If you’re interested in investing in bitcoin, here’s the first thing to know: the currency isn’t tethered to the economy, as are fiat currencies, commodities and real estate.
With fiat currencies, for example, “loss of spending power is a small risk in most developed countries where central banks are committed to relative price stability,” says BMO Capital Markets senior economist Sal Guatieri, in a weekly economics report. “Exchange rates can be volatile, but usually swing wildly only in response to occasional economic and political shocks, and eventually return to so-called fair value.”
In contrast, because bitcoin has no intrinsic value, it’s vulnerable to shifts in investor sentiment. (Guatieri also points out that bitcoin needs blockchain to exist, but blockchain doesn’t need bitcoin.)
To convince investors of its value, bitcoin must show more stability, but its track record on that front isn’t impressive.
“In early September, the price plunged 36% to $3,200 from around $5,000, before soaring 134% to $7,500 in the next two months,” says Guatieri. “It then took another gut-wrenching drop of 20% over four days to below $6,000, before soaring 37% to its current level of $8,200.”
Compare that to the loonie, which traded within 6% of the U.S. dollar over a similar three-month period.
Investors go by feel
Behavioural finance might help explain bitcoin’s movements.
“Bitcoin holders are reluctant to sell because they expect the price to keep rising,” says Guatieri. “The same trend-is-your-friend mindset compels prospective buyers to jump on for the ride.”
Investors have mostly ignored bitcoin volatility, as it’s been “generally in a steeply upward direction,” say CIBC economists Andrew Grantham and Royce Mendes in a weekly economics report. However, if the currency starts to show “two-way volatility, its appeal will fade quickly as it’s seen as neither a currency nor a one-way bet.”
Guatieri says an important test for the currency is on the horizon: a bitcoin futures market might open by year-end, subject to CFTC approval.
That means skeptics will have opportunity to “sell bitcoin short in hopes of buying it back at a lower price,” he says. Essentially, “bitcoin’s price could fall if there are more skeptics who believe it is a bubble […] than enthusiasts who think otherwise.”