Virtual currencies are not a new phenomenon. From credit card reward points and airline miles to dotcom-bust casualty Beenz and Second Life’s Linden Dollars, virtual currencies have been in existence in one form or another for more than 40 years. However, it’s only recently that bitcoin, a fully-functioning, decentralized peer-to-peer digital currency, has entered the mainstream discussion.
First introduced in 2009, bitcoin is “mined” by participants’ computers as they solve complex algorithms and are rewarded with “coins” that are then stored in a virtual wallet. Bitcoin is (theoretically) an alternative to the currency concerns of today’s global economy—namely inflation, risk of collapse, complexity and over-regulation. Its supporters tout the innovation, value and benefits of such virtual currencies, claiming that they are the digital age’s answer to the risks and costs associated with traditional currencies.
The Cyprus bailout crisis and ongoing financial concerns in the eurozone have created a backdrop for discussions about bitcoin’s viability, as fears of sovereign debt default and bank runs have damaged investors’ confidence in traditional currencies. Free from the regulation or control of any bank or government, bitcoin has gained awareness as a way to sidestep volatility.
In theory, a business that deals predominantly in bitcoin can benefit on a number of levels. Bitcoins are stored electronically and traded for other market currencies via online foreign exchange portals. Therefore, there is no need for a bank account and its associated transaction fees, ultimately minimizing storage and transaction costs. In practice, however, companies are far more concerned with the operational than the theoretical. Are virtual currencies a feasible alternative for the corporate world, or are they simply a passing fad? To answer this question, CFOs and financial professionals need to understand the risks of bitcoin and address considerations around volatility, liquidity, market maturity, hedging, security and regulation.
Volatility
Unlike regular currencies, virtual currencies are not tied to any country’s economy. By floating against all other currencies, bitcoin is theoretically insulated from the effects of economic instability, fiscal/monetary policies and political unrest, such as the recent issues in the eurozone.
However, a look at the fluctuations in bitcoin’s value proves that the electronic currency experiences a great deal of volatility. In 2013, its value has increased from under $20 to over $260, back down to $50, then up to $130, then down to just over $100 by the end of July. In one day alone, the value of one bitcoin fell from $266 to $105 before rising back to $194—far beyond the type of volatility ever seen by any fiat money.
Since bitcoin is not tied to a single economic or political entity, much of the source of this unpredictability is speculation, rather than economic or fiscal policies. Media coverage, fluctuations in demand and rumors of technical glitches or breaches can act as triggers for such speculation. For CFOs, corporate treasurers and other financial professionals who work toward decreasing and managing risk, such uncertainty introduces an unacceptable amount of risk.
Lack of Liquidity
One of the biggest risks of virtual currencies from the corporate perspective is the lack of liquidity, which ultimately means that corporate finance managers cannot currently consider bitcoin a substantial alternative to “real” market currencies. The volume of bitcoins in existence is extremely low in comparison to market currencies—as of early August, there were approximately 11.5 million bitcoins in existence, worth nearly $1.2 billion—making it difficult for corporations to leverage it for anything but small transactions.
If corporations were to actively use bitcoin in daily business, their demand for the virtual currency would create a supply and demand imbalance, increasing price volatility simply through the execution of daily transactions. Although only 50% of the total bitcoins available are in circulation, unless volume is increased, the lack of liquidity would prevent any corporation from being able to utilize bitcoin as a viable currency alternative.
Formalized Market
As bitcoins are exchanged via unregulated online finance portals, supporters often see the independence from banks as a benefit. For corporations, however, this disconnect with banking institutions limits the options available when looking to transact. When approaching online finance portals, there is a lack of system integration and formalized confirmation procedures. In turn, this increases the time and resources required on the corporate side to complete the diligence and regulatory compliance to support each transaction.
The immaturity of individual exchanges also presents challenges. MtGox (the Japan-based exchange that handles 70% of all bitcoin trades and 80% of all trades to and from U.S. dollars) recently suspended U.S. dollar cash withdrawals for a two-week period, as it was unable to efficiently process the high volume of dollar transactions. Although transfers in other denominations were still allowed, the need to use a traditional exchange for transacting back into dollars negated the cost savings (and anonymity) of using bitcoin.
Inability to Hedge Exposures
Hedging risk exposures is the mandate of any corporate treasurer. Should a corporation carry significant bitcoin on the balance sheet or have payables or receivables in bitcoin, then protecting the value of these amounts is an absolute requirement. The virtual currency market is both too small and too immature to support derivative instruments and therefore holding of or transacting in bitcoin exposes the company to risks—especially given the volatility the virtual currency has experienced recently.
Security
One of the most important risk factors for bitcoin is security. The lack of regulatory body or government backing means that, should something go wrong, individuals or corporations have no recourse. Although one of the benefits (to some) of bitcoin is the lack of a paper trail, this also means that, should someone’s bitcoin virtual wallet be hacked, tracing and finding those responsible is next to impossible, and bringing them to justice is even more difficult. Although personal wallets can be encrypted, and the SHA-256 encryption algorithm of bitcoin itself is considered extremely secure, should a vulnerability be found and exploited, it could have a catastrophic impact on bitcoin’s reputational risk.
In addition to the security of individual accounts, the security of bitcoin exchanges needs to be scrutinized. A wild one-day swing in bitcoin’s value last spring was initially driven by a DDoS (distributed denial-of-service) attack on MtGox. Further attacks could prove fatal if trade is seriously impacted for a prolonged period.
Market Regulation
Virtual currencies lack regulatory oversight—a driving force behind their initial popularity. As transactions cannot be tracked and user accounts are anonymous, enforcement of market practices, taxation and regulatory reporting are impossible. While these are attractive elements to certain groups of users (perhaps those seeking ways to operate outside of the law), they are show-stoppers for corporations that operate within a different mandate.
While the future of virtual currency market regulation is unclear, one online foreign exchange portal, Liberty Reserve, was recently closed by the Treasury Department as a result of its suspected role in money laundering.
Too Much Risk—For Now
The rise of bitcoin has sparked numerous debates, but when it is considered with a corporate finance professional’s goals in mind, it is not currently a realistic currency for the corporate environment. Despite its value in protecting against sovereign risk, bitcoin introduces unnecessary risk to a business. This risk, incurred through the lack of liquidity, market regulation and reputable counterparty involvement, far outweighs any benefits or value its supporters advocate.
Virtual currencies such as bitcoin are maturing rapidly, and as more established organizations take an interest in them—in terms of venture capital investment, trading partners, and industry and government regulators, for example—there is certainly the possibility that they could evolve into a credible alternative to existing government-backed currencies. However, for the time being, companies should steer clear of bitcoin unless they have a serious appetite for risk.