Economic and Financial Sustainability of Bitcoin

Bitcoin has been in the headlines lately for not all of the good reasons. The recent slide in the value of bitcoin has created a flurry of news about the utility of the cryptocurrency that broke into the market in the wake of the 2008 financial crisis. It has been almost twelve years since bitcoin has been trading yet there is still a lot of confusion about the status of bitcoin as an investment asset.

What is Bitcoin?

Bitcoin is a crypto currency, which simply means that it is based on a decentralised blockchain platform. It is not a part of the regular financial and monetary system. It is not created or issued by the Central Bank, which makes bitcoin and cryptocurrencies in general a thorn for the central banking system.

Bitcoin represents the movement to create a decentralized financial system, one that is not controlled by central banks and monetary authorities. While the merits of such a system are many, the current central banking system is far too strong to lose its grip.

Satoshi Nakamoto, anonymously launched bitcoin in the wake of the 2008 financial crisis to provide a decentralized digital crypto currency. Bitcoin was thus initially intended to be used as a “currency”. However over time bitcoin has been used more as a store of value and an investment asset rather than a currency. Why?

Governments have for obvious reasons been reluctant to accept bitcoin as a legal tender. While in many countries bitcoin has been used as an alternative currency, a lot of countries have clamped down on bitcoin trade, transactions and mining, thus minimising the potential of bitcoin to be used as a medium of exchange.

Secondly, bitcoin and all crypto currencies in general are characterised by extremely high volatility. Such high levels of volatility make bitcoin ideal for short term traders looking to make quick profits through daily price variations.

The graph in figure 1 shows the all time price chart for bitcoin. It can be clearly seen just how volatility bitcoin is both in the short and the long term. This volatility of bitcoin is driven by multiple factors, just like any other investment asset but what makes bitcoins particularly risky is the fact that they are still not a part of the conventional monetary and banking system.

For instance the current drop in value comes after a long rally of positive indicators where bitcoin was perceived as going towards mass adoption but the news of Tesla not dealing in bitcoin due to fossil fuel based energy powering bitcoin mining, followed by the crackdown on bitcoin mining in China, caused a mass sell off that triggered circuit breakers on major bitcoin exchanges like Coinbase and Binance.

Bitcoin and Energy Consumption

Tesla has a mission to accelerate the world`s transition to sustainable energy. Accepting bitcoin payments runs opposite to the stated goal as bitcoin mining consumes a lot of energy.

This graph shows the estimated bitcoin energy consumption between 2015 and 2021. According to Cambridge centre for alternative finance, bitcoin mining is consuming around 145 TWh of energy globally. This is about 0.65% of global energy produced, which is more than the energy consumption of Italy. If bitcoin were a country, they would be among the top five consumers of global energy.

Mining bitcoins and other crypto assets, in particular on fossil fuel based energy does not make economical sense. As mining increases, the demand for energy will increase and thus more fossil fuels will need to be burned. This is one reason why China has clamped down on bitcoin mining. China accounts for almost 70% of global bitcoin mining, which puts tremendous pressure on the power grid. China is already lagging behind the sustainable development goals, the latest crackdown on bitcoin mining came as China aims to meet the net zero emissions goal by 2060.

Is this the end for bitcoin? No. Bitcoin mining through renewable sources makes more economical sense. At present, according to the University of Cambridge, roughly around 60% of bitcoins are mined through hydroelectric power. The transition to fully sustainable mining is the way ahead for bitcoins but that may take some time.

Bitcoins and Transparency

The second major issue that has caused a lot of volatility in the value of bitcoins is transparency. Bitcoins are based on blockchain and by default, public blockchains are some of the most transparent systems that exist today. There is no issue with the underlying blockchain. The issue arises with the decentralised and unregulated nature of bitcoins.

Investor protection and money laundering prevention are two major concerns that regulators in many countries are trying to work around. India banned bitcoins due to regulatory concerns in 2018 but the order was stayed by the courts, Pakistan took a similar decision and later removed the ban but still maintained a grey zone over crypto transactions. The latest move by China to ban bitcoin mining (not transactions) comes in a similar light, to grapple with the regulation of bitcoins.

The two main points which regulators cannot seem to work around are the irreversibility of crypto currency transactions and consumer protection. This is tricky because immutability is one of the characteristics of bitcoins and cryptocurrencies in general. It means that once a transaction has been made on the blockchain, it cannot be changed, edited or reversed.

Countries, mainly in Europe where regulators have softened up have seen increased usage of bitcoins and creation of ecosystems. Whereas countries like the USA and China, which are big markets, have a tough stance towards bitcoin regulations. If they soften up, the bitcoin value can see a big surge but it seems less likely as far as China is concerned because China in addition to Russia is all set to introduce its own centrally regulated digital Yuan. This is another reason why China has, after all these years, decided to clamp down on bitcoin mining.

Will bitcoin become a safe haven asset?

From an investment perspective, bitcoins are a very risky asset. In the last decade bitcoins have gone through multiple bubbles with two very high value bubbles. Although the fintech revolution is powering the mass adoption of digital technologies and bitcoins are a part of this revolution, their hyper sensitivity to news and decentralized and unregulated nature of the market makes them a very high risk asset for investors looking to develop a portfolio.

Some investors hail bitcoin as the next safe haven asset after gold. It certainly looked like it during 2020 when bitcoin showed resilience at the peak of the pandemic. However is bitcoin really a safe haven asset?

A team of analysts at Morningstar developed a framework to test whether bitcoins and cryptocurrencies in general can replace gold as a safe haven asset or not. The framework tested cryptocurrencies against gold on criteria such as scarcity, liquidity, future demand, functional purpose, permanence and certainty of value. Out of all the criteria, bitcoin only matched gold on scarcity. Thus, at least according to the framework developed by Morningstar, bitcoins are not going to replace gold as a safe haven asset any time soon.

In conclusion, the environmental impact, price volatility and regulatory concerns mean that for the foreseeable future bitcoins and other crypto currencies will continue to be unpredictable. Resulting in windfall profits as well as landslide losses.

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