Developments around Bit Coins have been rapid, much like the price changes. All of these things and more should be expected. My last piece “Freedom Take it! Its Yours. Why you should Invest in Bit Coins” for The Global Journal talked about the basic economics of the Bit Coin universe.  In response I received quite a few questions about what investment value or trasactional efficiency do Bit Coins or digital currencies bring. This short essay looks at those questions.

As the eco system evolves and more people get involved, trying to explore the intrinsic value of Bit Coins becomes relevant. It is time to take a closer look at the inner workings of Bit Coins and also of some of the traditional financial instruments that they could potentially displace or reinvent. As is now widely discussed, Bit Coins are considered to be instruments for two broad purposes: A. Units of transaction and B. Store of value. What do these two mean?

Post barter, for transacting products and services, accepted units of currency, what we know as ‘money’ evolved as the means of exchange. While transacting, the value you wish to charge for the good or service you sell is up to you and is a function of demand and supply for your product. The role of money is ‘merely’ to allow you to exchange that value with someone interested in buying your product. Once you receive the said currency, you can yourself use it to buy from a seller of some other product or service that you might need. This much is simple enough. As a unit of exchange of value what you needed traditionally, was that the currency should be accepted by as many buyers and sellers and should not get devalued while you are holding it. This devaluation as we know is mostly on account of inflation which is driven by economic factors and Government decisions beyond an individuals immediate control. Nowadays added to this is the complication of international supply chains and a high degree of cross currency financial transactions which add FX risk to the value of your local currency or your buying power.  So the 'time risk' to holding currency is further complicated and enhanced. In short therefore, the quicker the transaction, the better it is.

Development of payment systems such as VISA and Master or American Express on whose back most money transactions are done using plastic or credit and debit cards was a giant leap in payment and transaction processing. It removed the need to go to a Bank to withdraw cash and then spend it, resulting in significant efficiencies. However the actual transaction process became more complicated and in some significant regards, slower. When you pay for your coffee at Starbucks with cash, you have immediately transferred the value with the currency note or coin to Starbucks and reduced your net money holding in a way that you cannot reverse. When you pay by card however, the transaction takes approximately 2 days to be completed between your bank and Starbucks’ bank account (The complete cycle of this process is explained in the paragraphs following. *) therefore the actual transaction takes longer with Plastic (Cards) than it did with cash. So for the efficiency and safety of not having to withdraw and carry cash we have become accustomed to using a different albeit slower transaction process. 

Then came the Internet and people could buy and sell from many sources in remote locations across borders while sitting at home. This has made trade more efficient, quicker and convenient. The banking system involved with settling online transactions between buyer and seller has still however remained similar to what was used for card transactions. Online payment gateways allow transactions online by entering details in a secure and encrypted format through account numbers and passwords. This has not replaced the banking transaction settlement systems but only removed the need for paying at a till. Banks verify the details of the payee and receiver and make the transaction flow online. This too hasn’t crunched the time of the actual transfer of value from payee (buyer) to receiver (seller). This is certainly going to change in the wake of Satoshi Nakamoto’s paper and the consequent development of Bit Coins. That a central ledger where transactions are logged and value transferred from one individual or business to another within an hour and can all be managed by a crowd sourced network without layers of intermediaries is without question the most sensible way to make such transactions happen. Satoshi’s paper brings back the immediate nature of cash transactions by almost immediately transferring ownership of the money from one person to the other in a secure manner also preventing any reversal of transactions and without the need for a bank to intermediate. It is in this space that I imagine J P Morgan is trying to get a Patent. Whether a company or a bank can do so or will be allowed to do so is one of those volatility-inducing games that are now afoot. So watch this space for one of the sources of volatility on Bit Coin Price. In sum, the transactional efficiency role of the single ledger to monitor payments is vastly attractive.

