Why Bitcoin Is Doomed to Fail

In recent weeks, interest in Bitcoin, the counterculture cryptocurrency, has soared along with its price -- at last count, one Bitcoin fetched $138, up 2,600% in a year and 550% in two months. A number of journalists and financial bloggers simply aren't sure what to say about Bitcoin, because it's not generally well-understood, even within the small circle of true believers that stand to gain the most from continued publicity. Some people will tell you that Bitcoin has a bright future as a currency based on attributes that place it at odds with every other widely accepted currency in use today. Others want to stand back and watch it rise as a store of value, caught up in the excitement of rapid price-appreciation.

Not me. I learned about Bitcoin in 2011, just before it went on its first massive run, from less than a dollar to a peak of $35 that summer. I didn't think it was worth anyone's time then, and it's still not worth anyone's time now, unless you have a taste for gambling and some money that you don't particularly care about. The very reasons why Bitcoin has taken off today will be major reasons why its value is likely to collapse tomorrow.

Don't believe me? Today we'll be taking a look at one of Bitcoin's greatest problems -- its dramatic price instability -- and attempting to explain why that instability will continue to undermine wider adoption. This, perhaps more than any other reason (although there are others), will cause the ultimate failure of the Bitcoin experiment.

Bitcoin will fail because it has no fundamentals beyond the news cycle
Most currencies will fluctuate in value against other currencies based on a number of known factors. Maybe the issuing nation's economy grows stronger relative to the rest of the world, so the value of its currency grows. Maybe there's too much currency in circulation, causing the currency to devalue relative to others. Maybe interest rates create too much inflation or too little. Generally, though, the world's major currencies tend to be reasonably stable.

Bitcoin, however, is not stable.


Source: Blockchain.info.

Why is the price of a single Bitcoin so high right now? We can delve into any number of complex answers that may be partially right and get the big picture wrong. The simplest explanation of the current spike in Bitcoin value is that the price of a Bitcoin is directly related to the publicity given to Bitcoin. There's no better way to highlight this than to pair the above graph with one showing Bitcoin search interest over time:


Source: Google Trends.

Here's what Apple's (NASDAQ: AAPL  ) search interest chart looks like, for comparison:

The spike in interest in late 2011 (C) corresponded with the death of Steve Jobs. The spike in late 2012 (A) owed to the iPhone 5. Apple's stock price actually peaked in September of 2012, just before the iPhone 5 spike. Media-driven popular interest in large, liquid stocks -- and in major currencies -- generally has a low correlation to prices.

AAPL Total Return Price Chart

AAPL Total Return Price data by YCharts.

Of course, the argument persists that Bitcoin does have fundamentals that make it a viable and valuable currency, and over the next few days I hope to dismantle those arguments. The only real fundamental attribute of Bitcoin is a known degree of scarcity, but this alone doesn't justify a move from $10 to $135 in two months. For now, let's stick to the stability problem. Why does the news cycle drive prices so much? Simply put: Very few people who hold Bitcoins actually want to use them once they've been acquired, as the prevailing belief among Bitcoin holders is that it will continue to appreciate in price.

Bitcoin will fail because a small number of hoarders control most of the supply
Blockchain.info, which claims to be Bitcoin's most popular wallet (every user needs a digital "wallet," which is something like an anonymous checking account, to transact Bitcoins), provides the following statistics on its userbase and on Bitcoin itself. I've rounded some numbers for convenience:

  • Total wallet users: 180,400.
  • Bitcoins created to date: 11,000,000.
  • Bitcoin transaction volume (weekly moving average): 344,000.
  • Wallet users engaging in transactions (weekly moving average): 10,000.
  • Total Bitcoin exchange dollar volume (weekly moving average): $9,600,000.
  • Estimated Bitcoins transacted on exchanges (at $135 price): 71,000.

According to these figures, only about 3% of all Bitcoins are in circulation at the moment, and less than 1% of all Bitcoins currently in existence are sold on the exchanges. With less than 10% of wallet users actually engaged in transacting their Bitcoins, it becomes easier to see why even a little bit of news can cause massive price swings.

It's actually a bit instructive to look at this against some highly liquid stocks. Bank of America (NYSE: BAC  ) , for example, is nearly always one of the highest-volume stocks on the market. Here's what's happened to its price over time:

BAC Volume Chart

BAC Volume data by YCharts.

Bank of America's share price does better when fewer of its shares are traded, as is generally the case for most things traded on public markets. Supply and demand is a relatively easy thing to explain. If I had a million shares of Bank of America, I could sell them and live comfortably for the rest of my days, but my sale would barely move the price of a stock that experiences at least 200 times that much trading volume on any given day.

