Business professor explains the impact of Bitcoin on trading, investments

Editor’s note: This article was published originally in February 2018 and updated May 2018 to reflect the most recent changes in Bitcoin.

Bitcoin gripped the investing world in 2017, and its price increased by roughly 500 percent. In December 2017, Bitcoin hit a peak of almost $20,000. Since then, digital coins have lost $500 billion in value.

How might we analyze Bitcoin’s impact going forward? We spoke to H. Subramanian, assistant professor in the Department of Information Systems and Business Analytics in the College Business, to examine the risks and value.

What is Bitcoin?

Bitcoin is a cryptocurrency and worldwide payment system. Instead of banks mediating trust among the parties involved in a transaction, a set of software-powered computer nodes enable these peer-to-peer transactions. Special nodes called miners confirm and verify transactions using cryptographic algorithms and store a record of all transactions, in an ever-growing ledger known as the “blockchain.”

What is a cryptocurrency?

Cryptocurrency is a form of digital good (or an asset) which can, on exchanges, be traded for fiat currency. In more recent times, cryptocurrency has come to be synonymous with Bitcoin (and others that follow the Bitcoin protocol).

What has led to the deep plunge in Bitcoin’s value?

Of late, cryptocurrencies have dropped in value because of a few important regulatory happenings globally. Governments are evaluating and modifying regulatory frameworks for cryptocurrency-based assets.

One of the biggest challenges for most governments worldwide is how to protect their citizens from being gullible investors in an asset class that is not backed by anyone. Key among those challenges is to contain capital flight from their shores while maintaining a banking system and a healthy equity market without a credit crunch.

With cryptocurrencies that are global in nature, many governments consider them an asset class that can cause capital flight outside their existing monetary system. As a result, they are trying to regulate it.

Any news of regulation or negative oversight will have a dampening effect on the demand for crypto assets, causing prices to tumble. That being said, any financial market will have to realize the importance of regulation and the regulatory framework, which can only make these markets more mature.

Are Bitcoin and other cryptocurrencies valuable?

Value is an attribute of an asset. Among economists, value of an asset is ascribed by markets based on a variety of criterion. For some, that includes the future value of the utility of that asset.

Some attribute the value to the monetary policy of a government – based on what the government or another central authority determines the value to be. Further, others attribute value to the net of the speculation – outflows and inflows. Using each of these different mechanisms, Bitcoin is supposedly an asset that holds value.

That being said, in monetary terms the total market-cap of all cryptocurrencies is significantly small compared to the total money supply in the world. Compare it to, say, the market capitalization of the top 10 firms or the net worth of the richest person in the world.

The entire cryptocurrency marketplace is worth less than the largest firm in the world, and possibly the richest man can own a lot of currency in the world.

What are the major risk factors of investing in cryptocurrencies?

Cryptocurrencies are a new class of asset that is traded 24X7, 365 days a year on private exchanges. Some people find it exciting because the price has risen abnormally high in the past three years. Some people find this volatility in prices extremely discomforting.

The risk factors are that this is a class of asset with very little government oversight or backing from central insurers. Many times these markets are rife with manipulation. For instance, the same person using different accounts to buy and sell the same cryptocurrency so as to artificially inflate the price, or sell to make a profit. More recently, a lot of fraudulent behavior has been detected and money laundering instances have been found.

Can Bitcoin’s recent run up inspire a bandwagon mentality that can create a dangerous bubble instead of investing in proven value?

Bitcoin is following principles of economics and principles of market efficiency. It is an asset that is not controlled by a central entity; that is secure, international and fungible, liquid, and is available in a limited supply for trade. This demand, at near constant supply, has caused prices to go up disproportionately in a short period of time, attracting more investors. There is no denial that there is a bandwagon effect, but the effect is temporary since governments world over have stepped up to regulate this.

What inspires people to sell low? Does fear play a role here?

Fear and greed are two behavioral factors that affect trade of assets in markets. However, with Bitcoin’s main use case of serving the underserved or excluded financial segments by providing access to value, the future utility value of this asset class is difficult to dismiss. That being said, there are technical, regulatory and economic factors that affect a trader’s behavior in this market.

What are the most popular cryptocurrencies today?

Coinmarketcap.com and coincap.io list the top cryptocurrencies. The top 4 have consistently been Bitcoin, Ethereum, Ripple and Bitcoin Cash. The rest of the popular ones are Cardano, Stellar, Litecoin, EOS, NEO, NEM, IOTA, DASH and MONERO.