Bitcoin is a risk asset, not a reserve currency
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Most central banks hold the US Dollar as their main reserve currency. They hold it because a majority of trade is invoiced in US Dollars and a majority of international lending is done in US Dollars which makes keeping the value of the domestic currency to US Dollars very important.
In the first half of this year, after the United States sanctioned Russia and effectively froze all Russian US Dollar holdings in the West, it was common to hear that the US Dollar wouldn't be the world's reserve currency anymore. One of the alternatives suggested by those in the cryptocurrency world was Bitcoin.
I think that Bitcoin is a very poor reserve currency for multiple reasons. As explained previously on this blog, central banks hold the US Dollars because maintaining the value of their domestic currency to the US Dollar is very important. It is important because a majority of international trade is invoiced in the US Dollar. If a currency depreciates against the US Dollar, then import costs would rise along with it. Similarly, most international borrowing is done in the US Dollar. If the domestic currency were to depreciate against the USD, it would lead to a very sharp rise in the cost of servicing debt.
So, central banks keep US Dollar reserves as a means of protecting against this. Another thing that helps is the relative stability in the value of the USD. The Dollar's real value measured against other currencies has only fluctuated by a margin of about 20% in the last decade. Over the long term, central banks can be assured that when they want to sell their Dollars they will get a reasonable price for their assets and the value will not fluctuate too much.
For Bitcoin none of these are true.
Almost no company (outside of the cryptocurrency world) has its revenues denominated in bitcoin. Many companies do accept payments in bitcoin, but the price is still denominated in USD. And despite claims that Bitcoin will be the future of international trade, no international trade is denominated in Bitcoin. There is little reason for central banks to buy it when it doesn’t help achieve their objectives of stabilising prices while maintaining employment.
The real question that comes after this is why very few people use Bitcoin in international trade. An obvious reason is inertia. Large organisations are slow to change, and resistant to anything that could upend old ways of doing things. But even after you account for institutional sclerosis, no new cryptocurrency startups pay their employees in Bitcoin. Those who claim to “pay in crypto” only use Bitcoin (or any other cryptocurrency) as a payment medium (like this blog post from Remote says) and pay the USD (or local currency value) of the salary via Bitcoin. But why is that?
The glaring answer is that the price of Bitcoin is so volatile that nobody wants to have contracts denominated in it. Imagine signing a contract to pay someone 1 BTC for some service for 2 years, 2 years ago. On October 31st 2020, the price of Bitcoin in USD was ~$13,750. A year after you signed the contract, the price of Bitcoin would have increased 4.6 times to $61,300. And a year after that, the price of Bitcoin would have dropped 3 times to ~$20,800 USD. Given such a high level of volatility, which economic actor would want to price their contracts in Bitcoin?
And worse is the possibility of pricing debts in Bitcoin - your liabilities could triple (or halve) in a year. Both lenders and borrowers would baulk at such a wide range of outcomes.
I’ve made this point before. What remains to be asked is why Bitcoin is so volatile.
Why Bitcoin is so volatile: it’s a risky asset
On a spectrum of safe assets (like US Treasuries) to risky (like small cap stocks in emerging markets), Bitcoin is on the very very risky end of this spectrum. To begin with, it produces almost no cash flow. The main argument for being long Bitcoin is that currencies are a Schelling point, and in the future more and more people will use and buy Bitcoin, which will push network effects in its favour. In comparison to a bond, this is extremely risky. It is much easier to predict if a government or company will pay its bonds, a little less easy to predict the profits of a company in the future, and much harder than all that is to predict the actions of other people who are in turn predicting the actions of everyone else.
This means that Bitcoin is a risk asset, and like other risk assets is very sensitive to liquidity conditions. When liquidity is high because large central banks like the Fed have low interest rates, more people buy Bitcoin and the price goes up. When this happens, capital flows enter the market and the price goes up again, which drives in more capital. Momentum chasing capital drives the price of Bitcoin up.
