Bitcoin- Effects on the Global Financial System
With its peer-to-peer structure that runs on immutable cryptographic protocols, Bitcoin has kind of stormed the entire financial system. From being labeled as junk, scam, and even bubble by industry leaders, Bitcoin has proved itself as an efficient mode of transferring value and a good store of value assets.
Often termed as a central bank killer, Bitcoin is one of the most disruptive technological innovations, designed to transform the entire financial system by removing financial intermediaries and lowering the cost of transactions. Though it has a minuscule percentage share in the global trade & commerce, the global cryptocurrency market is expected to grow at a CAGR of 32% in the next five years.
Now, going by the features and functionalities, Bitcoin/cryptos are highly utilitarian, which makes it far superior to fiat currencies. In this article, we will analyze the effect of cryptocurrencies on the global financial system and cryptocurrencies as an investment asset.
Bitcoin’s historic journey from $900 to $20,000 in 2017 was one of the biggest moments for the crypto sphere. Till then, Bitcoin was only considered as a speculative asset having limited economic application and a fad.
Compared to the traditional financial system, cryptocurrencies follow a very different approach to handling monetary transactions. Its decentralized structure lets no one control the Bitcoin network and can exist independently outside the traditional financial system.
What makes cryptos so unique and different from traditional fiat currencies?
The backbone of all cryptocurrencies including Bitcoin is its underlying technology called blockchain technology. In simpler terms, it is a digitized decentralized public ledger used for recording all types of cryptocurrency transactions. It records and stores transactional information in several public databases connected through peer-to-peer nodes. The transactional information is duplicated and distributed across the network of a computer system supporting the blockchain protocol. And, all the transactions recorded across the network are secured using a cryptographic hash.
This way of recording transactional information makes it extremely difficult to hack, modify, or even delete, therefore, making it a completely fool-proof system.
Now, coming to the economics of both Bitcoin and fiat currency, how both derive their value in a very different way.
In the case of fiat currency, it is backed by a sovereign entity/government that declares it as a legal tender and is not tied to any physical commodity, therefore has no intrinsic value. All fiat money exists in the system is because a part of the fractional reserve in the system is created as debt. For example, banks create money when you take a loan. And, on repayment, you return it with the interest. This exceeds the total amount of money in circulation. Thus, producing near-permanent price inflation and reducing the value of money. Whereas Bitcoin follows a very different monetary system and is issued through a process called mining, this is based on math and actual consensus of the user. Having a capping of just 21 million coins, its supply is finite in the market. And, its prices are completely influenced by market supply and demand for it.
Why Cryptocurrencies are Important for Safe and Stable Global Financial
System?
Since the US got independence from Great Britain in 1776, the world has gone through 19 major recessions or slow down and every time it has been caused by the same old factors like a high level of debt, market manipulation, and excessive financialization.
To recuperate from the 2008 financial crisis, the US and major economies relied on stimulus packages which included the decrease in interest rates and the purchase of toxic bonds to stimulate liquidity. In the process, the Federal Reserve’s balance sheet swelled to over $4.5 trillion up from just under $900 billion before the crash. And, in the current economic slowdown too, the world is following the same path for boosting the economy.
How does centralization harm the financial system?
The existing global financial system is highly centralized and interconnected, which makes it prone to various types of risks. A single point failure risks the entire system to collapse, this is what happened during the 2008 global financial crisis and had shaken the trust of people in the system. During the systematic collapse of the financial system in the US, to boost liquidity in the market, the Federal Reserve increased the supply of money in the market by printing more money. In the process, it reduced the value of the USD in circulation in the market, thereby increasing the value of goods in the market.
Being the world’s reserve currency, the value of foreign exchange reserves of many countries took a sharp dip, simultaneously impacting the global trade & commerce order.
One of the prerequisites for the efficient functioning of the fiat money system to retain its value is endless trust by stakeholders. If people begin to lose trust in the system, the value of fiat currency is bound to decrease. This is what happened in Zimbabwe and Venezuela. Due to years of bad economic and hyperinflation, people lost trust in the financial system and their currencies lost their usefulness. People there have to rely on USD, EUR, South African RAND for everyday transactions.
This is where Bitcoin makes the cut and proves its effectiveness to be a global currency. What makes it unique is its immutability and is a trustless system.
Being a decentralized monetary system, no participant (sender, receiver, miner) in the network needs to trust each other for the system to function efficiently.
However, you should remember, blockchain does not eliminate the trust factor, but it minimizes the trust factor by distributing trust among the different actors in the system through the process called incentivizing to cooperate with the rules of the blockchain protocol.
Thus making the system more resilient, transparent, and eliminates any single point of failure.
Why is Bitcoin Given the Parlance of Digital Gold?
Bitcoin and Gold share many similarities and both have a very high degree of correlation. During the second quarter of 2020, the prices of Bitcoin and gold have reached a monthly average correlation of 70%, an all-time high level. This is very unique, considering the fact that one asset class has a history of over 2000 years and one has just completed a decade of existence.
