The recent bankruptcy of the Mt. Gox bitcoin exchange underscores the complete lunacy surrounding this virtual currency. Speculation on bitcoins has reached epic proportions, and some very smart people have invested in them, and in the exchanges and other trading infrastructure to try to develop bitcoins as a medium of exchange.
Although the concept behind bitcoins makes sense — developing a single, universal medium of exchange that can be used for transactions over the Internet worldwide — the practical application simply will never work.
It is easy to understand why there has been so much excitement surrounding bitcoins. Developing a single virtual currency, accepted anywhere in the world over the Internet, that does not require any intermediaries, including banks, makes a lot of sense, keeps costs low and standardizes transactions.
For this reason, the currency has drawn the interest of several high-profile investors, including the Winklevoss twins, made famous by their fight over Facebook with Mark Zuckerberg. Unfortunately for these investors, and the rest who have been speculating on the value of bitcoins on exchanges like Mt. Gox, there are several fundamental flaws with the concept behind a virtual currency.
Investors, including the owners of the Mt. Gox exchange, lost an estimated 850,000 bitcoins worth about $473 million. Earlier in February, before filing bankruptcy, Mt. Gox was served an order by the Justice Department to preserve certain documents. Supposedly this exchange was hacked and these bitcoins were siphoned off, exposing the vulnerabilities of any virtual currency.
One of the reasons a virtual currency is unlikely to gain traction is that no country will allow a competing currency to be used as a medium of exchange in its economy. Countries have no upside in allowing bitcoins, or any other competing currency, to be used in their jurisdiction, much less to spend money and other resources to regulate it. Not only is there no upside, there is nothing but downside.
Think of the more than $1 trillion the U.S. government has spent on stimulus through the most recent round of quantitative easing (QE3). The point of this stimulus was to inject dollars into the economy to stimulate economic activity.
Monetary policy — controlling the money supply — is a key tool of the Fed. If there is a competing currency available in the United States, the Fed will not have control over this vitally important economic tool. Why would the U.S. government give up this tool by allowing a competing currency to be used here? Answer: It wouldn’t and will not.
Countries have enough trouble supporting their own currencies when they have an economy depending on it, the direct responsibility for regulating it, and significant resources set aside to support their currency when needed. (One need only look at Argentina’s recent unsuccessful fight to support its peso using billions of its U.S. dollar reserves before devaluing the currency.)
Tax collection is another major consideration for a country considering the acceptance of bitcoins — or any other virtual or alternate currency. If companies and individuals are allowed to conduct business in a different currency, how will governments collect taxes, either on individual transactions, or on profits that the individuals or companies earn? How will they track or calculate what those taxes should be? Governments are not going to accept the possibility of commerce occurring without getting their cut.
Another serious challenge for bitcoins — or any virtual currency — is the ability for companies across the Internet to adopt the currency for transactions. While on paper it might seem like as good idea, in practice, bitcoins are far too volatile.
Imagine a small business owner trying to price his or her products on the Internet when the value of bitcoins is fluctuating wildly on a daily basis. More problematic is the change in the value of the virtual currency after the transaction has been completed, but before the bitcoins have been received.
What if in that interim time period, the value of bitcoins falls significantly (which happens often; bitcoins fell by about 5 percent the day Mt. Gox went bankrupt)? The company could very easily lose money on the transaction if the value of the currency drops before it has a chance to exchange the bitcoins for its home currency, or spend them on something else. Small businesses cannot afford this kind of risk.
Companies would be forced to hedge the risk of the fluctuations in value of the virtual currency, which is risky itself, can be very expensive and requires an expert level of knowledge to accomplish successfully. Very few small business owners have this kind of expertise.
If we combine the obvious problems with virtual currency exchanges being hacked, the fact that no country has any upside (and lots of downside) in allowing a competing currency to be used inside their jurisdiction, and the serious problems with the practical application and adoption of a virtual currency like bitcoins for small businesses, it’s clear that bitcoins will be a complete failure.
Anyone “investing” in bitcoins should expect continued problems, fraud and eventual losses.
— Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at email@example.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.