On January 1, 1999, the euro (EUR) made its debut as an official European currency and lawful means of exchange for 12 independent states. Ten short years later, another revolutionary currency was introduced to the world. This new money is the first attempt at a “crypto-currency” and has recently become a topic of immense interest in financial circles, not just for its technical idiosyncrasies (you can “mine”) but its economic rules: decentralization, fixed supply, pure floating currency. We’re talking of course about Bitcoins (BTC). If you read the Wall Street Journal, The Economist, Financial Times, chances are you have come across the concept; maybe you’re one of the few that’s been curious enough to trade.

What separates the euro, the US dollar, or other traditional currencies from Bitcoins is that they’re not issued by a central monetary authority. Standing in place of a central monetary authority, which validates transactions and issues new notes in standard system, are individual users that collectively validate the log of transactions; the first user to finish the task receives bitcoins. Abracadabra! New money minted! Growth in the money supply is therefore mathematically predictable, and set to fall in half every four years until 2030 when approximately 21 million bitcoins will eventually make it into circulation. The concept is to mimic the extraction of minerals without the thrill of discovering a tremendous vein of untapped resources thus avoiding inflationary pressure (no gold rush here: we doubt the 49ers will change their name to the 256bitminers). And while it may be tempting to refer to Bitcoins as fiat it doesn’t quite fit the definition: they are not the legal tender of any country, and their value isn’t backed by anything.

Bitcoins first gained traction as a currency on the Silk Road – an online black market. Because of the anonymous nature of the money, they were the only form of payment accepted for the site’s illicit dealings. As the popularity of the currency has grown, Bitcoins have increasingly been utilized as payment for more reputable transactions. In Finland, a development firm has started offering the digital currency as a form of compensation for its employees. The currency can also be used for purchases such as pizzas, hotel rooms, cab fares (as one BBC correspondent discovered), or online services.

Bitcoin’s growing acceptance as a medium of exchange seems to strengthen the case for it becoming a viable currency. But it lacks in several critical areas: stability, liquidity, and the ability to hedge. In researching material for this newsletter, we were struck by the one topic that again and again wasn’t addressed: exposure from accepting Bitcoins as payment for goods and services. Take for example the BBC correspondent who paid in Bitcoins for a taxi. The taxi driver presumably isn’t receiving all of his income in BTC, but what if his reputation as a Bitcoin user grows such that the majority of his patrons choose to use him because he accepts BTC as payment? Maybe a stretch at the moment, but not unreasonable if more users enter the market. His exposure to the GBP-BTC exchange rate would be significant, not to mention a real inconvenience for covering his operating expenses!

Let’s say he calculates his fare in GBP. When it comes due for his customer to pay, he looks up the going exchange rate, calculates a conversion, accepts the Bitcoin amount, and carries on with his day. Later he has to purchase gas. His local petrol station only accepts the legal tender of the UK; our taxicab driver must now sell his Bitcoins on the exchange to receive pounds sterling to pay for the fuel that allows him to drive around. This process is repeated for every expense personal and business related: paying his mortgage, buying groceries, etc. So not only is he exposed to the long term GBP-BTC value, he’s also crossing the bid-ask on a daily basis. For liquidly traded currencies this isn’t too expensive. But at the current time, bid-ask spreads are pretty wide.

The price of a Bitcoin is also incredibly volatile. A year ago, one Bitcoin was worth less than $5 USD. Just six month later, the value had more than doubled to over $11 per BTC. Bitcoins continued their exponential growth in price and popularity to reach an all-time high of $266 per BTC on April 10th! It’s currently trading at $134 (or $126 or is it $63? depends on the exchange). Such volatility begs to be hedged. Are there exchange traded futures, customizable forward contracts? What about a dealer market – can I call up my relationship bank? Don’t count on it. Bitcoin derivatives are in their infancy, and the liquidity doesn’t exist. We found one site that had a futures market – it’s a start!

Whether Bitcoin truly becomes a viable currency or whether it retains a quasi-commodity status like gold is anyone’s best guess. But whatever it turns out to be, the financial risks Bitcoin presents are very similar to any currency or commodity you interact with on a daily basis. Questions to ask yourself: are my company’s revenues and expenses in different currencies like the cab driver? What does my exposure look like; is there significant volatility to consider? Is there operational risk, i.e. crossing the bid-ask on a frequent basis? Chatham’s here to help discover the answer.