[*To quickly explain this point a bit more, lets take a quick look at what currently happens when you pay for a coffee with your credit card at a Starbucks. Your card may be issued by say Citibank on a VISA platform. So you pay with your Citi Visa card at Starbucks, who may have an HSBC terminal installed to accept card payments. So when you swipe your Citibank card on the HSBC till, HSBC sends the transaction to VISA (in this example) or Master Card as the case may be. VISA then reads the number on your card and realizes it’s a Citibank Card and directs the debit instruction to Citibank, who then read your card number and debit your account. On the other hand a similar process also takes place in order to credit Starbucks the money they are owed for your coffee. Only that not all if any of these links happens immediately. So there are at least three parties involved and they all do their accounting at different times and in batches. All of which takes time. Consider that in contrast, with Bit Coin or other Peer to Peer transaction mechanisms, the transaction is a mere change in a ledger that just needs to be ratified by computers and its done within the hour. Also in addition to it being a ledger entry, it is also in itself a currency (BTC) therefore the need for banks' involvement is completely removed as long as you are willing to hold the value in BTCs. This is a significant departure from other online payment systems that need the traditional currencies and bank account involvement before a transaction can be completed. The current volatility in Bit Coin price makes it currently harder to transact in it, but that doesn’t mean that it is any the less efficient as a means of exchange in the long term or as a technology. ]

Going back to the two aspects of currency, transaction and store of value, I believe that on the former Bit Coin performs extra ordinarily well. That it has transactional value is almost never disputed. This in itself is a mighty innovation in financial transactions.   All this however is not unique to Bit Coins whose architecture is open sourced, so many other versions of the platform have come up, Lite Coin, Peer Coin and Name Coin to mention a few. Therefore we could see several attempts at creating this payment or transaction architecture outside of Bit Coin. Maybe, even without the crowd sourced element, but that remains to be seen and is not in my view a desirable development.

The second, the store of value aspect is slightly more involved. The volatility in BTC (Bit Coin) price is in fact a result of the varying expectations in this second aspect of Bit Coin. The fact that Bit Coins are finite in number (21 million to be ever in circulation) and that their production is incorruptible is significant. These two factors give it the financial feel of Gold or precious metals. However the reason why you and I may choose to put some of our GBP or USD into Bit Coins is because unlike the ultra high net-worth individuals (categorized as such by Banks) the average saver does not get access to international capital markets. The average saver doesn’t get the opportunity to think whether they want to put their savings in GBP or USD or CNY or in a basket of currencies if they are bearish on their local currency. This is especially true at times of recession, when most high net investors are able to move their money more freely than average savers. Also, average savers cannot easily escape inflation and low interest rates, which lower their spending power. For these situations, middle class savers have no means or options. Bit Coins serve as a vital means of solving this problem. Through a few clicks of a button from your living room, you could transfer your money into Bit coins and then into any currency you choose or keep it as Bit Coin, without having to go to any bank. People in many countries where capital controls are particularly stringent, have used Bit Coins for this purpose, thus adding to its credibility as a store of value.  In addition to the finite number and in corruptibility of Bit Coins, which is like Gold and other precious metals, it has the enhanced feature of being easier to transact being a digital currency. This is where savers in Latin America, Cyprus and Greece as well as China have used Bit Coin in a manner that seems to bolster Bit Coins claim to being a store of value. The fact that many savers were confident in converting their local currency into Bit Coin to get money out of their country or even to hold it for the medium term at this early stage of its adoption are significant facts.

Therefore tracking news around its use as store of value will help in understanding its volatility. Also while reacting to statements by central banks and governments one has to look at them in the light of their own vested interests. I wouldn’t be too worried by the statements from the Chinese central bank, even though they cause volatility or bearishness at times. The core architecture of crypto currencies is here to stay. The news from central banks and governments are along expected lines and are worth tracking for understanding developments around obvious regulatory hurdles but mostly for price movements in the short term.

 I would be more inclined to reacting to any competing currencies or deficiencies in the mining architecture or in the economics of mining if they were to crop up. As of now these latter concerns have no real substance, and therefore Bit Coins specifically and crowd sourced crypto currencies in general are a buy and hold. The single ledger transaction system should be raising concerns at Master Card and VISA and other payment systems and bringing a smile to people optimistic about Bit Coins and other crypto currencies. May be more than version of crypto currency emerges and might even be needed to fulfil the transaction and store of value aspects of this family of currencies. The change however is irreversible and therefore it is a technology to get accustomed to.