On the other hand, if I sell a million Bitcoins, the price will crash through the floor, because there simply aren't that many people actually looking to buy any Bitcoins. The average transaction, according to recent data, was only about seven Bitcoins per wallet for only 10,000 unique wallets, and yet the price has absolutely skyrocketed. Very few people want to sell their Bitcoins, even though the user base is already fairly tiny. If even 1,000 panicked Spaniards flood into Bitcoin (this has been suggested as a primary reason for the recent spike) out of fear that their bank accounts will be confiscated, they'll find even higher prices until anyone with substantial holdings decides to sell. And why should they sell?

The counterargument here goes something like this: More publicity will bring more people into Bitcoin, and the ecosystem will grow! This will make Bitcoin more stable, and people will be more willing to sell or transact fractions rather than whole Bitcoins, which will increase price stability as people adapt to transacting smaller quantities of a more valuable digital currency.

But here's the thing: So long as the current holders of most Bitcoins have a greater expectation of price growth in the future, they will never put more Bitcoins on the open market than will be demanded by new users. Divisibility doesn't matter so much as availability. You can divide a Bitcoin into a million little Bitcoin pieces and sell each piece for a fraction of a penny, but in the end you're still only transacting $135 worth of a billion-dollar bubble. Bitcoin, by design, actually bakes in an expectation of higher prices in the future, as the Bitcoin wiki points out:

Bitcoin users are faced with a danger that doesn't threaten users of any other currency: If a Bitcoin user loses his wallet, his money is gone forever, unless he finds it again. And not just to him; it's gone completely out of circulation, rendered utterly inaccessible to anyone. As people will lose their wallets, the total number of Bitcoins will slowly decrease.

Therefore, Bitcoin seems to be faced with a unique problem. Whereas most currencies inflate over time, Bitcoin will mostly likely do just the opposite. Time will see the irretrievable loss of an ever-increasing number of Bitcoins. An already small number will be permanently whittled down further and further. And as there become fewer and fewer Bitcoins, the laws of supply and demand suggest that their value will probably continually rise.

Thus Bitcoin is bound to once again stray into mysterious territory, because no one exactly knows what happens to a currency that grows continually more valuable. Many economists claim that a low level of inflation is a good thing for a currency, but nobody is quite sure about what might happens to one that continually deflates. Although deflation could hardly be called a rare phenomenon, steady, constant deflation is unheard of.

A Bitcoin is an investment in the continued interest of a tiny group of people, many of whom are ironically afraid of the perceived instability of widely accepted fiat currencies. Wide acceptance of Bitcoin -- and thus greater stability -- would require a user base several orders of magnitude larger than the one we currently see in Blockchain's numbers. That could happen in the future, but the hoarding of existing users acts as a barrier against wider adoption. Why would any casually interested person want to get involved with Bitcoins beyond an attempt to hoard it if the supply will always be constricted? On the other hand, a sudden influx of Bitcoins onto the exchanges, and the resulting price crash, would also undermine wider adoption, as it would break the illusion of steadily rising value that has brought more users in the first place.

There are other reasons why I feel Bitcoin is doomed to fail, and I'll be examining those reasons over the next few days. Stay tuned for:

  • Why an uncertain legal standing will never resolve in Bitcoin's favor.
  • Why Bitcoin's perceived "security" and lack of transparency are not true benefits.
  • Why cryptocurrencies can't succeed by rejecting the characteristics of modern (centralized) money.

Got questions? Want to weigh in? Feel free to let me know how you feel with a comment below.


Read/Post Comments (12) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 05, 2013, at 6:47 PM, NOTvuffett wrote:

    Q: Why is anybody even talking about something like a bitcoin?

    A: Because the Fed has done such a spectacular job of preserving the purchasing power of the dollar! lol.

  • Report this Comment On April 05, 2013, at 6:52 PM, paulsnx2 wrote:

    The author dismissed Bitcoin 2 years ago, and yet Bitcoin is still here today.

    Most of the people that I talk to have never heard of Bitcoin. Take my Dentist. He immediately latched on to the idea of being able to conduct transactions with customers without Bank and Credit Card charges.

    You also allude to the fact that anyone can get a free Bitcoin Wallet. While only as secure as the manage your private keys, it remains quite a bit more secure than a typical checking account with the proper management of the account.

