Bitcoin appears to be making headlines in the media more recently. Spreading like a contagious virus, the digital currency and few of its cryptocurrency siblings keep popping up wherever we go. This has attracted the attention of various analysts in the financial sector. Due to its continuous appreciation in value, it has equally attracted the attention of investors. As it stands now, the question still remains open and debatable, whether the virtual currency is here to permanently stay or disappear at some time to come. In this post, I attempt to cover a few aspects of Bitcoin. These include some background explanations, associated risks and future expectations. In addition, I will be expressing some personal views where needed.
Background of Bitcoin creation
Bitcoin is an electronic form of currency introduced in 2009 by an unidentified person or group. Mostly abbreviated as BTC, it is recognised as the first decentralised cryptocurrency. A cryptocurrency is digital money that makes use of a security feature known as cryptography to secure all financial transactions. There are currently over 1000 cryptocurrencies of which Bitcoin has taken the lead.
As mentioned before, Bitcoin is a decentralised currency. What this means is that there is no government, regulatory body or authority to control transactions. In our traditional currency system, governments, through their respective central banks, control and regulate all monetary transactions. The central bank holds the power to intervene and ensure that currency transactions do not end up in the hands of criminals for illegal activities. They do this by requesting for many personal details during financial transactions, to be able to trace all parties involved. The same banking institution, through their monetary policy, can print paper currency to increase supply which in some occasions brings about inflation. These are the main reasons that motivated the innovator to create bitcoin as an alternate currency. Just as he indicated in his white paper, Satoshi Nakamoto, the fictitious name for Bitcoin creator, stated:
“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution”.
Bitcoin transaction rather ignores regulatory bodies such as the central bank. In that, currency transactions are directly carried out between individual users without any intermediary institution. This expects to make financial transactions more efficient, faster, and less costly due to low transaction fees.
It therefore acts as a currency in its own [virtual] world- A world without government and regulatory institutions.
How does one acquire Bitcoin?
Bitcoin can mainly be acquired in two ways:
- Through the process of mining
- Through trading or exchanging of products, services and other currencies
Bitcoin mining process
Bitcoin mining is the process by which new coins are produced. The inventor(s) of Bitcoin compared the digital currency to Gold and hence made use of the term mining. In his white paper, Satoshi Nakamoto wrote:
“The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.”
Mining bitcoin involves the use of computer software to solve some complex mathematical equations. This can however not be done by ordinary computers. It takes the use of computers with advanced integrated circuits and processing units to be able to solve these complex puzzles.
In a real gold mining process, various resources are utilised to mine the precious physical commodity. In comparison, Bitcoin mining utilise resources in the form of high electricity to produce a non-physical commodity, an invisible or virtual-existing commodity. The use of high electricity is due to the number of high advanced computers involved.
At any point in time, many people compete against one another to be the first to solve the equation. Only one person who successfully solves one of these complex equations is rewarded with some bitcoins. Because of this, a number of people prefer to participate in groups in order to be faster at solving the equations. Once an equation or puzzle is solved, another equation is introduced and the cycle continues.
When Bitcoin started in 2009, 50 coins were rewarded to anyone who successfully solved an equation. This number kept decreasing after every four years. In every four years, the rewards reduce by half. The first halving is known to have taken place in November 2012 when the reward decreased from the initial 50 coins to 25 coins.
Definitely, solving complex maths equations is not for ordinary individuals. Thus, the most practical means to acquire the currency is to trade goods, services and other currencies for it.
Trading with Bitcoin currency
Bitcoin was mainly introduced as a medium form of exchange. A few companies have already shown interest in it. Notable of them is PayPal which announced in September 2014 to consider accepting it as payment. Although the number of trading companies adopting the cryptocurrency keeps increasing, it could also be that some organisations are only giving it a try. This is because a number of companies have revealed that they added bitcoin payment option just because their clients were interested. In business, you sometimes introduce products or services which are not in your interest but keenly requested by clients. Unfortunately other companies are not accepting the digital currency due to its high volatility and lack of backing from governments.
Even though it is becoming more popular in trading activities, Bitcoin may still not be considered as a legal tender. This is because it is a virtual currency with no official backing from a central bank. As a reference, a virtual currency refers to digital money which is introduced by any individual or group and recognised to be used by members of a particular virtual community. Bitcoin is accepted and used by members in the currency’s virtual community- A community of people who trust and approve of the cryptocurrency. Outside this community, Bitcoin cannot be accepted. A shop owner who does not approve of it would definitely not sell his products to a buyer wishing to pay in bitcoin.
