Big Money: Why you’d have to be a fool to do business in Bitcoin

Bitcoin dropped 15% in value against the greenback on Wednesday night after the creator of black-market website Silk Road was arrested.

Most people put the drop down to a huge amount of demand for Bitcoin having been driven by a desire to use it for nefarious activities on Silk Road. Bitcoin is, after all, untraceable by design, so it’s a far better way to buy drugs and firearms than traditional currencies.

But here’s the thing. A 15% drop in a day is only slightly more volatility than normal for the online currency. On any normal day, traders expect Bitcoin to jump up and down around 7% in value. On an unusual day, who knows what could happen.

This is because there’s not really a proper market for Bitcoin as a currency. The number of people trading and buying it are so few, and the amounts so meagre, that any one large trade can spectacularly upset its value.

And that’s even before you get into the fact that it’s prone to bubbles. Earlier this year, it rose 57% in just one week.

Bitcoin’s value goes up and down largely in reflection of whether or not people are talking about it. It’s a fad – something people remember when the media does – and not a genuine financial instrument that serves a purpose for many people whether or not we notice it.

An increasing number of businesses are giving their customers the ability to pay in Bitcoin. These include a number of Australian start-ups. There’s also a pub in Melbourne that’ll let you pay for your beer using the digital currency.

I’ve no doubt the savvy entrepreneurs behind these decisions are relishing the publicity. But let’s not kid ourselves here. If you’re selling something people can buy with other currencies, as most businesses who aren’t Silk Road do, you’ve got no real incentive to price in Bitcoins.

For one, your prices would have to float as much as the currency does so you don’t end up losing money. And once a payment is made in Bitcoin, you’d have to either cash it into a less volatile currency right away to preserve your income, or hold onto it and hope to speculatively sell when the price is high.

Neither of these options are very practical for a business. And even if they’re not that hard, they’re pointless. Why would a customer exchange dollars for Bitcoins to make a payment in Bitcoin so that you can they take that payment and convert it back into dollars?

Some people for practical or ideological reasons don’t like being traced. I can see why such people would want to use Bitcoin. But such people are a very small minority. Very few care that much about the government knowing where they bought their coffee.

Don’t get me wrong.

I think Bitcoin is ingenious, as is its unknown creator. Anyone who’s spent time learning about its underlying structure and architecture (I wrote about it here) comes away gobsmacked by its underlying logic. But it won’t work.

Most currencies in history have had inherent value. Barter economies directly traded goods, while gold itself has use value beyond what the market prices it as.

Modern currencies aren’t like that. Their value floats, and their worth is assured only by the trust in the governments that back them.

Bitcoin also has no value. Theoretically, it’s been built to be able to work despite a lack of a central authority. It’s the world’s first truly decentralised currency. But to actually work as a store of value, it needs many people to use it. This is Bitcoin’s problem. It doesn’t appeal to anyone but a small number, and that means it’s too volatile to be useful for broad usage as a currency.

Historically, when currencies are this volatile, people just find another one to use.

If we all used Bitcoins, it would be one of the greatest inventions made by man. But Bitcoin needs broad participation to be anything but a highly volatile plaything of hedge fund managers and cryptographers.

I can’t see it ever having the broad base necessary to be a viable alternative currency.