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JPM the Audacity of Bitcoin

JPM the Audacity of Bitcoin

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Published by zerohedge
JPM the Audacity of Bitcoin
JPM the Audacity of Bitcoin

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Published by: zerohedge on Feb 11, 2014
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02/20/2014

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www.jpmorganmarkets.com/GlobalFXStrategy
Global Rates & FX Research
11 February 2014
The audacity of bitcoin
Risks and opportunities for corporates and investors
Global FX StrategyJohn Normand
 AC
(44-20) 7134-1816 john.normand@jpmorgan.comJ.P. Morgan Securities plc
See page 7 for analyst certification and important disclosures.
Unlike other asset markets, FX rarely welcomes newcomers
for the simple reason that launching a widely-used currency traditionally required creating a sovereign or supra-sovereign entity with a central  bank to issue the unit and manage its supply over time.
Hencethe audacity of bitcoin
: it is a stateless, virtual and peer-to-peer currency, so exists only digitally and is associated with no sovereign, central bank or bank payments system. It is also incredibly illiquid extremely volatile and often caricatured.
After a brief Economics 101 refresher on the required functions of money, this research note addresses various
frequently-asked questions around this virtual currency
: whatis it; how is it created and transferred; what are its advantages and disadvantages for corporatesand investorscompared to fiat currencies; is it a serious contender for a global payments system; and can it prove more durable long-term than other somewhat fixed-supplycurrencies like gold.
At the risk of sounding like a luddite,
bitcoin looks like an innovation worth limiting exposure to
. As a medium of exchange, unit of account and store of value, it is vastly inferior to fiat currencies. Since governments are quite unlikely to accord it the status of
legaltender
,  bitcoin or other virtual currencies would not reach the scale and scope to render them worthwhile for widespread commerce, payments or investment.
Bitcoin’s greatest appeal is the
apparentcheapness of peer-to-peer fund transfers
, though it is unclear how economical these transactions truly are when the virtual world interacts with the real world. As  provocative as its underlyingtechnology may be, bitcoin’s practical role may be nolarger than that of an emerging markets currency subject to exchange controls.
For
corporates
, bitcoin’s appeal is two-fold: no or low transaction costs from a peer-to-peer payments system, and the potential brand recognition from trialing a new technology. These advantages must be weighed against extreme illiquidity and volatility, both of which impede risk management. All-in transaction costs may also be higher once the fees from transferring bitcoins to fiat currencies are included.
Investors
normally avoid an instrument with bitcoin's trading properties. The unit's main investment appeal is the potential long-term price rise due to limited supply, much like some commodities when the market  balance tightens.
 
2
Global Rates & FX Research
11 February 2014John Normand(44-20) 7134-1816 john.normand@jpmorgan.com
Introduction: the most audacious currency since the euro
Unlike other asset markets, FXrarely welcomesnewcomers for the simple reason that launching a widely-used currency traditionally requiredcreating a sovereign or supra-sovereign entity with a central bank to issue the unitand manage its supply over time. The world’s last new currency was the euro launched in 1999, though it has simply replaced18 national onesas countries joined EMU.
1
Hence the
audacity of bitcoin: it isastateless, virtual and peer-to-peercurrency.
Itexists only digitallyrather than  physically; it is created via an algorithm and a network of  programmers rather than by a central bank; and it is transferred directly amongst this network of programmers, consumers and corporatesrather than through the traditional third-party banking system.
2
It is also
incrediblyilliquid
(dailyturnover equivalent to the Mauritius Stock Exchange),
extremelyvolatile
(20times more so than theyen) and
oftencaricatured
(allegedly only preferred bycriminals,libertariansand anarchists). After a brief Economics 101 refresher on the required functions of money (medium of exchange, unit of account, store of value), this research note addresses various
frequently-asked questions around this virtual currency.
These include: whatis it; how is it created and transferred; what are its advantages and disadvantages for corporates and investorscompared to fiat currencies; is it a serious contender for a global payments system; and can it prove more durable long-term than other somewhat fixed-supplycurrencies like gold. At the risk of sounding likea ludditeunable to recognise the transformative effects of evolving technologies –similar to the late 1970s prediction that “there is no reason forany individual to have a computer in his home”
3
 –bitcoin looks like aninnovation worth limiting exposure to. As a medium of exchange, unit of account and store of value, it is vastly inferior to fiat currencies. Their greatest appeal is the
apparentcheapness of peer-to-peer fund transfers
, though it is unclear how economical these transactions truly are when the virtual world interacts with the real world. For
corporates
, the cost-benefit around bitcoin must weigh low transaction costsplus brand recognition from trialing a new technology against extreme illiquidity andvolatility,
 
1
We ignore the trivial case of the South Sudanese pound created in 2011 when South Sudan gained independence from Sudan.
2
The euro's launch was rather audacious too. Who would have thought to form a currency union without a central fiscal and  political authority? Critics lined up in the early 1990s well before the euro's launch, though their predictions of inherent instability required ten years and two recessions to be provencorrect.
3
Ken Olsen, founder of now-defunct computer maker Digital Equipment Corporation in 1977.
Chart 1: Bitcoin’s daily turnover has averaged about $20mn over the past year with extreme volatility
Bitcoin price in USD versus average daily turnover in $mn. Turnover is based on the sum of three largest bitcoin exchanges (mtgoxUSD, bitstampUSD and bitceUSD) comprising about 70% of exchange-traded activity.
Source: J.P. Morgan
Chart 2: Bitcoin is over 20times more volatile than USD/JPY
3-mo realised volatility; note difference in scales
Source: J.P. Morgan
which impede risk management. A consumer’s trade-off is  between lower transaction costs and the risk of operating in a payments system which lacks deposit insurance.
Investors
would normally avoid an instrument with  bitcoin's trading properties. The unit's main investment appeal is the potential long-term price rise due to limited supply, much like some commodities when the market  balance tightens.
Making money the old fashioned way
A discussion of bitcoin should begin with an Economics 101 refresher on money
 – 
what it is, how it is created and why we hold it.
The classic definition of money is anything that serves as
medium of exchange
,
unit of account
and
store of value.
A
medium of exchange
can be anything deliverable for a good or service, whether a mundane object, a precious metal or piece of paper. In all
0200400600800100012001400050100150200250101112121314Bitcoinprice,$Bitcoindailyturnover,$mn05010015020025030035040045046810121416182011201220132014Bitcoin,3-morealisedvolUSDJPY3-morealisedvol
 
3
Global Rates & FX Research
11 February 2014John Normand(44-20) 7134-1816 john.normand@jpmorgan.com
cases, users value the medium because employing it is more efficient than bartering. A
unit of account
is a way of measuring value froma common reference point, thus also facilitating commerce because goods can be compared more easily. (Recall the euro’s usefulness in this regard since now  prices in Europe are comparable across 18 countries.) A
store of value
is just a way of holding wealth until it is exchanged for goods and services or lent or given to someone else.
For centuries precious metals,or paper currencies convertible into metalat a fixed rate,served thesethree functions.
But followers of financial history knowthe limitation of asystem based on a fixed or slow-growing money supply: it imposes uncomfortable financial discipline on governments, households and corporates. Hence theprogressive debasement of pure gold coins withalloys; the global abandonment of the gold standard during the financial strains during World War I; and the US government’s suspensionofthe dollar’s gold convertibilitygiven fiscal and balance of payments pressure from the Vietnam War.
4
Today most countries employ fiat currencies, or paper and coins with no intrinsic worthwhose perceived value stems from government declaration
(or fiat
5
)
and collective belief.
The government creates demand for a currency by declaring it
legal tender,
meaningit must be accepted as payment for all debts and it will be used in any transactions between the government and other agents. Consumers and corporates accept this fiat currency because it is a requirement for settling all debts public (paying taxes) and private. The government attempts to guard the value of money by maintaining a monopolyonits production to avoid counterfeiting, and by establishing a central bank with a mandate to manage its supply responsibly over time.While thissystemmay sound like blithe existence in The Matrix, this relationship amongst government, central bank, households, corporatesand fiat currenciesis much more efficient than an alternative like barter. It also makes macroeconomic shocks much easier to manage than an alternative like the gold standard (recall the deflation of the Great Depression and more recently peripheral Europe).
Bitcoin as better money
Bitcoin proposes an alternative, however.
If despite their mandates –the world's biggest central banks risk inflation and currency debasement via the rapid expansion of their balance sheets (chart 3), and if even European
 
4
Foreign exchange market participants should celebrate this day in August 1971, since it led to the collapse of the Bretton Woods system of fixed exchange rates and the advent of floating currencies.
5
The Latin command meaning "let it be done".
Chart 3: Amongst the G4 economies, only the ECB’s balance sheet is shrinking
Central bank assets in the US, Euro area, UK and Japan indexed to 100 in 2006
Source: J.P. Morgan
governments still impose capital controls (Cyprus), couldn’t a non-state entity more responsibly supply a fiat-like currency to the world? And if this currency were created and exchanged digitally amongst peers of consumers and corporates, it would have the additional advantage of avoiding the fees imposed by financial intermediaries as well as the loss of privacy inherent in third-party payments systems.
Hence the purported appeal of a virtual currency:
a medium of exchange, a unit of account and a store of value without the allegedrecklessness, capriciousness, siphoning and snooping inherent in traditional systems. Even leaving aside this caricature of  bitcoin's underlying philosophy, there is something compelling about the idea.
Simple in theory, but more complex inpractice.
Consider the infrastructure of a traditional monetary and payments system to highlight what bitcoin attempts toreplace. A traditional financial system is a national network comprising a central bank owned by a government, which creates money by physically printing currency and minting coins, or by electronically creating bank reserves
6
. That money is used by households, consumers and the government to facilitate trade and investment via a  payments system of banks and other financial intermediaries(think PayPal, Visa, Western Union and in some countries, the post office). Financial intermediaries  provide numerous services of varying complexity, but their role in the payments system is simple: verify that Customer A has sufficient funds to pay Customer B,then securely transfer ownership of that money between accounts. For
6
Quantitative easing practiced by the Fed, BoJ and Bank of England created bank reserves (a liability of the central bank, just like cash) to purchase financial assets, thus boosting money in circulation.
5010015020025030035040045050020062008201020122014FedECBBoEBoJ

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