- Bitcoin came into existence in 2009 in part as a response to fears about financial intermediation and banking following the financial crisis of 2008.
- Aggressive rate cuts from the Federal Reserve and other central banks sparked fears, which proved unfounded, of high inflation that would sharply devalue major currencies.
- More recently, market liquidity generated by a low interest rate environment made its way into bitcoin, some analysts say.
It’s a testament to the ferocity of the recent rally in bitcoin that Federal Reserve Chair Janet Yellen was asked about it multiple times during her last press conference as central bank chair.
She said bitcoin “is a highly speculative asset” that “at this time plays a very small role in the payment system.” The cryptocurrency “is not a stable store of value, and it doesn’t constitute legal tender,” Yellen said.
Yet for better or worse, the Federal Reserve has played an important, two-part role in the emergence of the bitcoin phenomenon. Bitcoin came into existence in January 2009, in part as a response to fears – which proved unfounded with time – that central banks’ aggressive response to the Great Recession of 2007-2009 would generate hyperinflation and a collapse of conventional currencies.
In 2008, many of the world’s marquis financial firms either went bankrupt or stood at the edge of bankruptcy until taxpayers bailed them out. Lehman Brothers’ spectacular collapse in September 2008 marked the height of Wall Street’s panic.
“People were looking at what happened in 2007 and 2008 and thinking, is there a better way? These financial intermediaries turned out to be pretty risky they made terrible bets,” said Martin Chorzempa, a digital payments expert and research fellow at the Peterson Institute for International Economics (where I used to work).
And more recently, some analysts say that the market liquidity unleashed by the Fed’s prolonged policy of low interest rates, which it has been gradually reversing with rate increases since December 2015, has helped drive the latest leg of the bitcoin rally, which has taken its price to ever mounting records now close to $US18,000.
‘It looks less like a currency every day’
For Chorzempa, the problem begins with calling bitcoin a digital “currency” when it is fact anything but a stable store of value.
“It looks less like a currency every day because the price is just skyrocketing like a speculative asset,” he told Business Insider. “I look at this latest addition of margin and leverage with great trepidation.”
The Fed’s low-interest-rate policies are aimed at stimulating investment and spending in a weak economy, but there are fears that some of the money makes its way to more speculative uses.
“There’s so much capital flowing around,” Chorzempa said. “All the institutional investors are drooling over the kind of returns that you’re getting in bitcoin” even though very few understand the technology.
Chorzempa warned that a deep crash is very possible and could be self-reinforcing, because the incentives for bitcoin mining decline as the prospects for price gains decrease.
Another key concern for bitcoin holders is regulatory scrutiny. Yellen discussed bitcoin more as a risk for illegal activities than as a new paradigm that could lower the cost of funding for firms, as bitcoin evangelists tend to preach.
“The Fed doesn’t really play any regulatory role with respect to bitcoin other than assuring that banking organisations that we do supervise are attentive, that they’re appropriately managing any interactions they have with participants in that market and appropriately monitoring anti-money laundering bank secrecy act responsibilities that they have,” Yellen said.
Then, there’s the issue of liquidity
Imagine deciding that, hey, at $US18,000, it’s time to cash out. Not so fast. Turning bitcoin into cash can be difficult if not impossible.
“People overestimate their ability to cash out. If you have a million bucks in bitcoin trying to do it in an exchange you’re going to crash the price,” Chorzempa said. “So you’d need to go to an old fashioned broker, do an over-the-counter negotiation.
“The hardcore people who have a lot will do ‘cold storage’ – a USB drive, or write the code down on a sheet of paper and store it in a bunker in Switzerland,” he said.
Chorzempa does not believe a bitcoin crash would pose a threat to the financial system right now, but warned that steps to legitimise its trading, such as the introduction of a futures exchange, could ensnare more traditional banking institutions that could generate systemic risks.
“Where the problems start to emerge is where it starts to build links to the rest of the financial system. Futures build that link,” he said.
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