Damodaran looked at “three determinants of a currency’s price/power: the trust you have in its issuing entity, its acceptance in transactions and how securely you can store and save it, while generating a fair rate of return while doing so.”
1. Trust in the issuing authority
How much “trust” do people really have in the Federal Reserve? The ECB? For Bitcoin, Damodaran’s key question is, “Are there some computer algorithms that you trust more than some central bankers?”
Bitcoin’s key appeal is that it doesn’t have a central authority, but that means that its staying power will be tethered to “how impervious its source algorithm is to mischief,” according to Damodaran.
2. Acceptance in transactions
“Since the defining role for a currency is that it can be used in transactions, the price of a currency will depend upon how widely it is accepted in transactions for goods and services,” Damodaran writes.
As it stands now, “Bitcoin is a currency, but one that is currently accepted only in a small subset of transactions and used by only a few,” he writes. “Whether it or any other digital currency will be widely accepted will depend in large part on how its advocates package and market it. If the emphasis is on convenience, low cost and transaction speed, it has the potential for much wider acceptance, especially if it is made simpler to understand and not oversold. If the focus is on privacy, security and anonymity, I am afraid that the dark side will win out and it will become the currency of the paranoid and illegal, with all of the associated costs and benefits.”
3. Security and rate of return
“The final measure of a currency’s strength and durability is how easily you can convert it into other currencies, how securely you can store and save it and and whether you are compensated while you hold it,” writes Damodaran.
Citing the MtGox bankruptcy, Damodaran says current Bitcoin exchanges do not provide depositors proper protection against themselves or possible hacks.
“While it may conflict with the vision of some Bitcoin revolutionaries, the Bitcoin economy may need a banking system of its own that is regulated and perhaps even insured by a centralized entity,” he concludes.
Damodaran provides a chart to put digital currencies in context. He uses three paper currencies, gold, and Bitcoin. Check it out:
Based on his chart, Damodaran favours the U.S. dollar over the yuan, but the yuan over the peso. He likes the dollar over gold but “it is a closer call that it was five years ago.” He’d take gold over the yuan, but the yuan over Bitcoin.
“If you are a Bitcoin enthusiast, the pathway to its success requires three developments: the computer algorithm underlying the currency has to stay transparent, robust and protected, the usage of Bitcoins has to spread beyond the narrow band of enthusiasts to the broader marketplace and the infrastructure for securing, transporting and saving Bitcoins has to be strengthened,” he writes.
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