My next few posts will take a look at the world from a longer-term perspective and discuss some potential investment themes that I think provide interesting opportunities. This first post will discuss Bitcoin, the very confusing and often misunderstood cryptocurrency.
I’ve loosely followed bitcoin for the past 2 years but just started doing some in-depth research on it over the last month. It was actually the combination of some global macro risks and the price chart of bitcoin that sparked my interest. I’ve been thinking a lot about Central Banks, negative interest rates, currency pegs/devaluations, etc. and Bitcoin is one of the assets that came to mind that could benefit. Bitcoin has also undergone a few mini bubbles over the past few years, with the most recent occurring in 2013 when the price ran from $75 in July to a high of $1163 in November. The breakout level was in the $150 to $200 range. Typically, when a market makes a runaway move, it will retrace the bulk of that move back to the level it broke-out from – in this case, the $200 range. Bitcoin has now retraced over the past year all the way back down to this level, making a low last month at $152 and quickly bouncing back to above $200.
Bitcoin – 2 years (weekly)
I personally decided to buy some bitcoins for a few reasons (one simple one being the risk/reward at this price, based on the chart alone) that I’ll discuss here as well as my view and opinion of the whole thing – and try to keep it somewhat simple to follow. Please note: there’s no way to “invest” in bitcoin in a portfolio yet, although there are some investment trusts currently in the works, so this is not something I’m buying for clients.
I’ve had 3 primary concerns regarding Bitcoin to this point:
- Exchanges going bankrupt (and not being insured)
- Hackers “stealing” bitcoins, and
- Potential government interference in the form of regulations or simply banning the use
Fortunately, as Bitcoin evolves, we’re now at the point that I feel comfortable enough that the above points are no longer an issue. Any, or all, are still possible, but I feel the chances are relatively low if you setup correctly and therefore worth the risk.
After Mt Gox, which used to be the largest bitcoin exchange by volume, went bust about a year ago, the remaining exchanges made security and insurance their #1 priority. The top ones are now using security protocols that I consider safer than online banking. They’re also insured against theft for any bitcoins they actually custody for you (more on this later). In terms of governments, there’s still a lot of confusion/disagreement over what Bitcoin actually is and how governments should regulate it but we’ve seen a lot of progress made over the last year. The UK and Singapore are trying to take the lead in incorporating Bitcoin into the system, and in the US, New York and California seem to be spearheading the process. Make no mistake about it, the government wants a fully electronic monetary system so they can track and tax every dollar. A lot of taxes are avoided through “under the table” cash payments so I don’t think governments are as opposed to Bitcoin as some people might think. They just want to make sure they can control it (regulations) and more importantly, tax it.
I think most people misunderstand what Bitcoin actually is and the potential it holds to change the financial system. I’m sure you’ve seen articles or interviews of entrepreneurs saying that Bitcoin is the greatest innovation since the internet and has the potential to disrupt the financial industry. They’re not exaggerating. Bitcoin is not just a cryptocurrency that you convert your money into and then use it to buy things. The value in Bitcoin is the structure and design of the entire ecosystem.
The Overview
Bitcoin is known as a cryptocurrency. It’s online and digitally-based. I know a lot of people fear things that are digital because it’s not “real” and they can’t actually hold it. The truth is that our current financial system is digitally-based right now. Your bank isn’t actually holding cash in the vault equal to the amount in your checking or savings account. And if you make a payment or transfer money, they don’t actually move physical cash. It’s all digital bookkeeping which says you have a certain balance. The total money supply is a large multiple of the actual amount of physical currency in circulation. As technology pushes us deeper into the digital world, I think people will become more comfortable with the thought of digital currencies.
So where do bitcoins come from? Bitcoins are created through a process called “mining” which is basically just computers doing complex math and verifying each bitcoin transaction. These transactions are logged in something called the block chain – a public ledger of every transaction that has ever occurred using a bitcoin. Maintaining and creating the block chain takes time and energy, so the people working on it (anyone can work on it) are rewarded with a payment of 25 new bitcoins every time they complete a block. However, in order to make the system efficient, everyone is competing to complete the same block at the same time. Whoever does it the quickest and finalizes the block is awarded the payment. Once it’s finalized onto the end of the block chain, everyone starts working on the next block. Mining becomes harder over time so the rate at which new bitcoins are created slows (similar to rate at which the supply of a commodity, like gold, increases).
