning up the exchange infrastructure is vital to attracting institutional investors. In my view, the panic sellers have it wrong and that is why I bought bitcoin today.