The manic Bitcoin bubble is showing no signs of bursting.
In fact, the tolerance – if not outright endorsement – of the U.S. and Chinese governments is injecting fresh air into the digital currency's value, making it seem less like a tool for illicit activity and more of a legitimate financial instrument. What remains ambiguous is whether investors have any reason to prefer it to conventional forms of currency.
Bitcoin has burst into headlines recently as its price skyrocketed, reaching new all-time highs of $750 (U.S.) on Monday. It's no coincidence that the spike occurred the same day as the U.S. Senate Committee meeting at which observers predicted the Department of Justice and Security Exchange Commission would endorse Bitcoin as a financial instrument.
In a statement, Fed chairman Ben Bernanke said the digital currency "may hold long-term promise, particularly if the innovations promote a faster, more secure, and more efficient payment system." A Department of Justice representative acknowledged that "virtual currency systems offer legitimate financial services and have the potential to promote more efficient global commerce."
Based on volatility alone, it certainly looks like Bitcoin may be forming an asset bubble. In April, Bitcoin spiked up to $250, putting it briefly in the spotlight, but then quickly dropped back to $60. In October it climbed higher, breaking $200, and in the past two weeks Bitcoin surged up to $600.
So who is buying all these Bitcoins? Chinese savers have quietly been building their Bitcoin presence, reaping huge gains on the currency's rise. BTC China is now the world's largest Bitcoin exchange, and China comprises more than 50 per cent of global Bitcoin trades, according to data site Bitcoinity. The Communist Party all but gave its blessing to virtual currencies through state-owned media, promoting them on CCTV and People's Daily newspaper. Interestingly, while Americans have the highest number of Bitcoin users in the world, the U.S. comprises only 2 per cent of global Bitcoin trading.
Not everyone is a fan. On Nov. 5 the Canada Revenue Agency deemed Bitcoin a non-legal currency, and a November Bank of Canada working paper concluded, "it will not likely be profitable for such currencies to expand to become fully convertible to state-sponsored currencies."
Perhaps most puzzling is that Bitcoin's surge comes at a time when gold and silver, traditional venues for speculation, are tanking. So far this year, gold is down 24 per cent, silver has fallen 37 per cent, and Bitcoin is up 4,600 per cent, prompting talk that "bitbugs" are the new "goldbugs."
There are definite similarities. The same libertarians that are hoarding their money in gold in distrust of the government would likely embrace a digital currency that can't be traced. What makes Bitcoin special is its finite supply: only 21 million Bitcoins will ultimately be distributed, according to the algorithm that defines the currency. This perceived scarcity spurs a self-fulfilling rally. As more people pile into Bitcoins, the price could shoot up exponentially, or crash in a heartbeat – there's no central bank to keep it stable relative to other currencies, and it's value is derived only from supply and demand.
As of today, roughly 12 million Bitcoins are in circulation, according to online exchange Bitstamp. China's intentions are cryptic, as usual, but it isn't too far-fetched to see why the Chinese elite would want to put their money into Bitcoin. While China has just released plans to open up its capital controls, at the moment it's difficult for Chinese savers to invest or spend their money, and digital currencies could be a viable way for them to do so.
Still, unless investors are based in a country with similar capital controls, or are terrified of what the government might do with information on how you spent last week's paycheque, Bitcoin's appeal seems limited.
Instead, the heart of Bitcoin's miraculous appreciation is a more familiar phenomenon: pure speculation, especially at a time when investors are becoming weary about growth prospects around the world. Economists are slashing forecasts while stocks are trading at all-time highs, making them expensive and vulnerable to a correction. Investors are emptying their pockets into anything that shows promise, such as social media stocks, or most recently, Bitcoin.