The concept of the block chain is one of the most powerful aspects of Bitcoin. By having a public ledger which is verified, no one can ever go back and change it without everyone else knowing someone tampered with it. This is pivotal in a peer-to-peer system and creates a “trustless” system where the need of a middleman is eliminated. In our current financial system, banks, credit card companies, payment processing companies, custodians, etc. handle this “middleman” function. They act as the trusted entity which processes, records and verifies every transaction. By eliminating the need for this “trusted” middleman, you eliminate all of their associated fees and cut down on the amount of time it takes for the movement of money to “settle.” Think about how many ridiculous fees your bank charges you – or the international charges if you use your credit card overseas – or the processing fee credit card companies charge stores each time you use your credit card to buy something. It all adds up to a lot of money that could be saved and used for more productive means. The block chain protocol is an extremely efficient process that will transform many aspects of how money (or anything of value, like the title or deed to property) is handled moving forward.
Bitcoin is also a decentralized system that cannot be manipulated. As a currency, there are a finite number of bitcoins that can ever be created – meaning governments can’t just turn on the printing presses and erode away the value through inflation. In this sense, bitcoins are similar to gold in that they can act as a store of value. The major difference is that bitcoins have utility value because you can actually use them in everyday life to pay for things (over 37,000 companies around the world now accept bitcoin as a means of payment). There can only be 21 million bitcoins ever in existence, and there are currently just shy of 14 million in circulation. At a price of approximately $240 per bitcoin as of this writing, it has a market cap of about $3.4 billion – which is relatively very small!
When you purchase bitcoins through an online exchange, you store them in an online wallet or vault. Wallets are used for everyday transactions and vaults are used for longer-term storage. Every wallet has keys associated with it instead of your personal details, allowing for anonymity and protection of your private information. There is a public key which is recorded on the block chain and a private key which is encrypted and used to “sign,” or verify, a transaction and prevents the transaction from being altered by someone else. If someone gets your private key, they can access your bitcoins and do whatever they want with them. Most problems over the past few years of bitcoins being stolen involved the owner trusting the bitcoin exchange to keep their bitcoins and private key secure. Once the exchange was hacked, the hackers could access the various bitcoin wallets and steal the bitcoins. In order to alleviate this problem, most exchanges and people are now storing private keys offline. If you really want to be safe, you can take responsibility of the safety into your own hands and print off your private key and keep the paper somewhere safe so the key is not stored online or on your computer. Regardless, you just want to make sure it’s safe and backed-up somehow in case your primary means of storing the key are lost.
One final aspect is that bitcoins can be accepted anywhere in the world. As long as the person or business also uses Bitcoin, you can transfer/pay for something instantly. No currencies to convert, no fees to pay, and no days of waiting for things to process and settle.
Summary of the main benefits:
- Decentralized System (appeals to Libertarians)
- Stored in digital wallets and vaults that have public keys (recorded on the block chain) and private keys used to sign transactions
- Public Ledger called the block chain (this protocol will transform the way the financial industry functions)
- No “Trusted” Middleman
- Extremely Efficient (time and money saved)
- Irreversible Transactions
- Global Acceptance
I’m growing increasingly concerned that we will see some major problems in China as early as this year. The risk that they devalue the yuan is growing and I’m looking at Bitcoin as one hedge against what would be a major global economic risk. I’m viewing it like a call option without an expiration date. Risk a little to potentially make a lot.
I don’t think Bitcoin will ever replace a currency, nor will the world transition to a one-world currency like Bitcoin. Instead, I see it living in conjunction and allowing business to occur in a much more efficient manner. I believe Bitcoin will benefit over time as people become more comfortable with the concept, which should naturally occur as new companies come out with various ways (apps) that make it easier to use and incorporate in everyday life. In 2014 alone, there was over $300 million of new venture capital funding. Lastly, I’m sure Bitcoin will evolve over time and there’s no way to know the ultimate outcome. But I do believe the block chain protocol will be very disruptive to the current financial industry, creating the real possibility that the price per bitcoin moves a lot higher.
Please Note – This post is not a recommendation for you to go out and buy bitcoins. Please do your own research and make sure you understand the associated risks.
Stay tuned! The next few posts will cover some other major themes that are changing the world. Thanks for following!
-Nick