Should You Get on Board with Bitcoin?
With bitcoin absolutely flying this year – the cryptocurrency has grown 1,500% in value in 2017 – many people are asking if they’re missing out on some kind of brilliant investment. Even a prominent precious metals fund started investing in bitcoin recently.
If bitcoin is the future, shouldn’t we all be getting on board?
This is one area where it makes sense to step back and try to understand what’s going on below the surface. The bitcoin craze seems to involve a lot of emotion, but in many cases, it’s a bit short on analysis. It’s also surprisingly polarizing: some consider bitcoin to be a harbinger of a future of decentralized money, others consider it a ridiculous fad.
So, should you be investing in bitcoin? Let’s have a look at what it really is, how it functions, and what that means in terms of risk.
The basics of bitcoin
Bitcoin is a cryptocurrency, which means that it’s a digital asset (digital cash if you like) that uses cryptography to control the creation of more bitcoin, the transactions between holders of bitcoin, and the verification of those transactions on an open ledger.
The ledger is possibly the most interesting part. The operational chassis that underpins cryptocurrencies like bitcoin is blockchain, which is essentially an open-source ledger that grows with each transaction and, because of how the ledger is built, is highly resistant to manipulation. It’s open and yet secure at the same time.
That’s what makes blockchain so special. Where banks and other financial institutions have to create and control their own ledgers (and thus manage their own security risks), no single entity controls a blockchain ledger, or even the code that keeps it running. Every transaction is verified across a network of participants and the ledger is updated and maintained in perpetuity.
The trust isn’t in the owner of the ledger, but in the system of the ledger. There’s no controlling entity, like a bank or government, and that has special benefits and costs for the users of cryptocurrencies like bitcoin.
Navigating the nuances
By taking out the middle-man, blockchain (and thus bitcoin) allows you to transact without the restrictions, controls, and costs imposed by banks – and frees you from the implicit trust we place in them.
For example, if you send money or a stock certificate in your online bank or brokerage account, the bank owns and controls the record of that transaction. You’re not simply handing the cash or certificate to your recipient, you’re asking that the bank adjust both of your accounts accordingly.
Your bank might need to put in a request to another bank, they might make a mistake, or they might charge you for the favor. These are the costs of using middle-men.
Of course, there are also benefits to this system: things like regulation by financial authorities, requirements for identity verification, or the ability to block payments to criminal organizations.
But centralized management can control not just ledgers but the actors who rely on them. A blockchain system can’t be shut down by a government trying to preserve the value of its currency or a bank trying to manage a run. Because transactions are directly peer-to-peer, the people involved control their own assets at every step.
Within these differences lie both the benefits and the risks of cryptocurrencies like bitcoin.
Bitcoin’s lack of central control and uncertain position in the marketplace as a unit of value have made it volatile in a way that even the most dynamic fiat currencies are not. You might not have your assets frozen in a bank run, but you’ll also be exposed to the potential for a complete loss of your currency’s value.
Further, the system itself isn’t foolproof: bitcoin can still be stolen and exchanges hacked. The biggest on record, the MtGox exchange hack in 2014, affected what was then the world’s largest bitcoin exchange and cost consumers bitcoin valued at about half a billion dollars at the time.
Supply and demand – and emotion
These risks are all part of the bitcoin investment conversation, but there are also others.
Because bitcoin doesn’t have an economic value – in the sense that it doesn’t produce income streams, like a bond, and can’t be evaluated in net present value terms, like a stock – and the supply of bitcoin is limited, it’s price is primarily determined by demand, which is in turn driven by a perception of bitcoin’s usefulness and intrinsic value.
That means it also doesn’t behave quite like a regular currency. Generally, the exchange rate of a “floating” currency, which isn’t directly controlled by a country’s central bank, is impacted by economic factors, like the inflation rate, interest rate policy, or national debt levels. But bitcoin isn’t subject to economic policy – it isn’t even tied to a particular economic activity (or nation).
