The staggering rise of Bitcoin to over $1,000 has raised the debate over this four-year-old virtual currency. Some compare it to PayPal, a global online money transfer company, owned by eBay (EBAY 1.62%). Others compare it to gold.
But are these comparisons justified? Does Bitcoin resemble PayPal or gold? Should you consider investing in this currency? Let's examine the following points before you consider doing anything with Bitcoin.
Is Bitcoin the new gold?
The recent spike in Bitcoin's price has most likely been driven by speculative investors. But this type of behavior isn't new and resembles the movement of highly volatile investments such as gold. Gold investors tend to use SPDR Gold (GLD +3.51%) as an indirect investment in gold. Up until the past couple of years, the price of gold and SPDR Gold soared.
In the past several years, the Fed's decision to purchase long-term assets (also known as quantitative easing 1, 2, and 3) has reduced confidence in the U.S. dollar, which may have contributed to the strength of both gold and Bitcoin.
In the past year, however, the price of gold has declined as investors' concerns over the depreciation of the dollar have diminished. Moreover, the sharp rise in the cost of holding gold has also reduced the attractiveness of gold as an investment. The drop in demand for gold has also been reflected in the sharp decline SPDR Gold.
Since the beginning of the year, its gold hoards fell by over 37%. Moreover, investing in such an ETF, which follows the price of gold, has several downsides, including commission, lack of dividend, and unlike Bitcoin, the fact that gold can't be used as a currency. On the other hand, Bitcoin can be used to purchase services -- mainly online.
Bitcoin, much like gold, has a cap on its physical growth. Within the past year, Bitcoin's circulation grew by over 14%. Currently, there are roughly 12 million Bitcoins worldwide, and the cap is 21 million. After this cap is reached, no more Bitcoin will be created.
But until that point is reached, Bitcoin's market continues to expand. In the meantime, a wider circulation only drives the price of Bitcoin higher, because more people are using it as a currency. So if anything, the virtual currency, much like gold, acts like a Giffen good.
Therefore, Bitcoin has some similarities to gold: It may serve as a hedge against the devaluation of the dollar, and they both act to a certain degree like a Giffen good. But Bitcoin might be used not only as an alternative investment, but also as a mechanism to buy services and products online. So, is Bitcoin more like PayPal?
Is Bitcoin the new PayPal?
In recent years, many of the transactions on eBay have been done via PayPal. Much like PayPal, Bitcoin serves as an alternative to credit card and electronic check payments. The virtual currency is also slowly gaining acceptance from legitimate Internet sites, including Redit and Baidu.
Nonetheless, the issue of Bitcoin's level of security is still a problem -- there are still reports of Bitcoin heists. One of the differences is the level of security PayPal's service has compared to Bitcoin. PayPal, which generated more than $1.6 billion of revenue in the past quarter alone, has ample resources to invest in improving its security. Besides security, the level of acceptance of Bitcoin will remain the key issue as to whether it will continue to extend its reach.
If the U.S. government doesn't accept Bitcoin and deems it illegal, Bitcoin's upward trend could be halted. That doesn't mean the currency will disappear; it could keep growing in other countries, but this would certainty impede the currency's progress. The recent U.S. Senate hearing on Bitcoin has had some positive effect on Bitcoin -- this hearing has raised the chances of the U.S. accepting the virtual coin's validity.
The U.S. isn't the only one coming down on Bitcoin; China has also decided to outlaw the currency from its banks. So, if we don't know what's ahead, how can we value Bitcoin?
Valuation problem and high speculations
This new currency is likely to draw speculators, and the price is likely to experience big swings. But until it reaches an equilibrium, how would you value it? Shares in the Bitcoin Trust reached a net asset value of $42.44 at the end of November -- a rise from $12.88 when the fund was launched. Some have tried to examine its valuation with respect to other similar companies and commodities. But I think the valuation of this currency will remain unclear; any attempt to predict it will be moot. If the U.S. eventually accepts Bitcoin's validity, demand for Bitcoin will obviously increase.
For now, you may consider Bitcoin like a currency of a small country with a very unclear future. Would you consider investing in this country's currency?
Takeaway
The meteoric rise of Bitcoin might leave you wanting to enter this endeavor, but bear in mind, the currency's value is solely based on the public's acceptance and confidence in it. Currently, it seems there are too many unanswered questions to estimate this currency's future. Thus, this highly volatile currency might be too uncertain to invest in.
