"Bitcoin Surges to Record Levels," "Bitcoin More than Doubled This Year," "Bitcoin Plummets, Loosing $4 Billion of Market Capitalization," "Cyber Fraud Attackers Demand Payment in Bitcoin." These attention-grabbing headlines are typical of the recent media buzz related to this cyber-currency. What is Bitcoin, and why has it garnered so much attention in the investment world? Who will benefit? Will this be trouble for the banks, Visa, Mastercard and Paypal?
Let's start with some definitions, which we obtained from a white paper entitled "Bitcoin - A Primer for Policy Makers", by Jerry Brito and Andrea Castillo of the Mercatus Center at George Mason University:
"Bitcoin is an open-source, peer-to-peer digital currency" that relies on "the world's first completely decentralized digital-payments system. Until Bitcoin's invention in 2008 by the unidentified programmer known as Satoshi Nakamoto, online transactions always required a trusted third-party intermediary," like Visa/MasterCard or PayPal. Rather than relying on that third party, "every transaction that occurs in the Bitcoin economy is registered in a public, distributed ledger, which is called the block chain. New transactions are checked against the block chain to ensure that the same Bitcoins haven't been previously spent, thus eliminating the double-spending problem. The global peer-to-peer network, composed of thousands of users, takes the place of an intermediary." So, the term Bitcoin is used to refer to both the virtual currency as well as the decentralized payments network, and "the dollar value of a Bitcoin is determined on an open market, just as is the exchange rate between different world currencies."
This new virtual currency has caught on: a $100 investment in Bitcoin in 2010 would now be worth over $75 million!
Today's global currencies have evolved. Prior to 1971, the dollar was backed by a physical commodity - gold. In other words, you could theoretically take your dollars to the government and ask for gold in exchange. But in 1971, President Richard Nixon announced that the dollar would no longer be backed by gold, but rather by the full faith and credit of the federal government. In other words, "going off the gold standard" meant that the dollar was now a "fiat currency", backed solely by a promise from the government.
The move away from the gold standard reflected a desire to better control the supply of money, especially in times of economic uncertainty. An article on the Motley Fool website by Jason Hall ("Fiat Currency: What It Is and Why It's Better Than a Gold Standard") has this to say about an effective currency: "People need to be able to count on its value, and that value needs to be stable over time." Gold, while acting as a reasonably reliable store of value in normal economic times, did not provide the desired stability during times of financial crisis and economic upheaval. In fact, gold's tendency to appreciate during financial crises (as a result of hoarding) had the effect of restricting the money supply and thereby tightening financial conditions at a time when the opposite was needed. "By severing the link between gold reserves and currency," Hall explained, "the Federal Reserve is better able to combat major economic shocks to the economy."
Advocates of fiat currencies argue that the Fed's ability to print trillions of dollars ("Quantitative Easing") in response to the financial crisis was the only thing that prevented an even greater economic catastrophe on the scale of the Great Depression (or worse). On the other hand, advocates of a commodity standard (like the gold standard) would argue that the Fed's Quantitative Easing is dangerous as it will cause a surge in the money supply and will eventually lead to very high rates of inflation. Only by backing the currency with a scarce commodity like gold, they say, will policymakers be prevented from taking action that will devalue the currency. We suspect there is some truth in both.
In Bitcoin, we now seem to have a new form of currency that rivals fiat money as we move full speed into the age of technology. Unlike its predecessor currencies, it is not backed by a physical commodity (gold) or any government or bank. It transcends borders and allows for complete anonymity. Transactions are cheap to execute and it is quickly and easily transferred around the world. Bitcoins do not depreciate as a result of government budget deficits, and banks can't use your Bitcoins to make risky investments. Who needs a Swiss bank account? Or any bank account? What's not to like?
For starters, the value of Bitcoins has been extremely volatile. At $2,288, the value has increased exponentially in recent years - and it could go back down just as easily. Due to its anonymity, some people have been using Bitcoin to execute illegal transactions. Facebook founder Mark Zuckerberg believes that the surge in Bitcoin has been driven by the illegal narcotics trade. The recent "Wannacry" computer attack demanded ransom payment in Bitcoin.
While I don't have a firm opinion on Bitcoin as an alternative currency, I do have more conviction on Bitcoin as an investment: it is not an investment. It is speculation. But, that doesn't mean it won't continue to gain in popularity and broader use. Japan has legalized crypto-currencies. Other countries will likely follow.
Beyond the many illegal uses for an anonymous currency, there are other risks: hacking, no way to insure holdings (think FDIC), viruses, accidental deletion of accounts, and usual, other cyber-vulnerabilities.
As investors, we look to threats to the companies we hold or may consider as well as opportunities to invest in companies that may benefit. Earlier we mentioned the credit card companies and PayPal. PayPal emerged as a way to pay for online purchases by authorizing online transfers of money without having to disclose credit information online. It is now a stand-alone, publicly traded company with a market capitalization of almost $63 billion. Paypal links user accounts to their bank accounts or credit cards and doesn't undermine or erode banking or credit card businesses. Perhaps the banks will find ways to embrace cyber-currencies by linking those balances to credit cards or other borrowing and lending activities. Time will tell.
The internet has forever changed the world, and it continues to change and transform our lives. Cell phones have many times the computing speed and capacity provided by the enormous computers with reel-to-reel tapes of the 1960s. Bitcoin may prove to be the new monetary paradigm, but the bet is large and the risk enormous. If you want to gamble, go to a casino where they will at least give you a free drink! We will continue to monitor this new currency and the possible effects on our portfolio.