What's Next for Bitcoin?

December 3, 2014Currenciesby Patrick Foot

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A lack of Bitcoin trading may be by design

Throughout 2014, financial traders around the world have been enthusiastically taking to bitcoin as a new area for speculation. Analysts, commentators and investors have all ensured that 2014, for investments at least, may well be remembered as the year of the bitcoin.

There are two main reasons for bitcoin’s rise from a misunderstood market to a home for investors of all kinds. Firstly, its well-known meteoric rise in value. In 2013, a single bitcoin’s value in US dollars rose over 6000%, from around $53 to $681. At one point in the year, it surpassed $1,000 in value. The cryptocurrency’s cost dropped in 2014 and levelled at around the $350-400 mark; a significant loss to those who bought at the beginning of the year, but still a huge gain for earlier investors.

The second reason is contained within that remarkable rise, then drop, for bitcoin. Volatility is hugely enticing for many traders, offering the chance for quick gains (counteracted, of course, by the possibility of quick losses) and short term trading. Traditionally, other markets have provided the best opportunity for risk traders: but in 2014, that picture changed.

Bitcoin’s rise has come with huge swings in value. From February 5 to February 7 this year, the currency lost around $192.72 – or around 24% – in value. For traditional currencies, that is equivalent to the pound losing around 38 cents on the dollar almost overnight.

Bitcoin vs GBP volatility against USD, 1-2 December 2014

Even in periods of extreme volatility, such major swings in established fiat currencies are practically unheard of. And much of 2014 was spent in a period of record calm for forex, further entreating traders to look elsewhere. From May to August, forex volatility was at a 20-year sustained low, as low interest rates from central banks crushed currency movement.

Bitcoin’s similarities to gold have often been noted. Its role in 2014, as a haven for investments when central banks and governments are keeping excitement contained elsewhere provides an interesting counterpoint to the precious metal: so often turned to when markets got too unpredictable in the past. Traders should be wary to the comparison between bitcoin and gold, though. 

Yes, both are in limited supply, outside of the control of most central banks and require some form of ‘mining’ for demand to be met. But two key differences undermine the similarities: gold is not a currency, and gold does not have a uniformly steady production supply.

Bitcoin is, primarily, an alternative online currency, and new merchants accepting Bitcoin are an indication of its use. As such, and in contrast to gold, bitcoin’s relative value is influenced by – and important to – a number of players outside of traditional financial spheres.

There is also no scope for a bitcoin miner to ramp up production in an attempt to price out competitors by driving down the value of bitcoin, as is possible with gold. Instead, bitcoin is released at a steady rate until it reaches the defined maximum of 21 million bitcoins in circulation.

The prospect of restricted money supply causing eventual deflation of bitcoin is perhaps why many traders in bitcoin have been so unwilling to let go of their currency. As Tim Swanson has noted, 70% of bitcoins currently in the public domain have not been traded for over 6 months, as investors hold onto their currency whilst the price is still low. This behaviour is similar to that of many longer term gold investors: keep hold of your assets until they are once again valuable.

That strategy may work for traditional assets, but for bitcoin it could prove disastrous. Quashing liquidity and keeping the price low (by making the currency less attractive), investors who are reluctant to sell coins at a loss are hurting themselves in the short term. And in the longer term, bitcoin’s current performance makes the rise of another cryptocurrency –challengers, including Litecoin and Woodcoin, abound – all the more likely. 

Alongside the quelling of bitcoin’s value from hoarders, risk investors are exacerbating volatility and curtailing any attempts to drive the currency’s value upwards with profit taking. For more established currencies – with central banks factoring in the effects of zealous traders – such behaviours are expected. For fledgling bitcoin, which needs a measure of stability and enhanced liquidity to underline its legitimacy, it can be a real problem.

So what next for Bitcoin? A rise in positive media coverage would be a big boon for the cryptocurrency, particularly if more major retailers can be convinced to take it as payment. In the larger battle of convincing businesses and consumers that bitcoin is legitimate, the problems brought about by financial traders are relatively minor. Pushing the rise of alternative investment methods in bitcoin –spread bets and CFDs that don’t actually see any coin changing hands, for instance – may well go some way to improving the cryptocurrency’s prospects in 2015.

Are financial traders harming bitcoin? is republished with permission from IG.com

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