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.
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 (bitcoin.org) 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 Bitcoin.org 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. wealthwithin.com.au