Bitcoin – All you need to know


There’s been a lot of noise lately on the news about the cryptocurrency ‘Bitcoin’, especially around the high volatility (one week it’s $2,000 than a few weeks later it surges to $3,000+ only to plunge back down to earth again).

Normally people get excited by discounts as it makes things cheaper to purchase. In the case of stocks & shares it potentially makes them more profitable and safer to own, Warren Buffett and Benjamin Graham have said that buying at low valuation can both increase your upside and protect your downside.

But one of the quirks of investment, and the greed and fear which drive short-term price movements, is that rising share price seems attract more favourable comments (and often more money) and falling value makes investors look away for what could be a great investment.

There is no better example of this than the world of cryptocurrencies. 
Bitcoin is the biggest and best-known and since January 2017 one Bitcoin has surged from $997 to $2,865 (via its first ever move above $3,000 in early June), according to www.coindesk.com. 

Bitcoin has surged in 2017


Source: www.coindesk.com

That ’s amazing for something that started for less than a $0.001 in 2009 and only reached the $1 mark in 2011.
But there are other cryptocurrencies too. Ethereum has surged from less than $10 to over $225 this year and Ripple has moved up from $0.01 to over $0.19 this year.

According to the website www.worldcoinindex.com there are now over 500 cryptocurrencies in circulation, ranging from Bitcoin with market cap of around $45 billion to Ethereum at $21.3 billion and Ripple at $6.6 billion, all the way down to Clevercoins currently worth only $336.

All of this leaves me asking two questions:

• Is Bitcoin, and are cryptocurrencies, money?
• Is Bitcoin, and are cryptocurrencies, an investable asset?

Cryptocurrencies explained

Before I address those issues, it may be worth quickly explaining what cryptocurrencies are (please feel free to skip to the next sections if you already feel well versed on the topic).

For simplicity’s sake I shall look at Bitcoin in particular.

In essence, Bitcoin is a digital asset and payments system, a virtual currency, where intermediaries play a very limited role and central banks and Governments none at all. It is encrypted and the creation or transfer of every Bitcoin is kept on a ledger and archived for maximum transparency as to supply (although the encryption element ensures anonymity for users). This is all made possible by so-called ‘blockchain’ technology, a database that maintains an ever-growing list of records, called blocks. Each block is linked to its predecessor and bears a date & time stamp.

The concept was first outlined in a 2008 paper entitled Bitcoin: A Peer to Peer Electronic Cash System. The identity of the author, Satoshi Nakamoto, as well as his motives, remain shrouded in mystery but he issued (or mined) the first Bitcoins in 2009.

Bitcoin (after 8+ years) has by no means achieved universal acceptance (as investors cannot just walk into any shop or restaurant and spend Bitcoin) but its significant surge in price has spawned a host of rivals. The ten most actively traded cryptocurrencies currently are:

Name Price per coin Coins in circulation ($ billion)
Bitcoin $ 2,760.1 45.4
Ethereum $ 227.1 21.2
Litecoin $ 44.7 2.3
Status $ 0.08 0.5
Ripple $ 0.19 6.6
Digibyte $ 0.02 0.2
Ethereumclassic $ 15.97 1.5
Eos $ 1.93 n/a
Bitshares $ 0.17 0.4
Dash $ 199.23 1.5

Source: www.worldcoinindex.com on Monday 31 July 2017

Is it Money? 

Turning to the first key question raised by the rise (and rise) of cryptocurrencies – are they money?

To ensure objectivity, and avoid any accusations of taking a view one way or the other, any argument will be met with a counter argument. Investors can then decide for themselves.

Do Bitcoin and cryptocurrencies fulfil the function of money?

For: Money facilitates trade over time and distance and to do so it has to be trusted and readily accepted. Applying these criteria, the answer has to be yes, cryptocurrencies can and do fulfil the function of money, given that anything from cowrie shells to cows, paper to metal and gems to plastic cards have done the job perfectly well since time immemorial. Japan is working on legislation which will make Bitcoin legal tender and Russia is thought to be working toward similar laws for 2018.

Against: Even allowing for developments in Tokyo and Moscow, Bitcoin and its rivals are not universally accepted and under these circumstances it is impossible to view them as money. Companies in particular still fight shy of using Bitcoin it and other cryptocurrencies are unregulated and accounting rules have yet to be finalised.

For: The price surge shows growing acceptance of cryptocurrencies, where blockchain technology provides the transparent ledgers and archives which can also snuff out fraud and criminal activity to the benefit of the holder. The process is seen as safe and transparent, even relative to the wire transfers supplied by the likes of Western Union.

