“Trusted as an alternative to gold?”, Bitcoin began 2021 as a new investment star-turn, at least for a few days. It seems that every day this year financial journalists in the daily press have published an update or commentary on cryptocurrencies. The eye-catching focus has been the speed of the rise in the price of Bitcoin, some 42% in ten days. For most people this is like financial witchcraft.
Bitcoin along with its crypto cousins is attracting increasing interest from institutional investors who to date have been untrusting of Bitcoin and its marketplace. The Times of 9 January quoted a JP Morgan representative predicting that the price of a Bitcoin would rise to $146,000 (valued in early 2020 at around $4000, and in early 2021 at around $40,000) if it becomes a digital alternative to gold, the traditional default safe haven for many. That is a big if. That same edition recorded a Bank of America Securities’ warning that this is a bubble, implying a burst is on the way, and Warren Buffet, perhaps regarded by some as the wisest of investors, saying: “I can say with almost certainty that (cryptocurrencies) will come to a bad ending”- without saying when. They could all be partly right. Cryptocurrency is a word whose sound implies a shroud of mystery. What is it? What is Bitcoin?
THE CRYPTO MYSTERIES
Bitcoin is money. A cryptocurrency is money. But it is not established and accepted as such in the traditional financial system. It is money which is not issued or backed by any State, or Bank, or recognised authority – a strength and a weakness. As to what money is, there are various writings but Nick Szabo ‘s essay on the origins of money is interesting – he is recognised as a Bitcoin guru and his writing may lead to a conclusion that there is a large brain behind that writing.
Whether today a piece of money is worth anything seems to come down to belief or trust by enough people that it has a value, and that value can vary from day to day. Certainly, currencies can come and go. People talk of money as a store of value, with some longevity, such as the Dollar or Sterling; and also, as an exchange medium – it can be swapped for numerous other things which in turn are valued in monetary units, such as food. But money never really has any day-to-day existence, and it cannot really be seen or touched: of course, a coin or banknote can be felt but they are each but a representation of some perceived value on the day in question, and that value moves around. In fact, most money is today merely represented by a record of some sort, as a deposit, a book or computer entry as to ownership. If too much thought is given to the subject, a nervousness as to the tenuous risks around an individual’s nest-egg can quickly become all too apparent. Bitcoin is not yet established as a reliable exchange medium or a store of value, and not therefore as acceptable money – a bit like the currencies of certain unstable countries.
A Bitcoin is perhaps a unit of money created virtually, a computer file or digital token, but in some ways is similar to a normal currency. It is called a cryptocurrency because it is protected by cryptography, which protects digital information so that it cannot be accessed except by authorised people, who need to know the code: each investor in a cryptocurrency has a private code or key so they can transfer the Bitcoin. The Enigma Code of the Second World War notoriety changed normal text into another format protecting the information or message from the enemy, unless they found the Code. Digital encryption does the same job with digital data. A cryptocurrency is built on the blockchain basis – a digital ledger of all transactions in that currency, decentralised and spread across a network of computers forming the blockchain. The idea apparently is to render it impossible to hack or change the data. Bitcoin is the major cryptocurrency but there are thousand of others it seems, such as Ethereum, each having different characteristics.
But how can a Bitcoin or other like currency have any value? It seems to be an application of the supply and demand principle. For example, take a group of potential investors considering the purchase of an item. Each one places a value on it which is reached by assessing how much each other investor will pay for it, or value it. As investors multiply and history develops, judgements, or guesses, can be made as to how others will value the item due to past behaviour or the perceived strategies of those investors, weighing risks against a highly profitable best case imagined scenario.
MORE MYSTERIES
Bitcoin and alternatives to it are traded anonymously by investors. So, there is it seems no transparency of ownership, although if held on a digital exchange ownership is discoverable. No third party such as a bank, broker or other intermediary need be involved, so it should be cheaper to trade. Dealings can be obscure to and the asset unavailable to all authorities, such as tax collectors. Lack of transparency makes cryptocurrency attractive to criminals, perhaps facilitating money laundering; and may render the market open to manipulation. But every transaction is in fact public. There is limited regulation. Is it the investment wild west, ruled by cowboys? It is worth noting however that there is plenty of money laundering in the normal financial system, and cryptocurrencies may be becoming more respectable.
There are apparently a maximum of 21 million Bitcoins capable of issue (how this can be verified is unclear to the writer). A scarcity value is thus guaranteed at some point, depending on demand. This is very different to State issued money, as the ability of the State to issue and dilute is endless and perhaps dangerous, particularly in financially challenged times such as now!
Bitcoin can be divided theoretically into an infinite number of smaller units and so is flexible. But it has only had an existence of some 11 years, with a very volatile history of spikes and crashes, and so no historic confidence has yet been established as to its durability and longevity. Gold on the other hand has been turned to for hundreds of years as the ultimate wealth haven or money. The Financial Times records in an article by Gavyn Davis that according to Gold Hub above ground gold stocks were 198,000 tonnes and underground reserves were 57,000 tonnes at end of 2019. The current value of that is about $17trillion, compared to Bitcoin at $0.6trillion. But these days things move at breakneck speed and sentiment, on which investment values much depend, and arguably in Bitcoin’s case perhaps totally depends, can change. And who can say whether sufficient confidence in it as a store of value cannot be built within a decade or two, or less? After all Bitcoin is now being used to fund certain high-tech ventures. Where tomorrow?
