Can Bitcoin or any other cryptocurrency actually work as money? 

There are major barriers to a cryptocurrency replacing any major form of money  Credit: Chesnot /Getty

Most buyers of cryptocurrency are betting that the price of whichever “coin” they buy will increase in value dramatically. However, the ultimate aim of many digital currencies is not to remain a highly volatile asset for speculative investors but to offer a viable decentralised alternative to the current system of money. 

Most will not reach this goal. Some lack the technical ability to process enough transactions, all remain highly volatile, and there are then both legislative and psychological barriers in their way. There is also a huge amount of competition. 

Garrick Hileman, who holds positions at the London School of Economics and University of Cambridge and specialises in monetary systems, said there was a significant difference between currency and money.

“Many things in blockchain land meet the definition of currency,” he said. "Cryptocurrencies such as Bitcoin and Litecoin do function as a medium of exchange, as you can buy things with them [although relatively few retailers accept them]. They do store value from day to day, although they are very volatile and the fact that they can lose value so rapidly is a major question mark."

For something to become money, he argued, requires it to take over as “the unit of account”, in addition to functioning as a medium of exchange and storing value. The unit of account is the unit in which goods and services are priced in a certain country, such as the pound in Britain.

Mr Hileman said this was where cryptocurrencies “really fall down”.

“The unit of account sets how we think about money – most people don’t like to think in more than one currency,” he said.

“Some argue that this makes it very difficult for new currencies to become money, putting aside all the technical issues and volatility. There are then institutions such as central banks that are very keen to keep control of the unit of account, to maintain monetary policy.”

However, he added that in the future “the dominant user of currency may not be people”.

Already more than 50pc of internet traffic is bots [automated processes] and you can imagine a similar phenomenon with machine-to-machine transactions. Machines are happy to think in however many currencies they need to think in, so they could dictate which currency or currencies become dominant,” he said.

Volatility is also a significant barrier to a cryptocurrency achieving widespread adoption. Buyers don’t want to hold currency ahead of a purchase when it could lose 90pc of its value tomorrow, and don’t want to spend currency that could gain 50pc in hours. Similarly, sellers don’t want to accept a form of payment that could fall in value dramatically once they receive it. 

Despite this, Mr Hileman said volatility had "been a feature and not a fault of cryptocurrencies", as enormous price gains had "proved a tremendous asset in getting millions of people using them". 

However, beyond initial adoption, he highlighted the argument of Freidrich Hayek, the Nobel Prize winning economist, that "the most stable option would triumph" in a world that shifts to a form of money with no central control. 

“In the short term, cryptocurrencies suggest that’s not entirely true," he said. "Millions are happy holding highly volatile, strengthening cryptocurrency. But nothing can rise forever. We may be in a temporary interim period where a preference for capital gains dominates a preference for stability. It's too early to know." 

Finally, there are practical considerations over what a cryptocurrency needs to be able to handle to fulfil a role as money. In particular, they need to achieve the scale required to handle huge numbers of transactions. This is something that many newer cryptocurrencies have tried to address.

Bitcoin is currently severely hampered by its energy usage, limited transaction volumes and enormous transaction costs, although a proposed “lightning network” built on top of Bitcoin aims to solve some of these problems.

Litecoin, another of the largest cryptocurrencies, specifically aimed to offer faster transactions and lower fees when it was launched, by using a less energy-intensive process for verifying transactions.

Iota, another top-10 cryptocurrency, takes a different approach again. For a transaction to go through, the computer, smartphone or other device the transaction originated from must solve a mathematical problem to confirm two other random transactions. This, in theory, makes it easy to increase the currency's scale. 

Mr Hileman said: “There are a lot of ideas and solutions, and it’s unclear who will have the best technical infrastructure. This is part of the reason we’re seeing so much volatility among the largest cryptocurrencies – the winner could be an existing player or something still on the drawing board.

“There’s a general view that one of these, if not many, will be able to scale up and handle the transaction volumes required to be something like money. In other words, it’s a question of who can get there first with the best technology, brand and marketing to claim the prize.”

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