Bit by bit

Updated on: Jan 12, 2017

Bitcoins may not have lived up to the initial hype, but they do pose systemic risks

After doubling relative to the dollar in 2016 and sailing past $1,100 last week, the value of the bitcoin — the much-hyped virtual currency — has suffered a steep 20 per cent loss. To bitcoin investors, this must be an unpleasant reminder of 2013, when bitcoin’s value hit an all-time high of $1,165, only to lose over 80 per cent in subsequent months when Mt Gox, the leading Japanese exchange for the cryptocurrency, failed after hackers ‘stole’ $460 million in bitcoins. The recent sell-off has been triggered by the People’s Bank of China issuing warnings to bitcoin exchanges, worried about illicit capital outflows via the bitcoin route. The country, in recent times, has emerged as a hub for bitcoin mining and trading, with investors taking speculative punts on the bitcoin against the depreciating yuan.

In the last two years, it has become increasingly clear that the initial hype and hoopla about virtual currencies decimating paper money, toppling central banks and rendering governments powerless, was quite overdone. At a market capitalisation of less than $20 billion, cryptocurrencies remain a minuscule fraction of global currency in circulation, proving that they haven’t gained wide acceptance as a medium of exchange. Wild price swings have rendered them poor stores of value too. With China dominating bitcoin volumes, there’s no immunity against State intervention either. The virtuous halo surrounding bitcoins has also been dented by narcotics peddlers, terrorists and money launderers using them, given their veil of anonymity. Despite all this, global financial regulators have stopped short of imposing an outright ban on cryptocurrency trades. The prevailing view seems to be that the problems with cryptocurrencies will need to be tolerated in the interests of furthering innovation in the block-chain technology— the bedrock for bitcoins — which has many promising applications in customer service, accounting and financial product regulation. Russia, which toyed actively with a bitcoin ban, did a U-turn last year. China has decided to regulate cryptocurrencies as ‘virtual goods’. The US has swept virtual currency trades under the aegis of its Commodity Futures Trading Commission (CFTC), which has been registering cryptocurrency marketplaces and enforcing basic payment and settlement rules.

These precedents make it easier for the RBI to initiate a formal regulatory framework for virtual currencies. It is imperative that this be done soon. The painful demonetisation exercise was premised on the belief that paper money is at the root of all ills. But left unregulated, cryptocurrencies can fund a gamut of illegal activities. The bigger lesson from the recent bitcoin flare-up is that virtual currencies gain traction mainly in desperate times. All bitcoin bull runs have coincided with sudden jolts to public confidence — be it demonetisation in India, hyper-inflation in Venezuela or sharp currency depreciation and capital flight in China and Russia. The best way to keep virtual currencies from making big inroads into the financial system is for policymakers to refrain from administering such shocks.

Published on January 12, 2018

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