    Lastly, most of us are familiar with the "Stability" of the Dollar. It is a constant downward spiral of value. This is true of all currencies managed by central banks today. Bitcoin establishes the rules of transactions up front. Everyone knows what it will do.

    And you make a big deal about how dropping a Million Bitcoins would lower the price of coins. What you don't mention is that this is pretty much a one time thing someone can do. After the coins are dropped, they get snatched up by hundreds and maybe even millions (someday) of people. They are not available to be "dropped" on the market again, once they have been pretty much given away.

    In contrast, the BOJ of Japan has just announced they are going to print over 60 to 70 trillion yen, and they are going to dump it into the market that only has a monetary base of roughly 138 trillion yen. How is this different from dropping a million Bitcoin?

    It is very different. The BOJ can do this over and over. It isn't a ONE SHOT thing.

    Bitcoin is built to resist manipulation of the supply. And thus it must gain in value over time. This makes Bitcoin an excellent store of value. This means anyone with a choice between "instability" that rises in value and "stability" that is by design and policy going to fall in value, some people are going to pick Bitcoin.

    That's why Bitcoin continued after you dismissed it 2 years ago. And this is why Bitcoin will continue after you dismiss it here.

  • Report this Comment On April 05, 2013, at 7:01 PM, chalash wrote:

    Hi Alex,

    I have been following your coverage on Bitcoin with great interest, and would like to offer some comments to your article.

    In order, I would like to address the following arguments that you made:

    1) Price instability precludes mass adoption.

    2) Bitcoin has no fundamentals other than the news cycle

    3) Hoarding will cut off availability and reduce uptake

    4) Early adopters have too much economic clout

    1) Price instability is conceivably bad for both merchants and customers. You don't want to receive something that will be worth less tomorrow, nor do you want to pay for something that you could buy for half price in a day. However, this problem is already solved through payment processors such as BitPay who allow people to transact in Bitcoin and be credited in USD. It completely removes the exchange rate risk so that people can continue doing business as usual. You may ask, "Why would somebody pay with Bitcoin when they could use USD?" And I would offer you this value proposition. Amazon turns over an enormous amount of revenue but has a comparatively small profit margin. Credit card charges of 2-3% are a large part of their cost structure. Using Bitcoins, even through an intermediary payment processor, would in effect, double their profit. That's without doing anything else whatsoever. Yes, you read that right. Double.

    2) Bitcoin has very similar fundamentals to precious metals, which are analyzed and traded in highly liquid markets around the globe. It can be inspected from a number of angles including but not limited to supply and demand, price action, user uptake, trade volume, trade velocity, investor attitudes, and geopolitical developments.

    3) This argument I find the most difficult to understand. Taken to an absurd level, it sounds to me that you are saying: "Bitcoin will become so valuable that it will become worthless." You build the case that the price will go up, and that people will not spend their coins, and then price will continue to rise. But you leave us there, with Bitcoins holders being worth millions of dollars, before you jump, in my opinion, a very long distance in an odd direction to claim that this will kill the currency. What would happen, in fact, is that people will always spend or sell their Bitcoins at a price. This price is different for different people, and that's why we have market places. You do mention that from time to time wealthy individuals may flood the market with Bitcoins, but from your stance, this should a solution to the hoarding problem, rather than a new problem in itself. Can you have it both ways?

    4) Anybody with money has clout. And Bitcoin early adopters would be no exception. It's natural to be envious of any early adopter, including those fine ladies and gentlemen in silicon valley who seem to always find ways to retire when they are 30. But remember, that the worst thing rich people can do it buy something from you. It's the tax man who has his hand in your pocket.

    Thanks for reading my comments. I look forward to the aforementioned installments to follow!

  • Report this Comment On April 05, 2013, at 7:10 PM, UgolinoII wrote:

    I found out about around the same time as you it seems.

    I wasn't so quick to dismiss it then, and I think it's naive to dismiss it now.

    I'm sure you are right, speculators will get burned, they always do, but through the madness remains something that has never before existed.

    I think it's just as foolish (small f) to dismiss it as it is to bet the farm.

    I could well afford to lose the $100 I spent on getting some coins. I am not so greedy as to not sell regularly as this irrational exuberance unfolds.

    Have you read any if taleb's work, his thoughts on positioning yourself to benefit from the unexpected seem to apply here. Everyone expects it to crash. What if it doesn't? Picking up a coin as insurance doesn't seem like such a terrible idea. Limited downside risk, potential black swan to the upside.

