Bitcoin And The Fuss Around It: A Scam Or The Next Big Thing?

The price of Bitcoin has accumulated by a staggering 50,000% over the past 5 years (yes, you have read that correctly) from $12 to nearly $11,000 attracting rising interest from investors. However, the value of Bitcoin has conjointly suffered many sharp declines over this era and is clearly terribly volatile. We are not going to pretend to be experts on this rapidly emerging technology, but there are some very important investment principles to consider (the first of which is to avoid investing in something you don’t fully understand, even if it has made other people a lot of money).

WHAT SPECIFICALLY IS BITCOIN?

Bitcoin is the best known of cryptocurrencies (although it’s only 1 of thousands). According to its creator, Satoshi Nakamoto (probably a pseudonym), Bitcoin may be a “purely peer-to-peer version of electronic cash” permitting on-line payments “to be sent directly from one party to a different while not surfing a monetary institution”. It depends on a rising technology referred to as blockchain, a digital, decentralized and public ledger. Blockchain advocates regard it as an additional economical, cheaper, quicker, safer and clear approach of transacting, compared to ancient banks. Transferring cash is one in every of several applications of blockchain technology. Processes that place a value on imposing trust (such as transferring cash, exchanging derivatives, imposing legal contracts and validatory audits) may be created considerably additional economical mistreatment blockchains.

HOW BLOCKCHAIN LEDGERS WORK

Currently, a transaction between 2 parties usually involves 2 ledger entries, one at party A’s bank then one at party B’s bank. With blockchain technology, the transaction seems to happen at the same time and publically on each party’s ledgers for verification, creating it faster and additional clear whereas eliminating the necessity for a central authority to protect against manipulation. All transactions are cryptographically (but not centrally) confirmed, stored and protected.

WHY ALL THE HYPE?

The promotion is driven by 3 factors: First of all, as mentioned above, the more the value of Bitcoin rises, the more the attention it attracts. Secondly, it will seem to be an essentially helpful technology. Thirdly, post the world financial crisis; several have lost faith in the traditional monetary establishments and in the central banks that manage the system. Bitcoin is seen as an alternative that is outside of government control and interference.

CAN BITCOIN REPLACE TRADITIONAL CURRENCIES?

Economics textbooks assign 3 characteristics to a currency: a method of exchange, a unit of account, and a store of value. Bitcoin (and its full cousin cryptocurrencies) tick the first box however the second two are questionable. We are very far from a point where companies or individuals measure their income and expenses in Bitcoin (and since Bitcoin’s value is expressed in dollars, it is the dollar that would remain the unit of account). Its volatility means that it is unlikely to be seen as a store of value. Moreover, currencies are backed by a lender of last resort (the issuing central bank) to step in when trust between market participants and liquidity evaporates. With Bitcoin, the trust lies in the fact that transactions are cryptographically protected. The fact that there is no central authority backing Bitcoin and that it is largely outside government reach is seen by its fans as a plus. But who will step in if trust in Bitcoin has been breached? The global financial crisis showed not only the importance of authorities stepping in to put out fires, but also the inherent instability of unfettered markets revealing that financial activities need a form of regulation. The US dollar remains the world’s reserve currency because of the strong US legal system, the backing of their government, the credibility of the central bank (the Fed) as lender of last resort as well as the very deep, liquid and open capital markets where dollar assets can be traded.

IS BITCOIN A BUBBLE OR THE IMPORTANT DEAL?

There is no normal monetary definition of a bubble, but broadly speaking it has the following four elements which are all present:

• A compelling story, sometimes of a revolutionary new technology (e.g. railroads, vehicles, the internet) or a nearly infinite new supply of demand (Chinese demand for commodities) or a severe offer restriction (peak oil).
• Rapid price increases completely divorced from any measure of intrinsic value.
• A craze of happy speculative activity, attracting non-professional investors. Over-exuberance will terribly simply develop into worry and so costs will re-rate extraordinarily quickly.
• The supply of low-cost credit.

The lesson of the 1990s internet bubble (and earlier iterations) is that although the hype of the new technology was justified – the internet has transformed our homes, businesses, and social connections – investors were simply prepared to pay way too much for IT companies. For instance, Microsoft’s share price took 16 years to regain and surpass its December 1999 level despite the widespread use and profitability of its software. Too much good news was priced in. A different example: smartphones are ubiquitous today, but buying shares in Blackberry, the first smartphone maker, would have been a terrible investment (Blackberry’s share price fell from a peak of $319 in June 2008 to $24 today).

WHAT ARE THE RISKS?

The first main risk is just valuation: Bitcoin’s price surge means any growth will have to take place off an already-high base. The second risk area is a regulatory one. The more widespread cryptocurrencies are used, the more likely governments are to step in to limit tax evasion, money laundering, bypassing of capital controls (a big issue in China), and all manner of illicit activities. The third risk area is competition: it is often argued that Bitcoin’s price is supported by its limited supply (that has to be “mined”), but there is virtually no limit to the amount of competing cryptocurrencies. Blockchain technology will likely reshape global financial (and other trust-based) processes, but this is no guarantee that Bitcoin will maintain a leading position (remember MySpace came before Facebook, eBay was dominant before Amazon, Hotmail used to be more popular than Gmail and at least five major search engines came before Google’s domination). There are already cheaper, faster, more efficient and more anonymous cryptocurrencies available. Traditional institutions will not stand by if their lucrative core business areas are under threat, and many are already making big investments in new technologies, including blockchains. Many major global banks, multinationals, governments and leading universities have been building blockchain-based systems and applications across a variety of valid use-cases. These institutions have both resources and client bases which exceed the current reach of Bitcoin.

WILL MY FUNDS INVEST IN BITCOIN?

No, firstly because Collective Investment Schemes may not, at this stage, invest in cryptocurrencies. But more importantly, while blockchain might turn out to be a game-changing technology, the speculative nature of Bitcoin means that we cannot reasonably build conviction in future price expectations. Fiat currencies can be assessed by their fundamentals (economic growth, inflation, monetary policy and governance), but Bitcoin’s intrinsic value is almost impossible to pin down. While supply is known (limited coins are created at a rate that can reasonably be assessed by mining ‘hash’ power and transaction rates), demand varies widely – hence creating the characteristic volatility we see in the Bitcoin price – and is subject to the risks discussed above. Also, since Bitcoin pays no interest, future returns depend entirely on price increases, instead of compounding income over time.

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