As with any groundbreaking innovation, whether it be the Internet or the cell phone, its ultimate success or failure is often not evident during its infancy. While advocates and early adopters envision unlimited potential, critics see only flaws that will limit its usefulness, legitimacy or sustainability. It may take months, years or even decades for an idea or technology to gain traction and prove its long-term value, or lack thereof. Bitcoin, the upstart digital currency, is no different.
Recently, the Bitcoin infrastructure (uppercase B) and its associated bitcoin currency (lowercase b) have garnered both positive and negative attention. This decentralized, peer-to-peer digital money and payment network uses cryptography, rather than a central authority, to enable transactions. Bitcoin has grown from being an unproven concept into a global multi-billion dollar upstart currency in just a few short years. But can, and why, would the bitcoin ever replace the U.S. dollar as the global trading currency?
For decades, the U.S. dollar has been the world’s primary reserve currency, and the standard currency for the vast majority of trade, including oil. In a landmark 1973 agreement, the U.S. promised to provide military protection for Saudi Arabia’s oil fields. In return, Saudi Arabia began accepting only U.S. dollars for its oil sales, while simultaneously investing much of its oil proceeds directly into U.S. debt securities. Within a few years, all OPEC member nations also began pricing oil exclusively in the U.S. dollar.
Commonly known as the petrodollar system, this arrangement increased the demand for both the U.S. dollar and its debt securities. The flow of oil-related money through the country’s Federal Reserve system strengthened the dollar and made it the primary currency for most international trading. Therefore, the U.S. would likely have the most to lose if the petrodollar system ended.
Although most oil transactions still use the U.S. dollar, there has been a growing movement against it. When the U.S. abandoned the gold standard in 1971, its dollar was no longer convertible to a fixed rate of gold. This made the dollar a floating currency susceptible to fluctuations in value. As a result, the price of oil often rises when the dollar weakens. The theory is that the purchasing power of oil-producing countries and companies decreases when the dollar weakens compared to other currencies. To meet profit margins, they then make investment or production decisions that cause oil prices to rise.
Some countries have advocated a switch away from the dollar, perhaps to the euro. However, recent economic events have demonstrated that all floating currencies, including the euro, can fluctuate substantially. The Shanghai Futures Exchange hinted in late 2013 that it might price its crude oil futures in the Chinese yuan. For political reasons, several OPEC nations that are not particularly fond of the U.S., including sanctioned Iran, also prefer an alternative currency. Clearly, many countries support a change.
Some have suggested using gold instead of any one particular fiat (government-decreed) currency. However, using actual physical gold has its challenges. Imagine exchanging literally tons of gold for large oil purchases. People would likely resort to using paper notes or electronic account balances to represent the gold, again enabling possible central bank manipulation and/or inflation. Additionally, gold-producing nations such as the U.S., China and Russia would have a built-in advantage.
That leads to the possibility of the bitcoin. The Bitcoin network allows users to transfer digital money quickly and easily across national borders without the assistance of banks or the influence of central banking systems. Currently, the overall number and value of bitcoins varies. However, bitcoin production is limited each year to half of the previous year’s total, until there exists a maximum of 21 million bitcoins (each divisible into eight decimal places).
According to Blockchain.info, over 12.2 million bitcoins have been mined (produced) as of January 2014. At that time Mtgox.com, a popular bitcoin exchange site, reported that each bitcoin was worth slightly over $900. However, major or minor news events and transactions can influence the price significantly. Bitcoin claims that its system is intended to inflate in the beginning years, but as bitcoin production tapers, its value should stabilize. Ideally, the bitcoin will eventually be resistant to the arbitrary inflation associated with fiat currency.
Bitcoin must overcome numerous obstacles before it has even the slimmest chance of becoming a favored world currency. National governments must first recognize its legitimacy. In November 2013, the U.S. Department of Justice acknowledged that the bitcoin could indeed be a legal means of exchange, a positive sign for the digital currency. However, while many nations have taken a wait-and-see approach, others such as China have banned or limited its use. Although rapidly growing, bitcoin use and acceptance remains relatively small.
Bitcoin must also contend with significant image issues. Little personal information is required for bitcoin transactions, making it an attractive currency for criminal activities. This causes an instant distrust among law-abiding businesses, individuals and governments. Only a broader use among legitimate people and enterprises, along with a better understanding of the system and its security features, will help counteract this. Bitcoin appears to be gaining momentum as evidenced by its expanded use, increased conference attendance and intensified media coverage. However, whether this indicates a forthcoming breakthrough or a bubble burst is unclear.
Will the bitcoin overcome its growing pains and eventually become a revolutionary currency strong enough to replace the petrodollar system, or will it go down in history as an interesting but flawed financial experiment? Only time will tell.
Jill Tennant is a freelance writer and former BP chemical engineer. She can be reached at firstname.lastname@example.org