about 3 years ago • 3 mins
Bitcoin’s price may have risen 300% in 2020 to record highs – but a huge part of its attraction, particularly for newly enthusiastic institutional investors, is the idea that bitcoin could one day become the world's “reserve currency”. I’m not so sure that claim stands up to scrutiny, however – and the consequences for crypto-heavy portfolios could be dire.
Reserve currency is money held in large quantities by central banks in order to help their countries conduct international transactions and influence their domestic currency’s exchange rate. The US dollar is currently the world’s most dominant reserve currency, accounting for around 60% of official global reserves.
It’s crucial to remember that reserve currencies are held because they’re useful for paying for things – whether that be physical goods or debt obligations. Most commodities are priced in US dollars – and so countries hoard dollars to pay for these. So too are many company and government bonds – and low US interest rates, which make borrowing in dollars cheap, have further underpinned the greenback’s global ubiquity.
If a decentralized cryptocurrency such as bitcoin is to challenge this dominance, what matters isn’t its price or its institutional ownership, but whether or not people and companies are taking on bitcoin-denominated liabilities. And that doesn't include simply paying for something priced in dollars or euros using bitcoin – it means having actual obligations (debt, rent, wages etc.) that involve a specific amount of crypto.
So far, however, this is nonexistent. There are two main reasons. First, the price of bitcoin is extremely volatile: no company in its right mind would want to denominate liabilities (or assets, for that matter) in a currency whose value can shift 10% between bedtime and breakfast. Ironically, bitcoin’s meteoric rise makes it even more of a concern from this perspective. Imagine agreeing to pay a supplier one bitcoin when it cost $7,000, only to see its price then rise above $30,000?
The second reason why nobody’s taking on bitcoin-denominated liabilities is that the cryptocurrency has a scalability problem that prevents it from being widely used in transactions. The very “proof of work” technology that makes bitcoin so secure also limits the speed at which it can process transactions to about 4.6 per second. Payments giant Visa, by contrast, processes 1,700.
Let’s recap. A lot of people, including senior analysts at US investment bank Morgan Stanley, reckon bitcoin has a shot at becoming the world’s next major reserve currency – and may well be buying it accordingly. Countries only hold reserves if they need to conduct transactions or meet liabilities in that currency, however. And when it comes to bitcoin, two big inherent issues mean there’s no sign of the cryptocurrency taking off in this respect.
My verdict on all this is that the case for bitcoin’s status as a global reserve currency is fundamentally flawed. The big question, of course, is what happens if and when investors finally cotton onto this. Whether the removal of such a reason for owning bitcoin outweighs the desire to HODL on in the hope of even greater gains remains to be seen – but as many will have found out to their cost this week, the cryptocurrency’s swollen price doesn’t mean it’s immune to sudden plunges.
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