Bitcoin – the cryptocurrency and digital payment system – is in the news again this month, as it closed in on $3,000 last week on reports of increasing blockchain technology adoption and rumors of new Indian cryptocurrency regulations. What exactly is Bitcoin and what can it mean for your portfolio?
What is Bitcoin?
A “bitcoin” is a unique string of data, created (or “mined”) by solving a computer algorithm of increasing computational difficulty. This algorithm is tied to transactions on the Bitcoin blockchain, which is the shared digital ledger of every transaction and every bitcoin spent. Solving the algorithm accomplishes two things simultaneously: it creates new bitcoins for the miner while extending and verifying the record of Bitcoin transactions for everyone. This dual result serves as a quick and efficient payment processing service.
Once created, a bitcoin is kept safe using a system based on public key encryption. A bitcoin owner (the one sending the bitcoin as payment) first generates a pair of cryptographic keys. One is public and shared, and the other is private and secret. Anything encrypted with the public key can only be decrypted with the private key, so bitcoins are safely encrypted only if the owner’s private key stays secret. To send a bitcoin, the owner attaches it to the recipient’s public key, and signs the transaction with their private key. The transaction is then published to the Bitcoin blockchain, publicly recorded and verified. It is irreversible at that point.
This protocol effectively prevents double spending, but only if the bitcoin is sent digitally and recorded in the blockchain, which is a distributed database that maintains Bitcoin’s records. If it is transferred on paper or some other physical form, there is always a risk that the sender could still use it (if he or she does, it changes ownership, thus invalidating the paper copy of the bitcoin).
The magnitude of bitcoin price often swings, and variable government response to Bitcoin highlights both the promise and risks in a currency system not controlled by any government. Unlike a fiat currency system, which is backed by a government guarantee, Bitcoin is a “hard” currency, designed to act like gold or silver.
The power of the Bitcoin blockchain system lies in its ability to accurately process and record data transfers without needing a third-party intermediary, such as a bank. Bypassing a bank in a purchase or sale, particularly in international transactions, can drastically cut lag-time and fees. This is a huge benefit for smaller businesses burdened by credit card fees, or for workers who send remittances overseas to their families. Bitcoin may also become a way for people in countries with high inflation rates and capital controls to exchange their currency while avoiding government oversight. It can be attractive for anyone looking for an alternative to their home country’s fiat currency, i.e. a legal tender that is backed by its issuing government.
Bitcoin is not without its own set of unique challenges. Its manifest benefits as a unit of exchange – no central authority, no physical assets, semi-anonymous transactions – are also what makes it so volatile as an investment. Without any defined value or connection to an established currency, the price of a bitcoin fluctuates wildly in cycles of fear and excitement. And without any third-party guarantor, there is a very real risk of theft or fraud for any Bitcoin holder. Add to that a constant risk of regulation by world governments, and holding Bitcoins long-term is an obviously risky proposition.
Bitcoin, the Blockchain, and Initial Coin Offerings
Outside of Bitcoin itself, the blockchain has real value as a decentralized record keeper. Some new financial transactions and contracts are now mediated over the blockchain without any oversight, posing a challenge for financial regulators.
One of the hottest new trends is called an Initial Coin Offering (ICO). An ICO can be thought of as a crowdfunding effort by a new blockchain-related company. The company lists “tokens” for sale to early-adopters and uses that money as seed capital to grow. If the company succeeds, buyers hope their tokens will be more widely circulated and their value will increase. An important distinction between and ICO and an IPO is that unlike common shares of stock, a blockchain token has no claim on the underlying company. The value of each token is entirely based on its usefulness within the issuing company’s framework, or in its perceived value to others.
Our Take on Bitcoin
In Personal Capital’s view, both bitcoins and blockchain tokens issued during an ICO remain highly speculative. We don’t count them as an asset class because they have no underlying assets, cash flows, physical industrial value, or financial claims on any company. They have no regulatory oversight to prevent fraud. Without anything linking them to actual economic growth other than their perceived scarcity, they are susceptible to huge price volatility caused by spikes of fear and greed. And as the value of blockchain-linked assets continues to grow, so too does the likelihood that governments will begin to view them as a threat to their sovereign ability to wield monetary policy and regulate commerce.
We only consider or recommend investments that we believe have a positive expected return over long periods of time. Bitcoin may or may not survive, and blockchain technology will continue to evolve. Some investors have already made a lot of money buying bitcoins or blockchain tokens, and that may continue in the future. But to us it remains a wager, and not yet an asset with a role as part of a long-term investment strategy.
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