The rise and rise of bit­coin and why you should avoid it like the plague

Some technophiles and in­vestors are tour­ing Bit­coin as be­ing a revo­lu­tion in cur­rency and the way the world trans­acts, how­ever we must be cau­tious when con­sid­er­ing Bit­coin as an in­vest­ment writes Blake Ster­ling.

Business First - - CONTENTS - by Blake Ster­ling

In 2010, James How­ells, an IT con­sul­tant from the UK qui­etly sat at his com­puter work­ing whilst si­mul­ta­ne­ously en­joy­ing his favourite cold bev­er­age – a can of le­mon­ade. We all know that liq­uid and PCs don’t mix and af­ter an un­for­tu­nate fum­ble, James could only watch on in hor­ror as most of the re­main­ing con­tents of the can seeped into his now se­verely dam­aged PC.

Frus­trat­ingly, the PC was toast. James’ next steps were to pull ‘old faith­ful’ apart, plac­ing the hard drive into an al­ready over­flow­ing com­puter spare part drawer and sell the re­main­ing us­able parts on­line. Fast for­ward two years and whilst the PC in­ci­dent had long been for­got­ten, James’ pile of spare com­puter parts had quickly grown. Fed up with trip­ping over the oc­ca­sional key­board and los­ing pre­cious space to James’ hoard, his wife or­dered an im­me­di­ate clean out to rid them of all the spare parts that weren’t needed. With these de­mands, James be­grudg­ingly be­gan the la­bo­ri­ous task of throw­ing away most of his PC stash in­clud­ing the dusty hard drive from his old, le­mon­ade soaked PC.

James told re­porters in Novem­ber 2013 that he did have sec­ond thoughts about throw­ing the hard drive away, just be­fore he placed it into his bin and saw it for the last time. How­ever lamented he had no idea that the 7,500 bit­coins, worth ap­prox­i­mately AUD $8 mil­lion, held on the hard drive, would ever be val­ued at more than the 20 pounds he spent to buy them.

When sur­pris­ingly ques­tioned on why he wasn’t down at the lo­cal tip, madly search­ing for what could only be de­scribed as a nee­dle in a haystack James replied “Why aren’t I out there with a shovel now? Well, I think I’m just re­signed to never be­ing able to find it.”

Wel­come to the world of Bit­coin, a crypto-cur­rency and the first of its kind to use highly com­plex math­e­mat- ical al­go­rithms to con­trol its cre­ation and trans­ac­tions. A visit to the Bit­coin web­site (bit­ pro­vides more de­tail on what Bit­coin ac­tu­ally is. Here’s a para­graph from the FAQ page on the web­site:

“Bit­coin is a con­sen­sus net­work that en­ables a new pay­ment sys­tem and a com­pletely dig­i­tal money. It is the first de­cen­tralised peer-to-peer pay­ment net­work that is pow­ered by its users with no cen­tral author­ity or mid­dle­men. From a user per­spec­tive, Bit­coin is pretty much like cash for the In­ter­net. Bit­coin can also be seen as the most prom­i­nent triple en­try book­keep­ing sys­tem in ex­is­tence.”

Con­fus­ing? Yes. But as the para­graph sug­gests, the best way to think about Bit­coin is ‘….like cash for the in­ter­net.’ Bit­coin is seen as the ‘ bad boy’ of the cur­rency world. An un­der­ground, vir­tual cur­rency that is nei­ther owned nor con­trolled by Govern­ment or of­fi­cial agency.

This lack of reg­u­la­tion could also be pointed out as a ma­jor weak­ness. In re­cent months, sev­eral high pro­file Bit­coin ‘ex­changes’ have ei­ther filed for bankruptcy or closed with­out warn­ing amid hack­ing and theft scan­dals. Funds have been frozen and those hold­ing Bit­coins with such ex­changes have lit­er­ally lost their hold­ings overnight. Ja­panese com­pany Mt. Gox, once con­sid­ered the world’s dom­i­nant Bit­coin ex­change filed for bankruptcy in late Fe­bru­ary fol­low­ing a large scale hack­ing theft of 850,000 bit­coins – worth more than AUD $600 mil­lion at the time of writ­ing. The com­pany’s web­site is no longer ac­tive and sev­eral ‘Bit­coin traders’ have launched law­suits against the com­pany in the hope they can re­trieve their money.

