Bitcoin has captured the imagination of the investment world alongside “meme” stock trading (GameStop) and stocks of companies identified as “disruptors.” In fact, bitcoin is considered by some to be the ultimate “disruptor” financial creation. Furthermore, nothing fuels the imagination better than something that goes up five-fold in value in just six months!
What is bitcoin?
Bitcoin is very difficult to classify. Is it a currency, a payment mechanism, an investment, or even a “digital commodity” like gold?
Bitcoin could be characterized as the king of cryptocurrency, which is a digital form of money that can be used like traditional currency to pay for goods and services. Currently there are more than 7,000 forms of cryptocurrency, although the five leading currencies – Bitcoin, Ethereum, Cardano, Binance Coin, and Tether – account for approximately 80% of the market cap of the crypto sector.1
While cryptocurrencies such as bitcoin are designed to be used as a form of money, for now, such transactions are relatively rare. The real attraction has been as an investment for speculative investors.
Cryptocurrencies like bitcoin are considered to be “decentralized” currencies with no state central bank to issue it or oversee it. Transactions are verified in a public ledger known as a blockchain.
A key feature of bitcoin, which has helped drive valuation to such heights, is the limitation that ultimately only 21 million units can ever be put into circulation. By contrast, central banks of sovereign nations have the authority to issue an unlimited amount of currency in pursuit of economic goals.
This limitless ability by central banks has led to currency debasement through inflation over time. Over the course of history there are many instances where poor central bank monetary policy has led to extreme currency debasement.
For activist investors, bitcoin, with no ties to a central bank and a hard limit on the amount ultimately created, would become the incarnation vision for the future of money. However, this vision runs contrary to centuries of sovereign and financial institutional structure around money. Today’s bitcoin volatility and valuation reflect these very disparate and conflicting views of what money will be in the future.
To date, one of the biggest obstacles facing bitcoin is that it struggles as a currency. It is volatile (price swings of 5% intraday recently), somewhat cumbersome to use, and can be irreversibly destroyed by human error.
As a payment mechanism, it holds some promise. Today, you can buy a $5 coffee and the transaction will take a cumbersome 30 minutes and cost $18 in fees, which are high currently due to network congestion. (A year ago, the fee was $1.) However, if you need to send $1 billion across the globe, the transaction will also take 30 minutes and cost $18. In both transactions you will have irrefutable proof of payment on the blockchain and no intermediaries, including banks or credit card companies and their attendant fees, will be involved.
As in investment, bitcoin is somewhat like gold in that it may be a long-term store of value, providing a degree of inflation protection, albeit in considerably lighter form! However, gold has millennia of history as a store of value – bitcoin has 13 years. Both bitcoin and gold have serious limitations from an investment standpoint in that neither provides intrinsic value from earnings or dividends. Both derive their value from their degree of scarcity and the degree of acceptance by the investing community as an “investable” asset.
Recently bitcoin has received notable acceptance in the investing community. Some very high-profile individuals and companies have mentioned their purchase of bitcoin as a diversifier. (Tesla recently purchased $1.5 billion in bitcoins and announced that it plans to accept the cryptocurrency as payment.) However, as a percentage of holdings for most companies, the stake in bitcoins tends to be extremely small.
Other issues with bitcoin
Although bitcoin has earned some significant acceptance as a financial tool and/or investment, there are some non-financial issues that diminish its appeal. First, because of its pseudo anonymity and use outside the realm of the globally regulated financial system, it has become the currency for illicit transactions or repugnant behavior. Bitcoin ransoms are frequently demanded in malware attacks while the global drug and arms trade is frequently denominated in bitcoin.
The risks of bitcoin are also more tangible than its value. The wrong sort of coding bug, mathematical innovation, or outright computer theft can leave an investor with a zero balance in their crypto “wallet” without warning. Furthermore, government regulation could suppress its value, or a new cryptocurrency, even one sponsored by one or multiple central banks, could become dominant.
The creation of bitcoin through “mining” requires a staggering amount of computer power, consuming an immense amount of electricity. It is estimated that the amount of energy consumed to mine bitcoin now is equivalent to the annual consumption of electricity for countries such as Norway, Sweden, or Argentina!
Furthermore, it is estimated that a single province in China, powered entirely by “dirty” coal plants, produced 65% of the bitcoin mined last year. Clearly there are political and environmental (ESG) ramifications to such a significant amount of energy being consumed to produce this intangible “digital commodity.”
Investing/trading in bitcoin
For very sophisticated investors who have a conviction about bitcoin as a long-term digital store of value and who understand its volatile history and are comfortable with its shortcomings, bitcoin can be purchased directly and left in custody through various exchanges. There are currently several blockchain exchange traded funds (ETFs) on the market, but none based in the U.S. yet. If the SEC approves a pure bitcoin or crypto currency ETF or mutual fund, expect it to have expenses that will be a modest drag on returns, particularly for an underlying asset that does not generate interest, earnings or dividends.
An alternative, and potentially lower risk approach, is for disciplined investors to seek out firms that comprehend the risks and opportunities of the blockchain technology that underpins bitcoin. That technology could be the true value creating “disruption,” rather than bitcoin or other crypto currencies. Some large financial technology companies such as PayPal have embarked on this path with some success.
For most investors, buying bitcoin directly is not advisable unless it is to gain experience with this emerging instrument and specifically the blockchain technology that underlies it. If one is willing to invest a small amount of disposable income (not retirement assets) in bitcoin, the next time a friend or client asks you about bitcoin, take out your phone and show them your small stash – and maybe even send them a few satoshis!