Why bitcoin could fail

January 24, 2014: 12:04 PM ET

As the virtual currency goes mainstream, many of the reasons why investors embrace bitcoin could go away.

By Sanjay Sanghoee

131223132455-2013-tech-bitcoin-620xaFORTUNE -- Every few years the world of technology witnesses a revolution, the next big development with the potential to change how we function and to spawn a highly profitable new industry. There's been the explosion of personal computers, followed by the Internet, smartphones, tablets, cloud computing, and other large and small disruptive technologies. The latest such game-changer seems to be the arrival of virtual currencies, personified by the biggest player in that arena: bitcoin.

On the surface, bitcoin seems like a great idea and maybe an inevitable one. Bitcoins (the actual units of this virtual currency) are a form of electronic money that can be traded directly between parties; do not require the physical backing of gold, dollars, or any other traditional store of value; and whose price is based on demand over a peer-to-peer network. That isn't that different from mainstream currencies -- since the abolition of the gold standard in the 1970s and the creation of floating exchange rates, even the U.S. Dollar functions mostly on the same principles.

The big difference? Regulation. Unlike cash, bitcoin isn't backed by a central bank, which essentially gives conventional currencies their real value.

MORE: Bitcoin is not just digital currency. It's Napster for finance.

To understand this, consider that a shopkeeper sells a candy bar to a customer for a fixed price. The customer knows before he walks in that the dollars in his pocket will yield a certain amount of value. That value (the price of the dollar) might fluctuate in foreign exchange markets but only within a narrow band and will not affect the ability of the customer to buy the candy bar in real time. If the value of the dollar fluctuates too far out of an acceptable range, it will usually be brought back in line through currency transactions by central banks. That's precisely why a fiat currency system (not pegged to gold) can still work and not be disrupted because of currency speculators.

By contrast, the volatility of bitcoin makes everything a lot less certain. Neither the shopkeeper nor the customer would know how to correctly price the candy bar at any given time, since the value of the virtual currency undergoes such extreme highs and lows. Over the past year, the price of a bitcoin has gone from $14 to more than $1,100, settling back down around $500 at the end of 2013. The fluctuations not only make predictability of value impossible but also render bitcoins almost worthless. The reason for this is that bitcoins, due to their lack of any official anchor, exist only in the context of barter or speculation, and when the transactions and hype stop, so does the music. In other words, the success of bitcoin is based on a self-fulfilling prophecy, which is just as dangerous as it sounds and does not even pass the test for a real currency.

There is also the small problem of bitcoins being irreplaceable, a case in point being a man who lost some $7.5 million worth of bitcoins because he threw away a hard drive. Cash can be misplaced too, of course, but hardly in such quantities and so easily. This factor, combined with the issues mentioned above, makes bitcoin an extremely unreliable medium of exchange, which detracts from its value proposition: anonymity, tax free transactions, and low transaction costs compared to credit cards.

Finally, there is Silk Road, the online marketplace for illegal goods shut down by U.S. authorities and facilitated by bitcoin. The popularity of bitcoin for conducting illegal trade due to its anonymous nature and peer-to-peer system might bode well for bitcoin investors but is almost sure to attract fire from law enforcement sooner or later (Silk Road being one example) and could result in heavy restrictions being placed on its usage. This week at the World Economic Forum in Davos, U.S. financial leaders shared a similar outlook on bitcoin: "The question isn't whether we accept it," JPMorgan (JPM) CEO Jamie Dimon told CNBC. "The question is do we even participate [with] people who facilitate bitcoin? The people who are going to eventually really get upset with it will be governments."

MORE: Don't believe the tech bubble hype

And there's the paradox that could be bitcoin's downfall. In order for it to become a bona fide currency, it needs widespread acceptance from central banks (including in places like China, which has rejected it, and Finland, which has designated it a commodity) and regulation to stabilize its value, but that would destroy the very aspects that make bitcoin so attractive: privacy and the ability of users to transact directly and outside of the banking system. This would relegate it to the status of just another digital wallet, which is hardly a game-changer. Even the much-touted Google Wallet has ultimately struggled to take off against more traditional payment systems.

So given all this, why is the price of bitcoin so high? Some of it is a natural optimism about a disruptive new technology, but mostly it is hype created by investors, including venture capital firm, Andreessen Horowitz. Other investors thinking of dipping their toe in these waters should take that into consideration and also remember that at one time Pets.com seemed like the wave of the future.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner, as well as at hedge fund Ramius. He is author of Merger and Killing Wall Street. For more information, please visit http://www.sanghoee.com

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