The story be­hind the rise and fall and then rise again of Bit­coin is an in­ter­est­ing one. A de­vel­oper by the name of Satoshi Nakamoto is cred­ited as the fore­fa­ther of the vir­tual cur­rency, work­ing on the con­cept in 2007. Mys­tery how­ever sur­rounds Mr. Nakamoto as he has never pub­licly re­vealed him­self and many be­lieve the name Satoshi Nakamoto is sim­ply a col­lec­tive pseu­do­nym for more than one per­son.

By 2008 a patent for Bit­coin had been ap­proved, the Bit­ web­site was cre­ated and a white paper dis­trib­uted on­line, by the mys­te­ri­ous Nakamoto char­ac­ter, tout­ing the ben­e­fits of the vir­tual cur­rency. Cited ben­e­fits in­clude the lack of ma­nip­u­la­tion of Gov­ern- ments and fi­nan­cial in­sti­tu­tions and that trans­ac­tions take place be­tween two par­ties with­out a mid­dle­man i.e. Bank act­ing as a con­duit to a trans­ac­tion. Im­por­tantly the white paper re­veals that a max­i­mum of 21 mil­lion Bit­coin will be cre­ated across a time frame end­ing in 2040.

In 2010, the first Bit­coin ex­change is born – Bit­coin Mar­ket and the vir­tual cur­rency is trad­ing at un­der USD $1.00. By Novem­ber 2013, Bit­coin is trad­ing over $1000. In De­cem­ber that same year, fol­low­ing a num­ber of high pro­file Bit­coin thefts and China’s Cen­tral Bank de­ci­sion to ban Bit­coin trans­ac­tions, the vir­tual cur­rency plunges to just above $500.

The cur­rency cer­tainly has had a wild ride over the last few years. Ex­treme price vo­latil­ity is ob­vi­ously a large com­po­nent of its re­cent pop­u­lar­ity and large for­tunes have been made and lost within days (just ask James How­ells). So the ques­tion begs - should you even bother trad­ing Bit­coin?

Bit­coin is es­sen­tially a com­mod­ity, ex­ud­ing char­ac­ter­is­tics much like Gold. The al­go­rithms be­hind the vir­tual cur­rency mean there will only ever be a max­i­mum of 21 mil­lion ‘coins’ in circulation and be­ing a limited re­source means it is im­mune to the ef­fects of in­fla­tion. In ad­di­tion Bit­coins have no fun­da­men­tal or in­trin­sic value as the cur­rency does not pro­vide an in­come. There­fore, value is de­rived purely from the ex­pec­ta­tions of what the Bit­coin com­mu­nity is will­ing to pay at a spe­cific point in time.

Whilst at face value this is not a bad thing. All com­mod­ity traders are only ever con­cerned with price di­rec­tion and hop­ing they’re on the right side of a trend, the key downside to Bit­coin is the risk in­her­ent with the vir­tual cur­rency. As a trader, a sig­nif­i­cant part of my suc­cess is re­liant on the man­age­ment of risk and by the nat­u­ral law of this process, min­imis­ing my risk at all times where pos­si­ble. Bit­coin on the other hand is sub­ject to a risk fac­tor that other pub­licly traded mar­kets and prod­ucts have no con­cern – theft. Hack­ers are re­spon­si­ble for steal­ing mil­lions of dol­lars worth of Bit­coin with lit­tle or no re­course on the side of the owner.

A sec­ondary is­sue for Bit­coin is liq­uid­ity. With­out a sat­is­fac­tory mar­ket size, the vir­tual cur­rency will not only re­main highly volatile but trad­ing will be the pur­suit of a limited num­ber of in­di­vid­u­als.

Then there is also the ques­tion around tech­nol­ogy. Sys­tems cur­rently in place for the trad­ing and use of Bit­coin are ob­vi­ously not up to scratch and highly sus­cep­ti­ble to theft and other il­le­gal ac­tiv­ity as demon­strated by cases such as Mt. Gox in Ja­pan.

Whilst these risks re­main and with­out proper reg­u­la­tion, most traders and in­vestors will likely pass on Bit­coin (my­self in­cluded) and I en­cour­age you to do the same.

Blake Ster­ling is an an­a­lyst with Wealth Within. wealth­

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