What is Bitcoin Exactly?
If you’re like me, you had certainly heard the words “blockchain” and “Bitcoin” before, but until recently had considered it a thing only for tech geeks and anti-government conspiracy theorists. Then suddenly, Bitcoin blows up and returns a whopping 817% over the last 12 months. Congratulations geeks, you have my attention.
Full disclaimer – I am not an expert on this technology nor do I own any myself or recommend their purchase for any clients. What I am is a fiduciary, with an intellectual curiosity about the space, and a belief that I have a responsibility to research and be conversant on new and emerging investment opportunities. So here we go.
So what is it? Is it a new type of digital commodity asset? Is it money? Does it do anything? Can I spend it to buy things? How are Bitcoins created? Who monitors it? Is it regulated? How do I value it intrinsically? And finally…should I invest in it? These are all questions I’ve been asking myself over the last few months trying to come to grips with it, all the while watching from the sidelines as the price rose higher and higher.
Bitcoin was first conceptualized in 2008 by a white paper, “Bitcoin: A Peer-to-Peer Electronic Cash System,” written by an anonymous hacker who called himself Satoshi Nakamoto. Nakamoto also devised and implemented the first blockchain database, and in 2009, the “Genesis” block was published for Bitcoin. Nakamoto’s opus stemmed from a frustration of relying on third party bank and government intervention; claiming that bank intermediation only increased transaction costs. His hope was to create a government-independent, fraud-proof, peer-to-peer payment system based on cryptographic proof instead of trust. Think Venmo, but without the “transfer to bank” step.
Bitcoin trades on a cryptographically-secure, public database called a blockchain. The best way I can think to explain this is to imagine there is one single shared spreadsheet on a cloud drive where everyone in the world has editing privileges. Blocks made up of hundreds of transactions are reconciled and irreversibly published on the public Bitcoin blockchain continuously. All the transactions on the blockchain are open sourced with no central clearinghouse, but “miners” provide the necessary cryptographic computing power necessary to reconcile and secure each transaction block. The miner who is able to provide enough cryptographic computing power or “proof of work” the fastest is rewarded with new bitcoins and transaction fees from those wishing to transact.
The system is therefore secure, or “unhackable” as long as honest participants collectively control more computing power than hackers. All the transactions are publicly viewable, but they are not linked to identities. Since Bitcoin owners are anonymous on the network, it was often initially used on Silk Road for illicit payments, a reputation Bitcoin is still struggling to shake off. In reality, Bitcoin or other digital token technology could hypothetically eliminate counterfeiting and illegal cash laundering because every dollar is accounted for.
Globally, we are already beginning to see prominent examples of a move towards digital currency: Sweden is nearly cashless; African countries, like Kenya, are transacting via mobile phone money accounts; and India has taken steps to curtail illegal activity by radically demonetizing 95% of circulating rupee banknotes just last year. Think of how much you use cash on average, or how much of your net worth has ever been in cash or check form? Very little for me, but my need for currency outside the US$ is negligible. I’m paid in USD and I buy things in USD, so transacting to another currency would only bring transaction fees. Bitcoin has no government backing, which could be good or bad depending on the stability of the currency you’re being paid in vs. the one you need to buy things in; but buyers must also trust that there will continue to be a liquid market for its value in the future.
Cryptocurrencies, coins, or protocol tokens as they’re often called, have now expanded far beyond Bitcoin, which today encompasses only about 50% of the crypto-coin market. Each protocol token is developed for use within its own network database and can be used to purchase digital assets or services within that network. These blockchains, or “cryptographic protocols” as they’re called, can be designed to provide users on the network whatever the network needs in exchange for its own “home” currency. The possible applications are endless.
I’ll illustrate: last weekend I went to the Texas State Fair in Dallas which annually hosts the OU/Texas game in the Cotton Bowl. Before the game, my companions and I were forced to stand in a very long, hot, and sweaty line to get fair coupons. Now every coupon is offered for $0.50, but everything within the fair network (corndogs, carnival games, funnel cakes) must be purchased with these coupons, not cash. I was hungry and getting cranky so I would have gladly paid $0.60 on the dollar to acquire coupons because of the scarcity of coupon resources. Then on the way out, knowing I no longer needed the resources of the fair network and worried that soon there would be no market for my leftover coupons, I would have gladly sold them for $0.25 on the dollar. Instead, I gave them to a kid.
Think of cryptocurrency like coupons to the fair, except instead of buying coupons from the booth, you must buy them only from the other coupon owners of which there is only a fixed amount. New coupons are printed, but only to pay those that work for the fair. If you didn’t need the resources of the fair to eat, for example, there would be no reason to purchase coupons. Unless, of course you knew there would be a scarcity problem on October 14th where that you could sell them to me for $0.60 at 10am and buy them back from me for $0.25 at 6pm.