  • Report this Comment On April 06, 2013, at 4:37 PM, Bestron wrote:

    Alex, I have to disagree with this article. Just like you, I have been following Bitcoin for about two years now. Unlike you, I am very fascinated by its novelty and ingenious concept, and see great potential for the new possibilities and technological potential it bears. A new form of money or commodity, that is independent of banks, authorities, or other middle men, safe, free (as in free speech), fast, available and applicable worldwide, anonymous and transparent at the same time, as well as easy and free to transfer, store, and backup. Sounds like the best of two worlds (dollars and gold) combined. And being 100% online, it fits today's digital era very well.

    You make a few claims that I'd like to address in particular:

    "bitcoin will fail because it has no fundamentals beyond the news cycle"

    Au contraire, Bitcoin brings some *very* fundamental value to the table. By saying "the only real fundamental attribute of Bitcoin is a known degree of scarcity" you're missing a plethora of other advantages that come with Bitcoin. People are fed up with banks and the mess they have created in their unbridled greed. Until now, we've always been dependent on banks, who had absolute power over our money and transactions. Bitcoin takes this power away from banks, and brings it back to the actual people who own the money in the first place.

    "As people will lose their wallets, the total number of Bitcoins will slowly decrease."

    The total number of bitcoins is of no relevance whatsoever. They're digital, and can be subdivided in arbitrarily large or small portions. Like gold, but easier (since it's digital).

    Furthermore, you mention the "uncertain legal standing" but there is no uncertainty whatsoever. Bitcoin is legal, period. And besides, who was supposed to declare it illegal anyway? Bitcoin is global and decentralized, and not related to any state, country, or jurisdiction.

    I'm curious to hear your opinion on Bitcoin's "perceived security" and "lack of transparency". Please do make sure to thoroughly understand how it actually works - I've read quite some ridiculous claims from people who obviously didn't even have the slightest notion whatsoever of how Bitcoin actually works. In fact, I'm willing to bet that both in terms of security (which, in case of Bitcoin, is based on a few simple, crystal clear cryptographic princples, rather than trust and promises) as well as transparency (with all transactions being publicly visible) does a far better job than any bank or payment system in existence.

    Here's a nice illustration that represents the sentiment about Bitcoin: http://bit.ly/Y55jec

  • Report this Comment On April 06, 2013, at 5:45 PM, ThomasEDay wrote:

    The author is clueless and clearly is mixing things up. He talks about the constantly rising value due to 'hoarding' (a classic 'gold standard', so i guess BC is the new gold standard?) problem, and then calls this 'deflation' (or the cited text). No. The other arguments against BC are, likewise, vacuous. Bitcoin reacts to interest rates in the monopolistic central banking space just as much as any currency is impacted by 'rho'; it also has a high delta, gamma, theta, and vega. Does this make it 'doomed'? No more so that the dollar, except that the elasticity of the dollar can fool a lot of the people - especially as a reserve currency - into believing in economic stability and sustainability. BC is, in contrast, more pure. It cannot be distorted by official sector - only private sector - actions. Unless, of course, the DOD, DHS, or other Agency or agencies decided to attack Bitcoin in an organized fashion by BOTH minting and purchasing, with the goal being to collapse the credibility of the currency. Even if this is not the case, the value of BC should fluctuate a lot based on the perceived instability of fiat currencies, like the Yen, as another explanatory factor in BC's rising value (also, Mt Gox is located in Japan, so fear of the govt shutting it down is another explanatory factor).

    Bitcoin is an exercise in assured scarcity of a viable means of exchange an store of value. The volatility we see in Bitcoin is good. The interest seen in Bitcoin - if it truly is a publicity thing (more sinister explanations exist too) - then this should be the better topic for discussion: why this interest? The answer is a growing awareness of the instability of centralized, monopolistic, legal tender fiat currencies. That's the REAL story here. No wonder it is called Mötley Fool. lol

  • Report this Comment On April 09, 2013, at 9:37 AM, jzcjca00 wrote:

    A bubble is defined as "trade in high volumes at prices that are considerably at variance with intrinsic values."

    If Bitcoin actually has zero chance of ever being widely used as a currency, then it has zero intrinsic value, so its current $200 price is clearly a bubble.

    However, I believe Bitcoin offers significant advantages over the fiat currencies, and may become one of the most widely-used currencies at some point down the road. The current price reflects the fact that many people agree with that assessment.

    The national currencies all suffer from the flaw that they are created by central banks whose sole mission in life is to fund irresponsible and reckless spending by their governments. This leads to excess "printing" of money, malinvestment, bubbles, exaggerated boom and bust cycles, inflation, and a steady erosion of value. You're actively paying a "currency tax" every second you have fiat currency in you hand, wallet, or bank account. Bitcoin is free from these manipulations and is designed to hold its value.