When large central banks increase interest rates, investors would want to sell risky assets like Bitcoin. There are multiple reasons for this but an important one is that the return on safe assets like short term government bonds goes up and it's less attractive to invest in riskier assets. The price of bitcoin falls, and momentum chasing capital that was in Bitcoin exits rapidly as they realise that they will not make quick returns anytime soon.
Meme from Joey Politano here
The combination of being an asset based on expectations of future market behaviour and momentum chasing capital makes Bitcoin sensitive to interest rates and increases the volatility of the asset.
I don’t see a reason for either of these reasons to change in the future. It is true that Bitcoin has some innovative properties like being able to send peer to peer transactions without an intermediary and the ability to hold money in a way that governments can’t take away. But the demand for these services is concentrated among privacy enthusiasts and people who are fighting or fleeing autocratic regimes.
Most people who did buy Bitcoin in the developed world bought it because they wanted the price to go up. More privacy enabling coins like Monero aren’t more popular than Bitcoin. Surveys of Bitcoin holders indicate that the main reason why they bought it was for investment reasons, and this is higher among people who entered the market in 2021 (when the price was going up).
As long as those factors hold, I think Bitcoin will still be more volatile than other risk assets. Given the volatility, it is unlikely it will ever be adopted as a unit of account by many people. There won’t be invoices priced in Bitcoin like they are in the US Dollar. And central banks which want safe assets to hold, won’t consider holding Bitcoin for the same reason.
Okay, I love your article; however, I might be missing something, so please correct me.
“no international trade is denominated in Bitcoin”... except for illegal online dark markets, right? People buy it to speculate, but how much spending in crypto is in these markets? (I have no idea, and finding any such data is hard).
If you get the item the next day, which I know is a thing now, at least in Canada, because we are overwhelmed (google Toronto Life Jeff Bezos of the international drug trade), doesn't that eliminate the yearly price fluctuation risk? As long as people are using it for such transactions (even though you can trace everything in the ledger and the government is extremely good at tracking wallets), it won’t be trading at 0.
I have no idea how to value it. But it’s not 0 if it’s the only way these people transact. I am interested in your thoughts here. What am I missing?
You are very busy, and the work you do is important. I love your articles. Thanks again.
https://torontolife.com/city/this-man-is-the-jeff-bezos-of-the-international-drug-trade/
Paraphrased from Bitcoin is Venice, with some of my own words added:
Ludwig Wittgenstein once asked a friend “Tell me, why do people say it is more natural to think that the sun rotates around the Earth than that the Earth is rotating?”
The friend said, “Well, obviously, because it just seems like the sun is going around the Earth.”
Wittgenstein replied, “Well, what would seem like if it did seem like the Earth was rotating?”
It doesn’t seem like bitcoin is money, yet. I can’t use it to pay for groceries, and its value wildly fluctuates up and down. I can’t put it in a safe, or deposit it into my bank account.
But what would it seem like if it seemed like a global, digital, sound, open, programmable money was monetizing from absolute zero?
Maybe…
It would seem like a promise of superior certainty in the future, with an admission of increased uncertainty in the present.
It would seem like as much an exciting and dangerous narrative and experiment as a provable guarantee.
It would seem like widely disparate views, rapid change, and no consensus, with sentiment ebbing and flowing unpredictably as the merits of the promise of the future certainty from the challenger and the supposed failures of this promise from the incumbent were constantly being weighed and re-weighed by the market.
It would seem like superficially extreme uncertainty masking such a substantial improvement in the promise of protection from dilution that the nuisance of the uncertainty of period of emergence could credibly claim to be outweighed.
If it did seem like a global, digital, sound, free, open-source, programmable money was monetizing from absolute zero, it would probably seem a lot like bitcoin seems today.
Just because at present it seems like bitcoin is volatile in dollar terms (sun rotating around the Earth), doesn't mean that in the future we can't or won't come to understand that it was the dollars that were volatile in bitcoin terms (Earth rotating around the sun).