However, generally a buyer of Bitcoin needs to know it can be turned into” normal” money, such as the U.S. dollar, so that it can be truly monetised. That depends on the use of digital currency exchanges which banks are willing to deal with. If they were to disappear or banks generally become unwilling to deal with them, a Bitcoin owner might be trapped unless and until the Bitcoin becomes an accepted unit of exchange. Such exchanges, for example Coinbase, are subject to regulation and, if Bitcoin is held on an exchange it is transparent to authorities and can be accessed by them.
BUT WHERE IS THE HARD ASSET?
Bitcoin has things in common with gold: neither has any real practical use, but at least gold is tangible as a mineral. However, when gold investments are made, gold is not normally physically delivered but book/digital records are kept, like Bitcoin. Gold is hardly in practice quickly portable, but Bitcoin is.
Bitcoin does not represent or rely on some physical asset or service or performance of actions to determine its value. Comparing securities issued by corporations or States, there is usually some hard asset or service activity being sold which underlies, albeit at a distance, the security and which day to day people use in some way. So too even money issued by Governments or Banks can be related to some national economic activity – for example the pound sterling is arguably linked in some way to the British economic performance and prospects, though perhaps less directly now than used to be the case. But Bitcoin and alternative cryptocurrencies have no asset representation behind them: their value is perhaps simply the aggregation of judgements of investors as to what others may pay for them.
As mentioned, lack of transparency in the market is a hindrance for Bitcoin and other alternatives, leading to wariness and scepticism on the part of traditional fund managers. It is not even public knowledge who invented it. However, as such investors show more interest in the crypto market, if the bandwagon gathers momentum and lemmings jump in to avoid missing out, the bubble will grow. Some say it will end in tears with a crash. It will dip probably but may bounce back. Who knows?
The trading pattern of Bitcoin is typically one of peaks and troughs, a yoyo. From the $40,000 peak in the first full week of January, it dropped like a stone (25%) in the second week. High volatility can lead to big winners and losers and attracts certain types of investor. There is however no underlying information published to inform investors, unlike say with shares where companies publish accounts and progress reports – but with Bitcoin there is of course no business to report on! Who knows what games investors, malevolent traders, or even States (especially corrupt ones) may play, in spreading information? The owners of big Bitcoin piles are unknown. Are stories concocted to manipulate the price? There is limited regulation to speak of. It seems that Elon Musk, the world’s richest man is a fan, but Warren Buffet is not.
WHAT WILL HAPPEN?
A fascinating game is being played out maybe over years. Gold is a bet. Bitcoin is a bet. Gold is money. Bitcoin aspires to be money. People will talk cryptocurrencies up, and others will talk them down. What drives the chat may be self interest or not. Mostly the driver will be profit.
Is the cryptocurrency data guaranteed to be secure? Maybe now, but technology changes, so what about tomorrow? If it attracts sufficient fund manager interest, is not tighter regulation of this market inevitable, and, if so, what will that do to value and respectability? Is Bitcoin a long term hold or a market in which to judge the ups and downs and make profits as they become available? Will it become a medium for making payments and exchange of goods and a store of value? What if State banks compete with their own digital currencies in competition with cryptocurrencies? There are lots more questions. They who can divine the answers may become wealthy indeed…. or not.
Cryptocurrencies are developed by people who are very clever at least as to digital technology and data. Investment in them can be considered by people who are in that respect a lot less clever. Being wary of trusting what is not well understood is a sound approach. Being wary of investing much, or anything that one would rather not lose, in a financial medium one does not understand could be even wiser. And yet from little acorns mighty oak trees grow!
For further reading see “The Bullish Case for Bitcoin” by Vijay Boyapati at https://vijayboyapati.medium.com/the-bullish-case-for-bitcoin-6ecc8bdecc1
2 comments
This is a very clear summary of the mystery surrounding a new Alchemy. Whilst the technology can be explained, I think the underlying integrity of the system seems elusive. We have been in difficult waters before, with complex assets like sub prime mortgage derivatives and look where that took us! You offer wise words for the would be investor- my only other thought is that if personal wealth is created from this form of speculation then some way needs to be found to tax it! I struggle to think that this form of profit is going to appear on tax returns anywhere!
I do wonder what will happen to Bitcoin when all the Millenial traders, currently sitting at home either on furlough or perhaps unemployed or even just underemployed, go back to a full-time day job. There seems countless new day-traders who arguably play a key part in driving the impetus behind the rise of cryptocurrency. When their focus goes back to the daily grind, commuting, deciding whether to spend money on investing or say going on holiday, family commitments or another Starbucks on the way to work, will we see a draining of investment in Bitcoin? And so an ongoing slide in the price…?