Against: The failure of Bitcoin exchange website Mt. Gox, which saw the theft of Bitcoin and has prompted legal action for embezzlement through the courts in Japan, will deter many from trusting cryptocurrencies, especially those that have no official (central bank or Government) backing. In addition, few consumers will want to be using currencies whose value swings around quite so wildly. It is bad enough that the pound can rise or fall from say $1.20 to $1.50 in a year – but that is nothing compared to this year’s movements in Bitcoin and its rivals. Unless consumers (and corporations) have more visibility on what a cryptocurrency is ‘worth’ they will be reluctant to use it.

Ethereum has seen big price pull-backs this summer


Source: www.coindesk.com

For: In an era of central bank profligacy, record-low interest rates and electronic creation of money through Quantitative Easing, Bitcoin and cryptocurrencies are a better store of wealth than our current currency system, which was only set up as recently as the early 1970s with America’s demolition of Bretton Woods and the gold standard. Bitcoin creation by so-called Bitcoin miners is scheduled to halve each year until around 2040, when in theory the number of available Bitcoins will be frozen at around 21 million.

Against: The proliferation of initial coin offerings (ICO) suggests that cryptocurrencies are no better at managing supply and providing sound money than the central banks. August promises to be a key month for Bitcoin in particular as fans debate whether segwit, segwit2x, BIP91 or BIP148 should be introduced so Bitcoin can be scaled up in the most efficient manner possible and smoothly handle growing volume transactions. In theory, Bitcoin Improvement Proposal 148 (BIP) is losing out among Bitcoin miners to BIP91, resulting in a ‘soft fork’ programming change rather than a ‘hard fork,’ which could even split the currency.

Investment parameters

Now to the second key question raised by the rise (and rise) of cryptocurrencies – are they an investable asset, like say stocks, bonds, commodities, properties or even items such as collectibles, like vintage cars, art and wine.

For: The absence of central bank involvement or Government interference means cryptocurrencies are an ideal investment in an era of Quantitative Easing, monetary policy experimentation and a rampant growth in the supply of money which can only devalue it over time.

Against: The Mt. Gox disaster and the forced shutdown of the Silk Road and now the Alpha Bay websites for their involvement in criminal activity both suggest that the authorities are taking a closer look at some areas where Bitcoin and cryptocurrencies are widely used. In addition, it is thought that one big reason for the surge in prices earlier this year was demand from Chinese nationals who were buying Bitcoins onshore and selling them offshore so they could salt money out of the country. Who is to say China does not move in a clampdown or even unveil its own cryptocurrency via an ICO?

For: Bitcoin and cryptocurrencies are an even better bet than gold at a time when Governments are too happy to print cash to buy votes and too frightened for their own jobs to stick to sound money principles. Even gold supply increases every year whereas Bitcoin supply is designed to be finite.

Against: Even if you take such a dim view of central banks and Governments, Bitcoin and cryptocurrencies may not be the answer for four reasons:

• First, the number of alternative currencies has mushroomed.
• Second, the debate over ‘soft’ or ‘hard’ forks for Bitcoin processing development shows that this is not a straightforward topic – and no-one should invest in anything unless they thoroughly understand it.
• Third, US President Franklin D. Roosevelt’s Executive Order 6102 which criminalised the possession of gold in 1933 shows that the authorities could still get involved if they wished to do.
• Finally, Bitcoin, like gold, offers no yield and generates no interest or cash. As such, investors are buying Bitcoin (or gold) in the view that can get someone else to pay more for it, not because it has the ability to provide consistent coupons on return. Some would argue this is simply a further example of the Greater Fool Theory at work.

For: Bitcoins and cryptocurrencies are now liquid and cheap and easy to trade. Bid-offer spreads are small and there are no pesky intermediaries charging fees, let alone central bank involvement or regulation. A growing number of retail brokerages facilitate Bitcoin trading and some even offer the opportunity to trade derivative instruments which are based on the cryptocurrency.

Against: There are intermediaries involved and they are the Bitcoin miners, who create Bitcoins, monitor and record and archive transactions. They will charge a small fee. Just because you can trade derivatives does not mean you have to buy them or even the underlying asset – the Financial Conduct Authority is already cracking down on spread betting and contracts for difference. And the US regulator, the Securities and Exchange Commission, rejected in April an application for approval for the Winklevoss Bitcoin Exchange Traded Fund (ETF), owing to concerns over the volatility in Bitcoin prices and whether the price could be in any way manipulated to the disadvantage of investors, given the lack of regulatory surveillance of the underlying asset being tracked by the ETF.

This third and final point perhaps echoes legendary US investor Warren Buffett’s quote: ‘If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.’

Anyone determined to start trading Bitcoin or any of its rivals needs to do their research every bit as thoroughly as they would for any individual stock, bond, commodity or fund and ensure that any purchases or sales fit with their overall investment strategy, time horizon, target returns and appetite for risk. Appetite for risk is best understood in this context as a willingness and ability to lose money in the attempt to earn it by investing it – and the Ethereum price chart above shows what could happen both on the way up and on the way down.

 

Nazrul Hoque – 01 August 2017

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