I have been following BitCoin and few other digital currencies for a while.  The prices continue to hit stratospheric levels – today I sat down to note down my own thoughts on it. Of course, am no currency expert, treat everything with a pinch of salt.

What is a currency?

A store of purchasing power. Simply put, its a middleman for a transaction in a society.

Qualities of a good currency:

1. widely accepted
2. can be stored safely (unlike salt, which too was once a currency 🙂 )
3. reasonably stable in value and doesn’t fluctuate too much
4. retains purchasing power over long periods
5. when all else fails, the currency itself has some value

In olden days we used gold, silver as currency which satisfied all the points above. Most rulers issued gold & silver coins. But, when Nero in Rome had only x amount of gold coins and his expenses were high, he simply reduced each coin by 20% to make more coins. Effectively, he was among the earliest guys to introduce currency related inflation.

Our misfortune, govt’s all over the world started doing it. Every time there was a need for more money, just reduce gold content in coins by some %. Of course, people would notice it and raise their prices accordingly, but with a delay. Inflation rose again.

Until mid 20th century, many countries still had their paper currency backed by gold. If you have 100 million in currency, it was backed by gold in the vaults. In 1971, Nixon took the USD off Gold standard – thereby releasing USD from being tied to gold. Now, US could print more and more without keeping any gold backing it. Voila – more money from nowhere, just print more paper! Majority of govts just print more paper these days.

Now, no one trusts these currencies anymore. Because all that is behind them is hope – no gold! The #5 from my list above is no longer there. Due to inflation, #4 is lost too.

Plus there are transaction costs. There is a govt that is behind it and regulates it. We all hate governments!

Lets start a new currency – a cryptographic one. Lets make it similar to gold, even better.

1. just like gold, it has to be mined
2. it is divisible
3. it is limited in supply (21 million for bit coin)
4. low transaction costs
5. easily portable
6. anonymous (i disagree to some extent)

Now, the problem with these currencies is

1. no intrinsic value behind it, just like paper currencies. But at least the US govt is behind the USD and it should retain some value if not all, but for these currencies, where is the floor? Just ask Mr Zimbabwean dollar.
2. too speculative and value fluctuates so much that businesses and large establishments will have a nightmare handling pricing, if it fluctuates so much (800$ today? up from what 2 months back?) Whats the ceiling? Whats the floor?
3. not mainstream – at least yet and its hard to become one with #2 pointed above
4. you and I could keep transacting a few million of digital currencies and push its value up higher and then offload it at a higher price to unsuspecting people – just like a bubble
5. surely, in future, there will be a lot of competition – a better digital currency, a more stable digital currency, a sexier name and what not. Already we have a handful – so the limited supply of 21 million doesn’t matter. Plus a govt or a large bank can start their own digital currency and guarantee it a minimum value – overnight you will these currencies plummeting.
6. not really anonymous esp if you use it commercially, for e.g. to buy a book on Amazon shipped to your home, your address is now known
7. govt can issue a law either outlawing it or bringing it under jurisdiction – might just happen

Also, any currency that is rooted in anonymity, attempting to go around govt regulations, etc is sure to go the mafia way. Or one step further, its the mafia that needs it badly more than the common man. Add to it speculation and volatility, the gullible could get punished hard with a mistake in such currencies. Remember, when there’s nothing cushioning the currency, the fall can be hard.

Simply put, it looks a lot like a bubble that could burst now, next year or next decade. Of course, it wont be a bubble when everyone says it a bubble. Then it will gain even more in value and slowly, those early doubters will start thinking, ‘maybe its not a bubble after all, let me buy some’. Then it goes up some more. Thats when it bursts – history taught us that quite well, but also that it is hard to time a bubble.

I see quite a few similarities between the digital currency trends and these.

• Tulip mania
• South Sea bubble
• Missisippi company
• Dotcom bust

Comments welcome.