Both falling under the category of speculative investments, their value is not affected by any economic factors like earnings, interest rates, and even economic meltdowns. They share an inverse relationship with the stock market.
For example, if you look at both the events, the global financial crisis of 2008 and the financial market crash of 2020 due to the pandemic. In both events, gold prices have shown a steady upward rise. While Bitcoin came into existence only after 2009 and has shown resilience and ability to move upside despite the economic conditions.
Bitcoin vs Gold: Which is a Better Investing Option?
According to Aristotle’s definition of a good form of money, it must be durable, portable, divisible, and intrinsically valuable and should have limited supply.
Comparing both the asset class on Aristotle’s definition of a good form of money, Bitcoin meets all the criteria to be called functional currency and in some parameters like portability and divisibility, it is better than gold.
But, unlike gold, Bitcoin has no intrinsic value as it is not backed by any physical commodity. So, how does it derive its value?
For any currency to gain value and establish itself as a medium of exchange, the most important factor is the trust of the participants in the network. This is where Bitcoin has an advantage an helps to gain its value. Being a form of trustless network, it ensures complete authenticity, transparency, and no double-spending. A system that people like to trust and is far more efficient than the traditional financial system.
The famous Winklevoss twins, also known as Bitcoin whales, gave out a statement in late 2017 comparing Bitcoin and Gold:
Taking bitcoin in isolation… we believe bitcoin disrupts gold. We think it’s a better gold if you look at the properties of money. And what makes gold gold? Scarcity. Bitcoin is actually fixed in supply so it’s better than scarce… it’s more portable, it’s fungible, it’s more durable. It sort of equals a better gold across the board.
Factors that will Contribute to the Growth of Bitcoin
Excellent Store of Value Asset
Bitcoin’s unique selling point is its ability to provide an efficient medium of exchange, which helps it to get the tag of the best store of value asset. For anything to be a store of value, it should have some intrinsic value, and in the case of Bitcoin, its value is dependent on its utility as a medium of exchange.
Limited Supply
One of the unique built-in features of Bitcoin is its scarcity. With a lifetime supply of only 21 million BTC, it prevents itself from getting devalued by limitless supply.
Mainstream Adoption
As Bitcoin gets significant investor attraction and gains legitimacy, it will push for more wide-scale adoption. Thus, would decrease the volatility and help to gain price stability.
Increasing Liquidity
The majority of the price fluctuations in the crypto market are due to the low liquidity in the market. As the market grows and matures with the availability of complex trading instruments, it will attract more investors and the liquidity level in the market will also deepen.
Price Performance of Bitcoin and Gold
Started at $0.0001 in Jan 2009, Bitcoin hit its highest price ever of $19,783 in the latter part of 2017. Being in a bubble state, Bitcoin and other crypto prices crashed soon after and hit the low of $3,500 per unit. Although Bitcoin failed to cross its peak again, it is still the best performing asset in terms of returns. A $100 investment in Bitcoin in January 2009 is worth over $10 million at current levels, or in other words, a return of over 9 million %, which is surreal and no other asset class has ever
generated. Whereas gold in the last decade has generated a CAGR return of 9.4% and in absolute terms, it is nearly 145%. If we factor in the inflation, the returns will be far less than the actual.
Cryptocurrencies are Next Best Alternative to Traditional Financial System
Bitcoin/cryptocurrencies are truly an alternative to the traditional financial system which comes with different sets of rules and tradeoffs. In other words, Bitcoin rejects the economics of the current financial system. Let’s understand this aspect of Bitcoin. The much-discussed Bitcoin halving mechanism makes it completely different and ahead of its time.
The halving mechanism is integrated into the Bitcoin’s blockchain protocol by design, in which it cuts the supply of new coins and rewards to miners by half every four years. For instance, started with 50 BTC as a block reward in 2009, the current block reward to miners has dropped to 6.25 BTC and in the year 2028, it will further drop to 3.125 BTC. After the recent halving that occurred on May 11th 2020, the inflation rate of Bitcoin also dropped to 1.8% from 3.6%. And, inflation is lower than most of the developed economies around the world, which is usually around 2%.
With Bitcoin prices going up and inflation rate going down simultaneously, it results in increased purchasing power, making Bitcoin a true deflationary asset. And, over decades, it will turn out to be the biggest wealth transfer system in the world. A complete contrast from the traditional financial system where inflation tends to reduce the value of money over time.
Bitcoin- The Road Ahead
In a very short span of time, Bitcoin has disrupted the whole traditional financial system and has posed a big challenge for the central banks all around the world. It has led to the emergence of many new markets and paved a way for the open-market economy, where the real power rests in the people’s hands, not the government or any entity.
Moving towards a completely crypto-based financial system will result in reduced economic volatility, a rise in per capita economic growth, help to manage our capital in a better way, and plug the inefficiencies in the system. Even it fails to replace the fiat currencies; it will have a long-term economic impact, possibly resulting in a better economic system.
But, for now, Bitcoin provides a much better investment opportunity, and including a small share of cryptos in your investment portfolio will provide much-needed diversification.