Investing in Bitcoin
Originally, bitcoin was not introduced as an alternate valuable investment, but rather as a currency exchange medium. It was mainly created to help reduce currency transaction fees, keep third parties and regulatory bodies out and make transactions anonymous. However, the purchase of bitcoin as an investment product has become more popular these days due to the continuous hype in its value. In fact, the price of Bitcoin has increased from $979.53 recorded at the beginning of the year to as high as $14,095.61 on 6th December 2017. This alone reflects a percentage increment of 1339%.
Bitcoin supporters argue on the analogy between the digital currency and gold. Their comparison is based on the premises that it cannot be easily produced just like gold. Besides, it is mined by digital means similar to how Gold is mined from the ground. Furthermore, the total quantity of Bitcoin has been programmed to peak at 21 million coins, after which no more of it can be produced. As of 30th November 2017, the number of bitcoin in circulation had been estimated at 16.7 million. Thus, the remaining amount yet to be mined is 4.3 million. This is similar to the analogy that only a finite amount of gold exists on the planet.
While the above assumptions may be true, we should also not ignore certain key characteristics of gold. When you buy gold, you have access to a physical commodity- Something you can see, feel or handle. I’m not sure the same can be said of Bitcoin? Purchasing Bitcoin gives you access to some sort of a digital commodity- Something you believe it exists but cannot physically see or feel, something that can be lost in the digital space should any cyber disaster occurs.
Cautions from experts on Bitcoin
Bitcoin has managed to survive upon all attacks it has received from some notable and public figures. Some have even referred to it as a “Ponzi scheme” in the past. Unfortunately, the current escalating trend in Bitcoin value has resurfaced more of such criticisms. A typical example is from Warren Buffett, who argues:
Unlike tangible investments such as company stocks, cryptocurrencies do not generate revenue or dividends. This makes valuation very difficult. Even though it keeps becoming popular in price appreciation, Bitcoin’s price seems to be depending much on speculation hype by its followers.
The CEO of JP Morgan (United States biggest bank), Jamie Dimon, has referred to Bitcoin as a fraud that will eventually blow up. He had even warned that he would immediately dismiss any of his employees known to be trading in the cryptocurrency.
Another key person who has added his voice is Robert Shiller, a Nobel Prize winner and economics professor at Yales University. In his comments, he expressed concern that Bitcoin network cannot be sustainable.
“It seems to me that the enthusiasm for bitcoin is a little bit out of proportion to its immediate application…I don’t know… maybe it’s possible that you can still ride this bubble on bitcoin. But I keep thinking there’ll be other currencies, other ideas [that] will come up and will eclipse this one. So it’s risky.” ( Robert Shiller)
The future of Bitcoin currency
The future of Bitcoin remains uncertain considering various potential factors such as government intervention, cyber security, competition from other cryptocurrencies and many more.
Intervention by regulatory authorities
Bitcoin may need official approval and backing from regulatory authorities in order to survive. We live in a world ‘controlled’ by governments and regulatory bodies. Unfortunately, this is something that cannot be changed- At least, not for now. Introducing a currency to run parallel or compete with currencies produced by these bodies cannot be so simple. As a rival to paper currencies (controlled by governments), bitcoin seems to compete and reduce the power of regulatory bodies.
Moreover, currencies need to be legal tender before they can be universally accepted. As argued before, Bitcoin is still not considered as a legal tender. As such, its future may not be secure considering the fact that it can be cracked down by some governments. Even though there has been no major government intervention in the operation of cryptocurrencies, recent developments indicate greater possibility of interference.
For instance, on 30th November 2017, businessinsider reported that the US Press secretary, Sarah Huckabee Sanders, had given a hint of the White House monitoring cryptocurrencies. As to whether the intention for monitoring is for good or not, no one can tell for now.
Again, businessinsider recently reported on a court case demanding Coinbase (one of the biggest cryptocurrency exchanges) to release transactional information of its clients to the internal revenue service.
There has also been a recent report by The Telegraph regarding a crackdown on Bitcoin in the United Kingdom over concerns of money laundering and tax evasion. According to the report, the United Kingdom plans to regulate Bitcoin and other cryptocurrencies by compelling users to reveal their identities. The use of bitcoin in money laundering, tax evasion and other illegal activities still pose a concern for many regulators.