That’s how I want to transition into thinking about whether Bitcoin or other cryptographic coins is a good investment. I think it’s important to first establish some definitional terms. I think it will help as we go through this for you to have some perspective of how I view investing and which types of assets I consider in each category. Consider that there are three types of assets:
- Use assets: these are investments you buy primarily to use and enjoy such as cash, a car, boat, or engagement ring. They hold value and can be resold, but generally for less.
- Investment assets: assets purchased that you expect to grow in value over time, provide consistent income over time, or both. Examples are long-term retirement account assets, buy-and-hold equity investments, oil and gas royalty interests, closely held businesses, rent-houses, etc.
- Trading assets: these are assets generally purchased primarily because you believe there is an opportunity within the current or future market to resell them at a higher price and make a profit. Generally shorter-term in nature, not very tax efficient, and may or may not provide any reward for holding them, such as: precious metals, foreign currency contracts, most derivative contracts, and equity day trading. Sometimes also referred to as speculative investments.
These categories are not mutually exclusive, your home for example can be both a use and investment asset. Stocks and ETFs can be purchased and held as investment assets for decades growing steadily and distributing dividends to the owner, or they can be aggressively traded back and forth throughout the day as trading assets. Gold can be made into beautiful jewelry as a use asset, or held in vaults as a diversifying trading asset. In all these cases, the buyer and the seller must accept that there is value and agree on a means and denomination of exchange for that value (traditionally government currency – such as the US dollar), before a value-for-value exchange can be made.
From my research, I believe cryptocurrencies may also be a hybrid. Many protocol utility tokens, such as Ethereum, can be used to trade for digital assets, storage, or work from other network participants; be held and speculatively traded as a store of monetary value; and perhaps will soon be used within a new technology platform owned and capitalized by a “real” investable technology company.
For me, and for I assume most of my investors, I don’t have a need for cryptocurrency as a use asset (yet). I live in the US, and am confident, for now, that my dollars earned and placed in my bank today will not be seized or devalued significantly the government. Those dollars are also exclusively accepted to purchase most of my goods and services, I don’t have an immediate need to purchase network services, and I otherwise gain no utility from just owning it.
To consider it an investment asset, I’m not yet convinced. Call me old fashioned, but determining an asset’s intrinsic value by calculating the discounted present value of its future cash flows is still the way to go. Bitcoin and other protocol tokens don’t have any cash flows, there is no way to systematically exponentiate demand growth, it doesn’t pay a dividend, you can’t eat it, you can’t burn it, and I don’t have the technical expertise to determine the value of one cryptocurrency over another.
That leaves me to conclude that for now, cryptocurrencies remain squarely in the trading asset category. Much like me at the fair, unless you have a use for them, or the technical knowledge to know when the demand will be high and when the demand will be low, it’s best to avoid as an investment for now. Much of successful trading is the ability to identify opportunities for value in inefficient or illiquid markets. I was reminded of this last week as my neighbor told me they were able to sell their trashed up, mid-century patio furniture left at their house by the previous owner, to an antique collector for $1,200. One man’s trash is another man’s treasure, but the ability to identify value and then exploit it by finding a willing buyer is the key to being profitable.
I still think the future is bright for blockchain protocol technology and digital money. Even though it’s currently overly technical, inefficient, and expensive to provide the cryptographic computing power necessary to secure the database; it will get better. Like any new innovation, many players are now entering the market, and there seems to be a new “ICO” (initial coin offering) to raise capital almost every day. Only time will tell whether Bitcoin, or another dominant player will emerge the victor, or whether government intervention will eventually redesign its delivery.
I hope this has helped to answer some of the questions you were too scared to ask. I’m just like you with the tech. I don’t fully understand it all, but what I do understand makes me believe that sticking your head in the sand and ignoring this revolutionary technology is a mistake, if not downright foolish.
As always, reach out with questions, comments, love notes, or hate mail at firstname.lastname@example.org.
Amy Hubble, CFA, CFP®
Principal, Radix Financial LLC
***This quarter’s commentary topic took me a while to complete because of the large and growing resources that are now available about this technology. If you want to learn more, I’d encourage you to read the original white paper by Satoshi Nakamoto, and listen to Patrick O’Shaughnessy’s three part audio documentary, “Hash Power.” Also thanks to the organizers and speakers of the 2017 Cayman Investment Forum, presented by CFA Society Cayman Islands for their insight and inspiration for further learning on the topic.