Bitcoin is probably one of the most talked about financial instruments/ideas/investments in the last few years. Why? Simply put – it’s price seems to be rocketing up and creating millionaires in days. Of course, those in the financial world understand that nothing can be that good, and so Bitcoin has also been met with some pushback by big institutions, fund managers, and big name investors. So… what is it?
Bitcoin is what is known as a cryptocurrency. The idea behind a cryptocurrency is that it cuts out the middle man – the banks, the governments, the credit card companies – when people transfer wealth to each other. While this is a doomsday kind of view, it is easy enough to understand.
Consider this; you go to an ATM and deposit a $10 note into your bank account. The ATM then spits out a receipt saying that you have deposited only $9. Since that receipt is the only evidence you have of your deposit, you have no way of disputing this.
The idea of Bitcoin is to remove the need for that deposit. You would be able to hold all your money for yourself, and instead of using a bank to transfer money between people, we would simply do it directly.
The way that Bitcoin does this is by using a ledger system called a block chain. In essence, this is a ledger recording all of the transactions taking place. This ledger is held publicly, so everybody can see it. The trick is that there is a huge amount of cryptography that goes into making entries to this ledger, meaning that it is extremely difficult to change.
In order to run this cryptography, Bitcoin relies on its users to verify transactions. In exchange for doing this work, they are rewarded with Bitcoin.
Does anybody actually use bitcoin?
A central feature of Bitcoin is that it is untraceable and anonymous. Obviously, this makes it attractive for people making unlawful transactions. Drug dealers, weapons dealers and people like that. Bitcoin would also be attractive for money launderers.
However, there are places that accept Bitcoin that are involved in legal transactions. For example, Microsoft does accept Bitcoin as a payment, and there are geek coffee shops who accept Bitcoin as the only payment.
What about Bitcoin as an investment?
I will start this section by saying that I am not a financial advisor in any capacity – and so none of what I say should be taken to constitute financial or investment advice.
Bitcoin is very illiquid – with several Australian banks occasionally suspending transactions into Bitcoin. Its price is also very volatile. As an investment, it fits into the same kind of space as penny stocks. You can make money, sure, but unless you are extremely good at what you are doing, your profitability will not last forever.
My view on Bitcoin is that you can invest in it with extra money you have lying around. However, it should be considered very separate to your portfolio. Money should not be invested in Bitcoin instead of something else. Money that is invested in Bitcoin should be viewed as money spent – a sunk cost. Therefore, you should view Bitcoin as something you buy – not something you invest in.
How do we value bitcoin?
Much like a normal currency, the value of Bitcoin is almost arbitrary. It is not pegged to anything and cannot be valued implicitly. One of the ways we can value Bitcoin is simply a market price. At this early stage, that is what is happening.
However, as Bitcoin matures, there will have to be some more material value for Bitcoin. One idea I have is some kind of value based on the cost of electricity that is required to complete the cryptography process. This is not perfect, as doing the work in cryptography is rewarded with Bitcoin, thereby lowering the cost of doing it. Additionally, it would remove any incentive for improvements to the Blockchain technology, as the slower the process, the more expensive it would be to ‘mine’ Bitcoins, and therefore the higher the value of the Bitcoin.
In my opinion, our world is a long, long way from seeing Bitcoin as anything other than a fun investment. I doubt that we will transition to using Bitcoin as a currency within our lifetimes. Perhaps at some point many decades into the future, some kind of cryptocurrency may become legal tender, but we are a very long way from that point.
Happy investing, researching, and studying!