As your financial partner, we want to be your source of knowledge on anything that could impact your financial life. Therefore, we are providing the following information on cryptocurrencies, and bitcoin in particular, for educational purposes only. This is not a recommendation to invest, or not invest, in bitcoin.
What’s The Deal With Bitcoin?
What is Bitcoin?
Bitcoin, like other cryptocurrencies, is a digital store of value* and is used as a system of payment or currency. It is stored in an online digital wallet to use for purchases of goods and services. However, unlike traditional currency that is supplied by central banks and moved through financial institutions like banks or credit unions, bitcoin is a peer-to-peer system for online payments. It runs on a decentralized network of computers around the globe that keeps track of all bitcoin transactions, similar to the decentralized network of servers that makes the internet work. Bitcoin transactions are recorded in a blockchain that stores the transactions as blocks of information, which are then chained together in chronological order to create a permanent transaction ledger.
First invented in 2009, bitcoin is created, or ‘mined’ through a laborious digital process and is introduced to the supply at a fixed rate of one block every 10 minutes. In fact, a single bitcoin transaction consumes more than four times as much energy as 100,000 Visa transactions. It takes incredible computer power, therefore electricity, to process the transactions and to ‘mine’ bitcoin.
How Do I Get Bitcoin?
You can buy bitcoins with dollars just like you can trade any other currency. The most popular way of buying or selling bitcoin is through a bitcoin exchange, such as Coinbase (among many others). You can invest in bitcoin through a growing list of funds and private placements, such as the Grayscale Bitcoin Trust (GBTC), in a self-brokerage account. The value of bitcoin (and other cryptocurrencies) is derived from its adoption as a store of value and status as a non-traditional system of payment. Like any other asset, the principle of buying low and selling high applies to bitcoins.
Although bitcoin was not designed as a normal equity investment (no shares have been issued), some speculative investors were drawn to the digital currency after it appreciated rapidly in May 2011, in November 2013 and again starting in late 2020. This is most likely for its scarcity value as there is a finite supply of bitcoin.
A stipulation in the original source code limits the amount of bitcoin mined to just 21 million (although bitcoin protocol could eventually be changed to allow more). With more than 18 million already mined, it is conceivable that the recent price surge can be explained not only by euphoria but also by a fear of missing out (“FOMO”). BCA Research (one of our main investment/economic research providers) has written “when people don’t have a good basis for determining what something is worth, they can let their imaginations run wild, causing prices to become unhinged from reality.”
Is Bitcoin the Currency of the Future?
Bitcoin is now an acceptable form of payment in exchange for goods and services by household names such as Microsoft, Expedia, and Subway. While very few merchants accept bitcoin as payment today, the list is growing. This increased acceptance also has helped to bolster the price. Some pundits argue, however, bitcoin is not really a realistic, useable currency. Transaction speeds for bitcoin running through the blockchain process are actually much slower than for financial transactions performed by MasterCard or Visa.
It may be difficult for bitcoin to be used as a medium of exchange given the dramatic price fluctuations it experiences. After all, why buy a car with bitcoin if the price of bitcoin might go up significantly in the next week? Some further argue that bitcoin has characteristics that make it less like a currency and more like a commodity, especially gold. Like gold, bitcoin’s value is dictated by the laws of supply and demand – how much traders are willing to pay for it. The gold supply has increased in recent years an average of 1.2% per year. While bitcoin supply is currently increasing about 1.7% per year, this is likely to fall given the finite supply. Further, gold has a sustainable record of tangible uses: for example, jewelry and raw materials for semiconductors that are used in mobile phones and computers.
What Are the Risks of Bitcoin?
Bitcoin comes with very unique risks, such as the inability to apply a value based on fundamentals (like a stock); regulatory risks include both the lack of regulation today and potential regulation in the future; security risks from being an online/digital entity; and market risk, including significant price volatility. As with any investment, it is important to clearly understand the risks:
- Regulatory risk – Cryptocurrency is a rival to government currency and may be used for black market transactions, money laundering, illegal activities, or tax evasion. As a result, governments may seek to regulate, restrict, or ban the use and sale (and some already have). The lack of uniform regulations on virtual currency raises questions over their longevity, liquidity, and universality. Governments also view cryptocurrency as a threat of their central bank’s ability to create money out of thin air. In the U.S. alone, this “seigniorage revenue” amounts to more than $100 billion per year, and cryptocurrency threatens this stream of revenue.
- Security risk – Exchanges are entirely digital and, as with any virtual system, are at risk from hackers, malware, and operational glitches.
- Market risk – As with any investment, values can fluctuate. But the value of bitcoin has seen wild swings in price during its short existence. Subject to high volume buying and selling on exchanges, it has a high sensitivity to any newsworthy events. According to the Consumer Financial Protection Bureau, the price of bitcoins fell by 61% in a single day in 2013, while the one-day price drop record in 2014 was as big as 80%. Extreme price volatility should be expected.
- Valuation Risk –The concept of a virtual currency is still novel and, compared to traditional investments, bitcoin does not have much of a long-term track record or history of credibility to back it. Further, its value is largely based on scarcity value and its adoption as a store of value and payment system, not on fundamentals like a company’s underlying profits.
At Trust Point, we are focused on creating diversified portfolios that achieve a client’s desired return on investment with the least possible risk. Our clear investment philosophy, combined with our proven principles, puts clients at ease and confident about their financial future. For any questions or to discuss your portfolio, please contact us at 800-658-9474.
*A store of value is essentially an asset, commodity, or currency that can be saved, retrieved, and exchanged in the future without deteriorating in value (milk, for example, would not be a store of value).