The Pot of Gold at the End of Your Internet Cable

09/12/2013 05:08 EDT | Updated 11/12/2013 05:12 EST

There may be no pot of gold at the end of the rainbow, but how about at the end of your Internet cable? As gold prices continue to underwhelm, the emergence of the virtual currency Bitcoin has raised the stakes in the world of commodity investing. But before you decide to part with your hard earned money and delve in to the cybernetic world, it's important that you understand how this virtual currency compared to more established commodities.

Determining a commodity's worth

Most people believe gold prices are heavily influenced by its natural scarcity; but man-made scarcity actually has much more of an impact on pricing. Generally, the global supply of gold increases by around 1.5 per cent a year, but this is dwarfed by the amount of gold still held by many central banks around the world -- a hangover from the days of gold standard currency. Any new supply is quickly gobbled up in the production of jewelry, new technology and by industry, which tends to dampen the impact of new supplies on the market. The massive reserves held by central banks create a strange supply versus demand imbalance and if central banks decided to dump their supply on the world market, it would far exceed current global demand.

The biggest influence of gold prices actually comes from investment demand. You see, gold is not just a shimmering metal sought after the world over; it is in fact a form of insurance against financial Armageddon and a barometer of economic health. Market expectations around inflation, which is a rise in the overall level of prices for the goods and services, will decide how much gold prices increase or decrease at any one time. A rise in prices affects the purchasing power of currency and since gold is seen as a good way of storing value, it essentially acts as a hedge against rising prices. Increasing inflation means that the real purchasing power of currency decreases, prompting gold prices to rise as worried investors seek assets that will maintain value. If there is an expectation that inflation with fall, increasing the real purchasing power of currency, then demand of gold will usually decrease, as will its price.

Cyber nine or just up in the air?

Bitcoins, the most popular of a recent wave of digital dough, are designed to be rare. A finite supply of 21 million allows it to mimic the paucity of gold. Bitcoins were not created to be an investment vehicle, but instead to be a secure, peer-to-peer method of buying goods or transferring money across borders without the "hassle" of outside regulation. In this unregulated world, with no central authority to create new Bitcoins, it is the invisible hand of the market that controls the value of this e-currency.

However, Bitcoin's fixed supply may be its Achilles Heel, as an increase in demand will ultimately lead to an increase in pricing. On a continual basis, increases in demand would result in deflationary spiral as more and more people simply hoard Bitcoins on the expectation that their value will continue to appreciate; leaving the original premise as a means of exchange in tatters. In essences Bitcoin would become a victim of its own success, trapped in a cycle of increasing demand and persistent deflation.

Cybernetic deflation

Why deflation? We're getting a little deep into Macro Economics 101 here, but stick with me. An increase in demand for Bitcoins will obviously raise their value. But because there is a finite supply, the implication of this is that as the purchasing power of a Bitcoin increases, the value of the goods it can purchase must logically go down. For example, imagine that today one apple costs one Bitcoin. Hypothetically, let's say that one year later the currency has doubled in value. That would mean that in a year from now one apple would only cost half a Bitcoin. If this trend were to continue, the value of an apple would keep dropping and Bitcoins' value as a transactional currency (remember this was the original reason it was launched in the first place) would be lost. It's hard to tell what this would mean, but it's theoretically possible that the Bitcoin could become worthless in a short period of time.

State of grace or State control?

Independence from any central authority allows holders of Bitcoins to spend or transfer money in an instant, free from the red tape and higher costs associated with traditional currency. This lack of regulation makes the currency potentially prone to scams, fraud and other security issues, and links to illegal drugs, money laundering and other forms of crime continue to surface.

However Bitcoin's Wild West days may be coming to an end; there is a new Sheriff in town in the form of governments and regulations, who are taking aim at bandit virtual securities. Germany's Federal Ministry of Finance has confirmed that Bitcoins are now recognized as a type of 'private money' while closer to home a Texas judge recently ruled that virtual currencies are subject to U.S. currency laws. In New York, the financial regulator has publically stated its interest in regulating the online currency and Bloomberg has even created its own Bitcoin ticker symbol (XBT). Even the Winklevoss twins, made famous through their "possible" involvement with Facebook, have registered to establish a Bitcoin ETF; it doesn't get more mainstream than that.

If Bitcoin is to become just another commodity, regulated and controlled by governments, then investors must treat is as such.

Both Gold and Bitcoin present interesting examples of assets that have little inherent utility other than as a store of value or a mode of exchange. The big difference in the case of Bitcoin is the lack of something tangible behind the investment; it's like investing in gold, without any gold.

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