Full text - I generally don't condone pulling stuff through paywalls, but the FT's policy is particularly daft and suppresses just the discussion their "readable when reached from a search engine" policy is supposed to promote.

Time to take the Bitcoin bubble seriously

By John Authers

The moment has come to take Bitcoin seriously. This month has seen notes on the online currency from mainstream foreign exchange analysts at Wall Street banks Citi and BofA Merrill Lynch. When Wall Street has to take Bitcoin seriously, the online currency has arrived.

However, governments and central banks are also now taking Bitcoin seriously. This week has also brought news that Baidu, the Chinese search engine, would no longer accept Bitcoins as payment, after the People’s Bank of China ruled that Chinese banks should not process or insure Bitcoin transactions.

So should investors also be taking Bitcoins seriously? There are two levels to this question, as Bitcoin aims to take at least two of the roles played by a currency; first as a store of value, and second as a means of exchange.

Its role as a store of value is encouraged by its founding computer algorithms, which guarantee continued scarcity. This gives it an appeal compared with “fiat” money, created for governments by central banks, where there is no limit on supply.

But, unlike fiat money, nobody is legally required to accept it. As Brown Brothers Harriman’s forex analyst Marc Chandler points out, creating such money remains a monopoly of governments. They are not likely to give it up.

Cryptographic defences

Therefore its value rests on perception – what people think it is worth. The same is true of gold. But millennia of history demonstrate that humans perceive some intrinsic value in a shiny metal. Bitcoins have only been around since 2009.

BofA Merrill Lynch’s heroic assumptions suggest that at very best Bitcoins might one day gain a reputation to equal that of silver, which is perceived as worth only a 60th of gold. That implies a total value of about $5bn – far below its recent implicit valuation of $13bn.

However, as a means of exchange, Bitcoin’s layers of cryptographic defences, the ability to pay instantly, and the security that comes with the ability to trace each transaction made with each coin, all offer intriguing advantages.

So far, it is not widely accepted. But this year’s hubbub of excitement over the currency suggests that it could be.

Increased trading in the decentralised virtual currency has begun to attract the attention of regulators

Merrill’s grand back-of-an-envelope estimate is that it might account for as much as 10 per cent of global online transactions, and of international worker remittances (which would again be a remarkable success). On that basis, Bitcoins could fund annual transactions worth $9.5bn in today’s money.

It is easy to poke fun at such huge extrapolations, but hard to come up with anything better. In any case, the point of Merrill’s guesswork is that even if Bitcoin is as successful as it is possible now to imagine, it looks overvalued at recent prices. It is in a bubble.

But this does not prove that the concept has no future. Shares in Amazon.com were also in a bubble in the late 1990s, and yet proved a great long-term investment after the bubble burst. Wild swings in value are typical when new technologies arrive.

Built-in scarcity

There is a further problem. Bitcoin, as Citi’s Stephen Englander points out, is replicable. The genius of the new currency is that it has built-in scarcity. But if the concept catches on as a means of payment, then demand will increase, and that scarcity will get in the way of its ability to function as a means of payment.

It is not possible to conjure up a new precious metal to deal with this problem. But it is possible to conjure up new online currencies and that is already happening.

This could be an investment opportunity. Rather than an alternative to fiat currencies, Bitcoin has a role in a critical trend; the disintermediation of banks. African tribesmen can now pay each other using their mobile phones, without involving a bank. Crowdsourcing systems raise loans over the internet without involving a bank. Internet currencies are part of the same trend.

Does Bitcoin have first-mover advantage? Will other currencies be able to compete? Again, compare with Amazon. It used its first-mover advantage to become the dominant online retailer, as did eBay in online auctions. Yet both contended with plenty of me-too rivals who were briefly valued very richly by the stock market.

In internet search, first-mover advantage was no use to AltaVista, for a year or two as dominant as Google was to become. The same proved true for MySpace among social networks, or AOL among internet service providers.

It is too soon to bet that Bitcoin will be the hegemonic online currency, but there is plenty of time to bet on its competitors.

Where does this leave us? Foreign exchange analysts agree, mostly off the record, that Bitcoin is not worthy of being treated as a real currency.

Buying Bitcoins while their price is so bubbly is nothing more than a gamble. Investing in other online currencies, or in companies that can help the Bitcoin economy develop, looks like a sensible use of a venture capitalist’s money.