    Bitcoin might become widely used first in countries where fiscally irresponsible governments and banks cause the most misery, like Argentina, Russia, Zimbabwe, or the Eurozone.

    The second problem with fiat currency is that the "financial services" sector sucks 3-5% out of the economy on every transaction. As the owner of a small business, it kills me to give 3% of every transaction to the credit card companies. When your profit margins are thin, that can spell the difference between black and red on the bottom line. Bitcoin allows direct payment from customers anywhere in the world without using a bank, credit card company, or other payment processor.

    I plan on adding an option on my website to pay in Bitcoin, and I'll give a 3% discount for doing so. It will more than pay for itself by protecting me from credit card fraud. As more merchants do the same, people will want to start paying in Bitcoin just for the discounts.

    Bitcoin is easier, faster, cheaper, more reliable, and a better store of wealth than the national currencies. In spite of the fact that the rich and powerful people who benefit from our current system will pull every dirty trick in the book, including writing thousands of biased articles like yours, I believe it will eventually come to be widely used all around the world.

    If Bitcoin eventually replaces all $60 trillion worth of existing national currencies, it will be worth $3 million per Bitcoin. If it crosses that threshold, we might then be in a bubble. Until then, we are still undervalued.

  • Report this Comment On August 09, 2013, at 11:51 AM, OEUoe wrote:

    I'm growing really tired of this ill-researched Bitcoin-bashing. One more article like this and I'll probably cancel my Fool subscription.

  • Report this Comment On August 20, 2013, at 10:32 PM, akcoins wrote:

    I thought I would check back on a couple of these Fool articles about Bitcoin after a couple weeks. After a quick search on fool, I am not surprised to see nothing new on the topic.

    Since this article has been written, Bitcoin has remained VERY strong. Bitcoin traded over $125 on Mt Gox this week. It has only gone up since this was written. Germany has accepted Bitcoin as legal tender, and prices are trending higher.

    Take advantage of these high Bitcoin prices and invest in some gold and silver bullion at AK Coins. You can also check out our blog for more relevant and realistic news on Bitcoin and precious metals.

    AK Coins

    http://www.akcoins.com

  • Report this Comment On September 01, 2013, at 1:22 PM, madtechtrading wrote:

    Your analysis makes me want to rush out and load up on these things. Where do I buy these and how do I get the wallet ? Looks to me like the difference between using the postal service and email or radio versus TV or maybe we should all go back to using black & white film camera's and typewriters ? Maybe you should be talking about whether they should be cashed out at 10k , 100k or a million instead of this drivel ?

  • Report this Comment On October 07, 2013, at 1:50 PM, DM9 wrote:

    I guess we could describe bitcoin as a hybrid currency/commodity. in my estimation its more commodity than currency though and i dont think will ever be capable of surviving on its own without stable/local fiat currencies to determine value for goods and services.

    this is whats happening right now by most early retail adopters and i dont think will ever change under bitcoins current working model.

    right now retailers determine the price of goods according to $dollar value then convert that to bitcoin. can you imagine prices for goods being determined by the daily price for bitcoin? it wouldn't last very long if today you could pay your rent and tomorrow you couldn't. so bitcoin needs fiat currencies to survive.

    price instability is bitcoins weakness as a true currency and why it will never be one. could you imagine if the president said tomorrow that the value of the dollar was going to be determined by the daily price of the Dow Industrial? people would riot in the streets. well hate to say it but this is exactly how bitcoins model operates. thats how an investment or commodity operates, not a currency, not in a retail environment anyways.

    i like the prospects of bitcoins future value. i own some and am holding them (not more than i'm willing to lose) as an investment in a commodity. There are a lot of potential benefits and uses for bitcoin but the above article should shed some caution. is very, very speculative.

  • Report this Comment On November 06, 2013, at 3:50 PM, mshiney77 wrote:

    The dollar can be used as a medium of exchange. Practically speaking, I cannot go to the gas station and fill up my car using bitcoins. I cannot pay my landlord rent with bitcoins. That is the biggest problem with using this "currency". There needs to be a double coincidence of wants, an occurrence that happens every time I go shopping with USD.

    The volatility is too high as well. You could make some money speculating on this stuff, but I'm not getting near it.

Add your comment.

DocumentId: 2348568, ~/Articles/ArticleHandler.aspx, 7/13/2014 1:00:04 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement