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Global Rates & FX Research

11 February 2014

The audacity of bitcoin
Risks and opportunities for corporates and investors
 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.  Hence the 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: what is it; how is it created and transferred; what are its advantages and disadvantages for corporates and investors compared 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-supply currencies 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 legal tender, 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 apparent cheapness 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 underlying technology may be, bitcoin’s practical role may be no larger 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.

Global FX Strategy John Normand
AC

(44-20) 7134-1816 john.normand@jpmorgan.com J.P. Morgan Securities plc

See page 7 for analyst certification and important disclosures.
www.jpmorganmarkets.com/GlobalFXStrategy

John Normand (44-20) 7134-1816 john.normand@jpmorgan.com

Global Rates & FX Research 11 February 2014

Introduction: the most audacious currency since the euro
Unlike other asset markets, FX rarely welcomes newcomers for the simple reason that launching a widely-used currency traditionally required creating a sovereign or suprasovereign entity with a central bank to issue the unit and manage its supply over time. The world’s last new currency was the euro launched in 1999, though it has simply replaced 18 national ones as countries joined EMU.1 Hence the audacity of bitcoin: it is a stateless, virtual and peerto-peer currency. It exists only digitally rather 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 corporates rather than through the traditional third-party banking system.2 It is also incredibly illiquid (daily turnover equivalent to the Mauritius Stock Exchange), extremely volatile (20 times more so than the yen) and often caricatured (allegedly only preferred by criminals, libertarians and 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: what is it; how is it created and transferred; what are its advantages and disadvantages for corporates and investors compared 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-supply currencies like gold. At the risk of sounding like a luddite unable to recognise the transformative effects of evolving technologies – similar to the late 1970s prediction that “there is no reason for any individual to have a computer in his home”3 – 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. Their greatest appeal is the apparent cheapness 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 costs plus brand recognition from trialing a new technology against extreme illiquidity and volatility,
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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.

1400 1200 1000 800 600 400 200 0 10
Source: J.P. Morgan

250 Bitcoin price, $ Bitcoin daily turnover, $mn 200 150 100 50 0 11 12 12 13 14

Chart 2: Bitcoin is over 20 times more volatile than USD/JPY
3-mo realised volatility; note difference in scales

450 400 350 300 250 200 150 100 50 0 2011
Source: J.P. Morgan

18 Bitcoin, 3-mo realised vol USDJPY 3-mo realised vol 16 14 12 10 8 6 4 2012 2013 2014

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.

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 proven correct. 3 Ken Olsen, founder of now-defunct computer maker Digital Equipment Corporation in 1977.
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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

John Normand (44-20) 7134-1816 john.normand@jpmorgan.com

Global Rates & FX Research 11 February 2014

cases, users value the medium because employing it is more efficient than bartering. A unit of account is a way of measuring value from a 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 metal at a fixed rate, served these three functions. But followers of financial history know the limitation of a system based on a fixed or slow-growing money supply: it imposes uncomfortable financial discipline on governments, households and corporates. Hence the progressive debasement of pure gold coins with alloys; the global abandonment of the gold standard during the financial strains during World War I; and the US government’s suspension of the dollar’s gold convertibility given fiscal and balance of payments pressure from the Vietnam War.4 Today most countries employ fiat currencies, or paper and coins with no intrinsic worth whose perceived value stems from government declaration (or fiat5) and collective belief. The government creates demand for a currency by declaring it legal tender, meaning it 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 monopoly on its production to avoid counterfeiting, and by establishing a central bank with a mandate to manage its supply responsibly over time. While this system may sound like blithe existence in The Matrix, this relationship amongst government, central bank, households, corporates and fiat currencies is 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).

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

500 450 400 350 300 250 200 150 100 50 2006
Source: J.P. Morgan

Fed ECB BoE BoJ

2008

2010

2012

2014

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 alleged recklessness, 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 in practice. Consider the infrastructure of a traditional monetary and payments system to highlight what bitcoin attempts to replace. 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 reserves6. 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
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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".

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.
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Global Rates & FX Research 11 February 2014

assuming that verification and transfer risk, intermediaries levy a fee. Bitcoin performs these functions of money creation, payment verification and fund transfer quite differently. Its network is international and comprises miners who create the currency and users who obtain the currency to buy goods and services. There is no central monetary authority or regulator. There is also no financial intermediary for exchanging bitcoins for real products. The closest to an intermediary is an exchanger who will swap bitcoins for traditional fiat currencies like dollars, euros, yen or renminbi, like a forex dealer or futures exchange.7 Miners create bitcoins electronically by solving a mathematical algorithm released in 2009 by an unidentified programmer (or perhaps group of programmers) known by the pseudonym Satoshi Nakamoto. Anyone can be a miner; they simply need to download the software required to interact with others on the network, and acquire hardware powerful enough to run the multitudinous calculations to solve the algorithm. Since the technology required to solve an increasingly complex algorithm grows over time, miners will probably be programming specialists rather than the average consumer or businessperson. Any individual or business can be a bitcoin user, however, by establishing an electronic account know as a wallet. This wallet is associated with a user's electronic address but not to any other identifying information such as their name, phone number or physical address. Thus bitcoin is a pseudonymous system rather than an anonymous one in that every user is known by something other than the legal names associated with traditional banking. To provide security as well as transact with other users, bitcoin employs cryptography which assigns two keys (alphanumeric codes) to each account – a private one known only to them and a public one known to all other users in the network. When two users wish to transact, they send a message to the network using their public keys signed by their private keys. This transaction forms part of a block chain or bundle of transactions entirely in the public domain along with all other historical bitcoin transactions performed in the network. Miners compete to verify that this trade is authentic via algorithms to confirm that indeed a user possesses the bitcoin and did not previously spend it. Programmers (miners) who solve the equations to authenticate a block of

transactions receive 25 bitcoins8 in exchange, thus increasing the money supply. Whenever the algorithm is solved, it becomes computationally more difficult so that the next attempt requires more time an effort (i.e. computing power). This feedback mechanism limits the growth rate of bitcoin supply, so is somewhat analogous to the production constraint on gold. The more that is mined, the greater the requirement to dig deeper pits, the greater effort required to extract the marginal ounce and the higher the price of the marginal ounce (or coin). The stock of bitcoins is arbitrarily set at 21 million units to be mined by 2140, 12 million of which have already been mined. At early-February market prices of about $700 per unit, the current bitcoin money supply has a value of about $8.5bn, equivalent to the market capitalisation of the Mauritius Stock Exchange. As complicated as this process is, it begins to address several acknowledged deficiencies of fiat currencies. It provides steady, predictable growth in the money supply. It eliminates the risk of capital controls because the network lacks a central authority. It provides verification of fund balances to avoid fraud. And it eliminates or at least significantly reduces transaction costs for payments because verifiers are rewarded through bitcoin creation. As fanciful – and indeed Matrix-like – as this bitcoin creation system sounds, perhaps it requires no more suspended disbelief than the traditional fiat system in which a government declares paper to have value and a central bank or national mint thus issues the specie. One doesn’t need to be the caricatured miscreant, Austrian economist or anarchist to appreciate the appeal of such a system.

Bitcoin as inferior money
What’s not to like about this system? A lot. Recall each of the three functions of money – medium of exchange, unit of account and store of value. As a medium of exchange bitcoin initially seems no better or worse than fiat currencies, since anything portable (like paper or an electronic data file) can be used as that medium so long as enough agents agree to use it. Therein lies bitcoin's limitation: with due apology to anarchists, there is no common power like a government to compel the public to use bitcoin as universally as its own fiat currency. Recall that currencies don’t become widely used spontaneously or through a grass-roots campaign. They become widely used nationally because a government declares them legal tender, and they become widely used internationally because they are legal tender in a significant economic area with large, unrestricted capital markets. Hence the primacy of the US
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7

About 75% of bitcoin trading is done versus USD, 13% vs CNY and 5% versus EUR.
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The current reward of 25 coins (worth $17,500 at the early February exchange rate of about $700), but that prize falls by half every four years.

John Normand (44-20) 7134-1816 john.normand@jpmorgan.com

Global Rates & FX Research 11 February 2014

dollar and euro in line with the economic significance of the US and Euro area, and the prospects for the renminbi as China pursues capital market liberalisation (chart 4). In the area of transactional demand for a currency, incumbency is an incredibly high hurdle to jump. A virtual currency’s transactional use will always be limited unless it performs the other two functions of money better than a fiat currency. As a unit of account and store of value, bitcoin also falls well short of fiat currencies given its extreme volatility. As highlighted earlier in chart 2, bitcoin's realised volatility has averaged 120% over the past three years, with a range of 50% to 400%. By comparison, typical G10 currency volatility is 8% with a range of 7% to 16% over the past three years. Typical emerging markets FX volatility is about 9% with a range of 7% to 20% over the past three years. Even during periods of extreme financial market stress such as the Asian Crisis of 1997/98 and the Argentine Default of 2002, currency volatility reached levels closer to 50% (Asia) or 120% (Argentina), and then only persisted for a few weeks. True, these swings may represent simply normal volatility for a start-up currency just like the fluctuations of start-up companies’ share prices during the 1990s. Even by dot-com standards, however, these moves are brutal. The Nasdaq only quintoupled in value in three years (19972000), while bitcoin's price has risen 50-fold in the past year (charts 5 and 6). Such price fluctuations make it impossible to seriously consider bitcoin as a unit of account or store of value for an material amount of corporate or investor exposure. How much does illiquidity due to lack of fiat currency status contribute to such volatility? That is unclear, but here are a few comparative statistics. Bitcoin’s market value and turnover are trivial by currency standards. There are currently about 12mn bitcoins in circulation, which at a current price of $700 given them a value of about $8.5bn. This figure compares to currency in circulation of about $1.2trillion for US dollars, €950billion for euros and £360bn for sterling. Relative to frontier stock markets and the smallest investable bond markets, the current market value of bitcoins is similar to the market capitalisation of the Mauritian Stock Exchanges or Peruvian government bonds. Bitcoin’s average daily trading volume across major exchanges is about $20mn, compared to average daily trading volume of FX futures on the Chicago Mercantile Exchange of about $33bn for EUR, $17bn for JPY and $1.4bn for MXN (chart 7). Recall as well that over-thecounter volumes in FX are about ten times that of exchange-traded activity. Still, none of these tiny asset markets nor lowest-liquidity fiat currencies exhibits the outstanding volatility of bitcoin. Perhaps the decision to limit bitcoin supply has consequences not imagined at the time.

Chart 4: Certain currencies are widely used internationally because a government compels their use in large, open economies
Nominal GDP (x-axis) versus average daily FX turnover for reference currency versus all other currencies (y-axis)
1400 1200 y = 0.07x - 31.44 R 2 = 0.88 USD

average daily FX turnover

1000 800 600 400 200 0 -200 AUD CAD GBP

EUR JPY

CNY 5,000 10,000 15,000

nominal GDP, $bn

Source: J.P. Morgan, BIS

Chart 5: The Nasdaq bubble – prices doubled in two years and quintoupled in three years
Nasdaq indexed to 100 in 1997

600 550 500 450 400 350 300 250 200 150 100 50 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source: J.P. Morgan

Chart 6: The Bitcoin bubble – prices have increased 50-fold over the past year
Bitcoin price indexed to 100 on January 1, 2013

10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 Feb 13 Apr 13 Jun 13
Source: J.P. Morgan

Aug 13 Oct 13 Dec 13 Feb 14

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Global Rates & FX Research 11 February 2014

Ironically the lack of external oversight may prove an obstacle to significant market deepening, since many market participants would prefer the accountability of known but fallible entities to one based on a mathematical code. (Query: who does one call when there is a problem with bitcoin?). In exchange for its low-cost peer-to-peer system, bitcoin’s network contains no recourse if bitcoins are lost or hacked. At least traditional fee-charging banks provide deposit insurance and other fall-backs. With fixed supply, bitcoin’s deflationary bias should also be clear. That quality serves owners well when exchanging into foreign currency, but it would be onerous for any economy operating with it as legal tender. Indeed Weimar Germany was unpleasant, but so was the Great Depression.

