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The rise and rise of bitcoin

Dubai - Between December 15 and December 20, bitcoin rallied by around 21%.

On December 16, the price of bitcoin crossed $20,000. In fact, as of December 20, bitcoin has delivered a return of a whopping 226 per cent, during the course of this year. This, when the yearly interest rate on bank deposits is barely a few percentage points. Just between December 15 and December 20, bitcoin has rallied by around 21 per cent. Why has the price of bitcoin rallied at such a rapid pace? Should you invest in the digital currency? Let’s take a look.

So what is a bitcoin?

It is a digital currency that does not use banks or any third party as a medium. It is governed by a string of cryptographical codes, which are believed to be military grade and very tough to break. An important point that makes bitcoins popular is the fact that unlike paper money they cannot be created out of thin air. The number of bitcoins is finite and cannot go beyond a limit of twenty-one million tokens. Currently, there are 18.57 million tokens in circulation. Unlike paper money, bitcoins are not backed by any central authority, like a central bank, but there is a ‘block chain’, a shared public transaction ledger, which can be accessed by all bitcoin users. The block chain contains all the transactions executed. The information in the ledger or the block chain is encrypted, and this ensures the anonymity of the buyer or seller in any transaction.

So anonymity goes a long way in making bitcoins popular?

It is the anonymity of transaction that has been a huge plus for bitcoin. Not only do the users, but even the founder of this the currency remains anonymous. Satoshi Nakamoto, who is believed to be the founder of bitcoin, remains unknown. It is not known whether the name Satoshi Nakamoto is a real name or a pseudonym. It is also not known whether it represents one person or a group. Interestingly, mining, or the generation of a bitcoin, happens when a computer solves a complex algorithm. Anyone can try to mine bitcoins, but with a finite number being generated at regular intervals and with the increase in the number of people joining the mining race, it has become increasingly difficult to solve the algorithm and generate bitcoins. The irony is that bitcoins, like modern paper money, do not have anything back them up, but that hasn’t stopped them from becoming immensely popular in the recent past.

Other than the anonymity, what has made bitcoins popular in the recent?

The rise of bitcoins can be explained by the need to look for an alternative to paper money. In the aftermath of the financial crisis that broke out in September 2008, the central banks of the Western world printed a huge amount of money to drive down interest rates. The idea being that at lower interest rates people will borrow and spend more and corporates will borrow and expand, leading to job creation and an economic recovery. Something similar has happened this year, as the Covid-pandemic has spread, the central banks around the world have printed a lot of money, in order to drive down interest rates, encourage consumption and generate an economic recovery. Just the Federal Reserve of the United States has printed close to $3.2 trillion between February end and mid-December. Money printing can lead to inflation, with too much money chasing the same amount of goods and services.

Are there any other reasons behind the rise of bitcoins?

In the past when central banks or governments printed money and created money out of thin air, people bought gold to hedge themselves against the fear of inflation. The price of gold (in $ terms) has gone up by a little over 25 per cent this year. In comparison, the price of bitcoin has gone up by 226 per cent. This shows the popularity of the new-generation bitcoin with the millennials in comparison to gold which is viewed as old and boring. Also, unlike physical gold, one doesn’t need space, physical security and insurance, to hold bitcoins. In the recent past, big financial firms have also finally gotten around to investing in bitcoins, leading to further popularity and rise in price of the digital currency. But more than these reasons, the main reason behind the popularity of bitcoin over the last few months is what can be referred to as the reverse law of demand.

What is the reverse law of demand?

The law of demand basically states that usually at a lower price, the demand for any good or service, goes up. But when it comes to investment assets what actually happens is the reverse. Investors get attracted to the idea of investing in an asset class only after it has shown some investment demand and delivered a decent amount of return. This is precisely what is happening with bitcoins. In an era of low single digit interest rates, it has given a very high return. This has increased its popularity and hence, investment demand, which can be gauged from the fact that the volume of transactions in bitcoins have constantly been going up. Having said that, it is worth remembering that there is nothing fundamental backing bitcoin and its price at any point of time is just a reflection largely of its investment demand. In 2018, the price of bitcoin had fallen by nearly 75 per cent.

Vivek Kaul is the author of Bad Money.