Although I am a big believer in Bitcoin, I do realize that there is a risk that the currency won’t make it and that my holdings may eventually be worth a lot less than they currently are. I am used to taking investment risks and am prepared to lose all the money I put into Bitcoin, because I think the potential upside is much bigger than the downside.

What could happen to Bitcoin? I think there are 3 main risks: speculation risk, government risk, and something that I would call the ecosystem risk.

Speculation risk

Speculation risk is more of a short-term risk to me. It means that the people that currently have large Bitcoin holdings would suddenly dump them onto the market. Without any new buyers the market will crash, something that happened in April for example (prices dropped from $266 to $70). This is not unlikely, especially because I believe that most of the Bitcoins on the market are currently held by speculators.

There is no real solution to this, but the longer Bitcoin exists the smaller the risk becomes. Not only because the market cap and number of Bitcoins on the market gets higher every day, which means that the volatility will be lower and more people need to sell in order to crash the market. But also because the ecosystem gets better all the time: when more people use Bitcoin for normal transactions, there is a larger base that won’t sell when there should be a price drop.

Government risk

Government intervention seems to be the biggest risk to many people, but I am not so sure about that. Governments will surely try to regulate Bitcoin and that’s fine because it makes Bitcoin more legitimate. When people see that the government regulates something that will lead to more widespread adoption. This week there are hearings in the US about Bitcoin, I look forward to reading about the results of those talks. Several other countries have already announced basic rules for Bitcoin, and in that way legitimized the currency. This is important for merchants, because uncertainty will lead most businesses to avoid Bitcoin for now.

There may be a chance that the government will try to stop Bitcoin because they can’t control it and it threatens the current system: it makes printing money useless! It’s a good tool for money laundering and tax evasion, and that’s something they don’t like. You can take your Bitcoin with you wherever you go and nobody will know that you have them with you (e.g. on your phone or as a piece of paper in your paper Bitcoin wallet). Are there ways that the government could pull this off? At first I thought they can’t do this, but now I am not so sure anymore. Although I don’t expect them to ban Bitcoin outright they can make it very hard for normal law-abiding citizens to buy and sell Bitcoin.

One way to do this would be to add VAT to every Bitcoin transaction. This is something the UK is planning to do, but I am not sure if they realize what they are proposing. The current idea would actually mean that if you change British Pounds to Bitcon, you would have to pay VAT on that transaction. The reason is that they classify Bitcoin as coupons, and for those the similar VAT rules apply. If this would become legislation (which is far from sure at this point) the UK would shoot itself in the foot, because if would not be part of the Bitcoin economy. In the short run that may seem like a smart move, but in the long run they may lose out on a lot of growth.

The main problem right now is that governments just don’t understand what Bitcoin really is and what it can be used for legitimately. Maybe they will try to start their own cybercurrency and say that it’s safer than Bitcoin. In the past they could have pulled this off easily, but in the current age of social media I am not sure if people would still believe them.

Ecosystem risk

Likely banks will do their best to stop Bitcoin, because they are starting to realize it will disrupt their business and may make them (partially) obsolete. If banks to refuse to work with Bitcoin companies, or (more extreme) even ban individuals that use Bitcoin, there will be a chilling effect on the market. Right now many US banks are not taking Bitcoin companies as clients, although it’s not completely clear if this is because of Bitcoin itself or because they don’t want to have potential anti money laundering risks. However, if US banks will keep on doing this it means that Bitcoin companies will set up operations in different parts of the world. In that case Bitcoin will thrive in Asia and Africa first. It won’t stop Bitcoin, but it will slow down its innovation and adoption. This is what I call the ecosystem risk.

If the ecosystem does not grow, the price of Bitcoin might not be sustainable. The current rates are much higher than what they should be based on daily transactions because many people buy Bitcoin for speculation purposes. That’s fine, as long as the ecosystem can catch up in the short to mid-term. This is the same as with stock prices, that are forward looking as well. But if the ecosystem should not grow people will realize the value of the Bitcoin may be lower than the current exchange rate and they could dump their holdings.

The development of the ecosystem is still in its infancy, although new investments in Bitcoin companies are announced every week now. But most companies are still in their development phase. That may change in a few months, and that’s the moment you might be able to see whether Bitcoin is overvalued or not. Will people start to use Bitcoin to make transfers to for example India or Africa? Will there be easier-to-use wallets on the market? Do more websites offer prices in Bitcoin? If so, a high price for Bitcoin might be justified. If not the market may crash. But even if it should crash there is a good chance that it will eventually recover when the Bitcoin ecosytem takes off at a later time.

Summarizing, Bitcoin is going up extremely fast at the moment and there are 3 main risks that I see. The speculation risk, where people dump their holdings. Government risk, where the government would actively try to stop the growth of Bitcoin. Or the ecosystem risk, where people don’t adopt the currency fast enough, which may lead to a crash. I follow all the news with keen interest and will keep using this blog to keep you up to date with how Bitcoin develops.