It is very possible that actions like these from the regulatory authorities can have a negative impact on the massive popularity enjoyed by the currency. This is because any interference of a third party may contradict the anonymity feature of bitcoin transactions? As stated by its innovator in the currency’s white paper,
“The main benefits are lost if a trusted third party is still required…”
Cyber security threats
No matter how secure Bitcoin network is, it cannot be immune to attack. After all, the inventor ‘himself’ had acknowledged this possibility in his white paper.
“As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they’ll generate the longest chain and outpace attackers.”
Bitcoin does not exist in physical form. If you own bitcoins, what you actually control is a personal secret digital key which you can use to prove to anyone on the network that a certain amount of bitcoins belongs to you. Unlike passwords that can be changed or reset, bitcoin’s secret digital key can never be reset in case an owner loses it. Thus, any person that gets access to your key would have absolute control of your money. The worst is that any transaction made by the one who steals your key cannot be reversed.
In the short 8-year history of Bitcoin, a series of major thefts amounting to millions of US Dollars have occurred. One famous hacking incident occurred in 2014 at Mt. Gox, which used to be one of the world’s biggest Bitcoin exchange in Japan. The hacking resulted in the loss of 850, 000 bitcoins equivalent to over $30 million at the time and the subsequent collapse of the company.
Also in August 2016, about 120,000 bitcoins valued at $78 million were stolen from users’ accounts in a Hong Kong-based cryptocurrency exchange, Bitfinex. The news about this theft alone caused a sudden drop of 20% of Bitcoin’s value.
Moreover, another hacking took place on 6th December 2017 at NiceHash, a mining market for the cryptocurrency. The hacking incident is reported to have caused a loss of its entire 4,736 bitcoins valued at $62 million.
I agree that we occasionally experience thefts in our traditional currency system too. However, unlike Bitcoin, the presence of regulatory authorities in the traditional currency system can at least provide some confidence. As it stands now, there is no insurance cover on bitcoin dealings. Besides, bitcoin transactions are not reversible. Thus, once a hacker gets access to your account and steals your money, it would be final. In comparison, traditional bank accounts such as savings accounts are normally protected by government institutions up to certain deposit limits.
Bitcoin network provides viable ground for cybercrimes, internet fraudsters and other criminal activities. This is not surprising as criminals prefer platforms that keep their identities secret. Somewhere in May this year, a serious ransomware attack, nicknamed ‘wannaCry’, spread across the globe. The perpetrators behind the attack locked several computers with malicious software and demanded from each of their victims, a ransom payment in bitcoins equivalent to $300. Imagine the millions or billions made by these cyber criminals.
Competition from other cryptocurrencies
There have been series of peer-to-peer digital currencies being developed by individuals to compete with Bitcoin. A typical example is Litecoin, which is noted as the closest competitor to Bitcoin. Besides Litecoin, other less-popular ones include Namecoin, Swiftcoin, Peercoin, Primecoin and many more. One thing to note is that some of these competing cryptocurrencies are created by miners who break away from the Bitcoin network. For instance, Bitcoin Cash was split from the parent network in August 2017. Numerous breakaways from the network may lead to confusion. This is because while some market exchanges recognise these break-away currencies, others refuse to support.
Bitcoin has so far been on a ‘successful’ journey in terms of price appreciation. However, it seems to be among the most risky investments due to various warning signals. With the continuous skyrocketing of its price, the possibility of a freefall can also not be ruled out. Just like the saying goes, “what goes up must come down”. The digital currency is definitely not for risk-averse investors but for adventurous and daring ones. As long as regulatory authorities keep staying out of the cryptocurrency business, these adventurers can continue to make fortunes.
Now, if you ask me on whether I would consider Bitcoin in my investment portfolio, my short answer will be “Not for now”. As someone who prefers holding investments for long term, it would be in my interest to choose investment products with future certainty. Bitcoin may rather be suitable for individuals willing to take as much risk as possible. At best, it may be appropriate for people who can bet on their money just like an online gambling- They either win or lose big.
Bitcoin has been thriving on popularity to grow. Nonetheless, its future cannot be guaranteed. Those having strong faith in it stand a chance of making fortunes if the cryptocurrency continue to develop and become universally acceptable. On the other hand, the majority with no faith in it would be losing the opportunity to these fortunes.
It is like having faith in an unknown [future] world after death, like the many religious followers working so hard on their salvation, hoping that someday they would be rewarded with ‘paradise’. If the existence of paradise is real, the religious followers who satisfied some prescribed conditions would definitely be rewarded in the distant future. However, the unbelievers who do nothing would lose such a reward.