Interestingly, this is where bitcoin has a special connection to gold.
Like gold, the “value” of bitcoin is determined by our collective perceptions about that value, and those perceptions can be influenced by passing sentiments, such as optimism about digital payments or fears about the global banking system. So, it’s not that surprising that bitcoin, like gold, has experienced periods of waxing and waning demand (though short-term gold prices have not been nearly as volatile).
Unlike gold, however, bitcoin doesn’t have a lengthy history as a useful product. It’s not something you can shove under the mattress, fashion into jewelry, or incorporate into machinery. That makes demand harder to predict.
And unlike a fiat currency, bitcoin isn’t backed by anyone’s full faith and credit – victims of the 2014 MtGox theft still haven’t been made whole, and may never be. Contrast that with holding cash in a bank account: up to Federal Deposit Insurance Corporation (FDIC) limits, your cash deposits are fully backed by the US government.
A new emerging market
All that said, it’s probably not entirely fair to explicitly compare bitcoin to gold, or even dollars, given that the US dollar is the world’s reserve currency.
For a fairer comparison, it might make more sense to look towards younger, or emerging, economies. Like many emerging market currencies, bitcoin has experienced wide swings in demand.
For a central bank, widely variable demand has direct implications on a currency’s exchange rate and thus on a country’s ability to manage inflation and service debt. That means rising or falling can lead central bankers into the difficult task of balancing multiple competing priorities. They do this with monetary policy – adjusting the money supply and using the tools available to influence interest rates.
In bitcoin’s case, there is no such thing as monetary policy, or the ability to adjust the supply of money to manage economic issues. The supply of bitcoin is tethered to the algorithm that produces it, and the total supply of bitcoin will eventually reach a cap.
In other words, where central bankers can adjust their policies to help manage volatility, bitcoin has no such mechanism. Because it’s a decentralized system, it’s completely exposed to the whims of demand.
Right now, that means significant holders of bitcoin are getting rich – at least on paper. If demand falls, their wealth could crumble.
Of course, human policymakers can and do make mistakes – and those mistakes can compound throughout an economy. Countries have been thrown into economic crises because of monetary policies that attempted to manage a currency’s value, and every monetary policy system (and there’s a range of approaches) has its costs and benefits.
Just as the decentralized bitcoin system has costs and benefits.
Perhaps a future cryptocurrency will develop a way to manage supply so that the impact of shifting demand isn’t quite so significant, or maybe markets will find a way to incorporate foreign exchange trading strategies on bitcoin to take advantage of market sentiments (and thus help to reduce their effects).
But in the meantime, there are serious unanswered questions about the viability of a currency that is completely exposed to the whims of the market, especially given that there isn’t an economic reality underneath it that can be analyzed and agreed upon.
The real “gold” in the system
There are people out there who argue that bitcoin mania actually misses the point, that the real game-changer here isn’t bitcoin or even cryptocurrency: it’s blockchain, the secure open-source, self-verifying ledger that tracks all bitcoin transactions.
Goldmoney, which we wrote about a few issues back, uses blockchain to manage its own ledger – and to bring transparency and credibility to the concept of buying fractional shares in gold bullion. The Australian stock exchange also adopted blockchain to track trading, and companies across several industries are investing in ways to use blockchain to improve business operations and management.
Some decry blockchain as just another database system, but many others see in blockchain a deep well of opportunity to improve transparency, efficiency, and security. In other words, where bitcoin might fly or fumble over the long run, blockchain could turn out to be a significant improvement on a pretty old concept.
Or it could be just another database system. There’s the rub with any innovation: the proof is always in the pudding.
Anna B. Wroblewska is a widely-syndicated financial writer whose work has appeared everywhere from CNN to Merriam Webster. She consults for a wide range of financial services clients looking to connect and communicate with their audiences. Find her online at www.auguryconsulting.com.