Chart 7: Average daily turnover on bitcoin is trivial compared to FX futures on the CME, and CME volumes are only 10% of over-thecounter volumes
Average daily turnover on bitcoin across the three major exchanges versus turnover by currency pairs on the Chicago Mercantile Exchange. Figures in US$ bn

40 35 30 25 20 15 10 5 0 EUR JPY GBP AUD CAD CHF MXN 18 10 34

8

7

5 1 1 0.02

Implications for corporates and investors
For corporates, bitcoin’s appeal is too fold: no or low transaction costs from a peer-to-peer payments system, and potential brand recognition from trialing an innovative technology. These advantages must be weighed, however, against the currency’s extreme volatility. Focusing on saving 1% on transfer fees seems misguided when currency volatility runs at more than 100%, and when exchanging bitcoins to fiat currencies could cost a few percent too. Cash management therefore would remain problematic since there are no financial assets in which to hold bitcoin receipts as a store of value. If cash should be liquid and stable to provide corporates with maximum financial flexibility, bitcoin provides corporates with neither. Finally, risk management around bitcoin exposure would remain difficult. Also correlations with other currencies appear higher (table 1), they are quite erratic over various sample periods. All-in transaction costs may also be higher once the fees from transferring bitcoins to fiat currencies are included. Consumers face similar tradeoffs: lower transaction costs but extreme price risk, while forgoing the benefit of deposit insurance offered by traditional banking. Of course many corporates operate regularly in countries with volatile, illiquid currencies subject to exchange controls, of which bitcoin could be considered another variant. But in other markets, restrictions may diminish as the country's financial markets develop (think China). It is unlikely that bitcoin could ever achieve meaningful scale relative to government-issued currency since a government would not grant it legal tender status. Transactional demand can persist, but perhaps on a scale comparable to a minor emerging markets currency rather than the basis for a company’s global payments. 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. How much could the price rise? All traditional models of exchange rate determination are useless in
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NZD Bitcoin

Source: J.P. Morgan, CME and bitcoin exchanges

Table 1: Bitcoin correlations with other currencies and with gold
Based on daily data over past year and past two years. All series are expressed as USD dollars per unit of foreign currency, gold or bitcoin
Past two years JPY JPY EUR GBP CHF CNY Gold Bitcoin Past year JPY JPY EUR GBP CHF CNY Gold Bitcoin 1 EUR -0.34 1 GBP -0.53 0.92 1 CHF -0.26 0.97 0.90 1 CNY -0.82 0.65 0.77 0.56 1 Gold 0.78 -0.49 -0.58 -0.41 -0.90 1 Bitcoin -0.71 0.63 0.79 0.63 0.72 -0.60 1 1 EUR -0.66 1 GBP 0.11 0.45 1 CHF -0.37 0.92 0.64 1 CNY -0.93 0.77 0.15 0.52 1 Gold 0.85 -0.50 -0.01 -0.27 -0.83 1 Bitcoin -0.60 0.57 0.48 0.50 0.67 -0.69 1

Source: J.P. Morgan

answering this question. Purchasing power parity frameworks cannot be used because there is no sufficiently large consumption basket of goods in the bitcoin economy to compare against the inflation rate of fiat-currency economies. Fundamental exchange rate models cannot be constructed for similar reasons: there is no meaningful bitcoin economy on which to base productivity or terms of trade calculations. The best framework is to consider the behavior of supply-constrained commodities when the market balance tightens due to rising demand: price trends turn exponential until supply increases (impossible with bitcoin unless network users collectively agree to alter the protocol), or high prices curb demand.

John Normand (44-20) 7134-1816 john.normand@jpmorgan.com

Global Rates & FX Research 11 February 2014

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Global Rates & FX Research 11 February 2014

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