Bitcoin: Medium of exchange or speculative assets?

Abstract

Bitcoin is defined as digital money within a decentralized peer-to-peer payment network. It is a hybrid between fiat currency and commodity currency without intrinsic value and independent of any government or monetary authority. This paper analyses the question of whether Bitcoin is a medium of exchange or an asset and more specifically, what is its current usage and what usage will prevail in the future given its characteristics. We analyse the statistical properties of Bitcoin and find that it is uncorrelated with traditional asset classes such as stocks, bonds and commodities both in normal times and in periods of financial turmoil. The analysis of transaction data of Bitcoin accounts shows that Bitcoins are mainly used as a speculative investment and not as an alternative currency and medium of exchange.

Introduction

According to Nakamoto (2008), Bitcoin is a peer-to-peer electronic cash system which allows online payments to be sent directly from one party to another without going through a financial institution. This definition suggests that Bitcoin is mainly used as an alternative currency. However, Bitcoin can also be used as an asset and thus would serve a different purpose. Whilst a currency can be characterized as a medium of exchange, a unit of account and a store of value, an asset does not generally possess the first two features and can be clearly distinguished from a currency.

Potential users of virtual currencies (e.g. Bitcoin) as a medium of exchange may be attracted by its low transaction costs, its peer-to-peer, global and government-free design and the possibility to purchase special goods (e.g. illegal drugs) for which the seller may prefer virtual currency. However, potential users may be “distracted” if the acceptability of the currency or the confidence in the system is low or if the price of the virtual currency is too volatile. If the virtual currency is also viewed as a (speculative) investment, demand for the asset may contribute to the price volatility of the currency and thus the “distraction” of potential users. The balance between potential users and investors may ultimately determine the success of the virtual currency as a medium of exchange, unit of account and store of value.

Theoretically, if Bitcoin is mainly used as a currency to pay for goods and services, it will compete with fiat currency such as the US dollar, and thereby influence the value of the fiat currency and ultimately affect monetary policies implemented by a central bank. If, on the other hand, it will mainly be used as an investment, it will compete with a large number of other assets such as government bonds, stocks and commodities and possibly play a minor role. Whether it is currency or an asset, the potential influence on the economy as a whole, depends on the success of Bitcoin or similar alternatives compared to existing currencies and financial assets.

To answer the question of whether Bitcoin is a currency or an asset, we analyse Bitcoin’s financial characteristics comparing them to a large number of different financial assets and investigate the usage of Bitcoins; i.e. are Bitcoins mainly used as an alternative currency to pay for goods and services or are they used as an investment?

Our paper differs to previous work on Bitcoin and digital currencies in trying to understand the determinants which make virtual currencies more useful as a currency. Papers on Bitcoin pricing tend to investigate the pricing efficiency of Bitcoin (e.g. Hong, 2016, Urquhart, 2016) or pricing determinants using past information (e.g. Kristoufek, 2015, Li and Wang, 2017). While the efficient pricing of Bitcoin is important in improving Bitcoin’s liquidity, it does not necessarily reduce the speculative element of virtual currencies.

We find that Bitcoin is mainly used as a speculative investment despite or due to its high volatility and large returns. Interestingly, Bitcoin returns are essentially uncorrelated with all major asset classes in normal and extreme times which offers large diversification benefits. This low correlation also implies low risk from a macro perspective. For example, if Bitcoins showed bubble-like characteristics (e.g. see Cheah and Fry, 2015), a significant fall in the value of Bitcoins could be an isolated event if the correlation remained at zero and thus no other assets would be affected. If, on the other hand, Bitcoin investments were debt-financed, a significant fall in the value could lead to margin calls and then also affect other assets (e.g. see Brunnermeier and Pedersen (2009) and Kyle and Xiong (2001).

The paper proceeds as follows: Section 2 provides some background into the history of money, currencies, the co-existence of currencies, e.g. dual currency regimes, and Bitcoin. Section 3 presents the empirical analysis of Bitcoin returns and user accounts (wallets) to identify its statistical properties and its usage. Finally, Section 4 summarizes the main findings of the paper and provides concluding remarks.