Many of you have probably heard of Bitcoin, a peer-to-peer payment system and digital currency that was introduced 5 years ago and gained tremendous popularity over the past year. Today we’ll discuss the relevance of Bitcoins and answer some of the questions we’ve been asked about it. This is not an investment recommendation: we are not suggesting that you purchase Bitcoins or transact in the currency.
What is Bitcoin?
It makes sense that the first “digital” currency has its share of skeptics. We, too, are skeptical about the future viability of the currency and the risks to holders of Bitcoins. The anonymity allowed by Bitcoin intermediaries reportedly made the currency popular in illegal transactions such as drugs and online gambling, which hasn’t helped its reputation and has also brought about regulatory intervention. At the same time, even as regulatory pressures increase, there are still plenty of major companies, including Overstock.com, the NBA’s Sacramento Kings and Zynga, that accept Bitcoins as a method of payment.
As of November 2013 there were more than 35,000 Bitcoin-accepting merchants online as well as 1,000 “brick and mortar” businesses willing to take them. As of this writing, the value of 1 Bitcoin (BTC) is approximately $558. Click here to see the historical USD/BTC conversion rate (value of 1 Bitcoin in US dollars).
Bitcoins as a “real” currency
Clearly Bitcoins are a different animal from most universally-accepted currencies, but there are also a number of similarities that may allow Bitcoin to become a “real” (and more widely accepted) currency. Like the US dollar, whose supply is regulated by the Federal Reserve, the growth and creation of Bitcoins is regulated by the Bitcoin protocol, which has similarities to a “central bank.” There are over twelve million Bitcoins in circulation with an approximate creation rate of 25 more every 10 minutes. These new issues are created, or “mined,” from transactions that award payment processors with newly issued Bitcoins that are added to the “block chain.” The Bitcoin money supply is kept in check, in part to monitor and prevent excessive inflation. Not surprisingly, this is also a mandate of the Federal Reserve.
The total supply of Bitcoins will be capped at 21 million, and every few years or so the creation rate will be halved, meaning that new Bitcoins will continue to be created for more than a hundred years (if they still exist that far into the future). While online wallets are the more popular method for storing and transacting in the currency, owners of Bitcoins can turn their online currency into physical bills and coins.
Why Bitcoins may not become a “real” currency
It’s undeniable that Bitcoins are a currency. If you can purchase Bitcoins using US dollars or other widely accepted currencies (which you can), and you can purchase goods and services using Bitcoins (which you also can), then technically it is a currency. But this by itself isn’t enough to solidify Bitcoins as a viable currency, and investors are not going to hold Bitcoins if they don’t think of it as a real, stable currency like the US dollar or the Euro. If major corporations and financial institutions have concerns about their exposure to the Turkish Lira and other emerging market currencies, they will not even think of holding Bitcoins. This fact alone may be enough to exclude Bitcoins from long-term viability, at least for anything more than transactions between consumers and small businesses.
Investors are hesitant to hold risky currencies, and Bitcoins will continue to be considered risky for years to come. Take the “Fragile Five” for example—the name given to Indonesia, South Africa, Brazil, India and Turkey owing to mounting pressures on their currencies in 2013. If even these well-established currencies that serve in nearly every transaction done in these countries can be suffer massive selloffs when investors start to worry, then certainly Bitcoins can as well. Thus it seems safe to say that if the currencies of the Fragile Five countries (with $trillions in reserves) are being sold off, then even a small regulatory hurdle, asset price bubble or other hiccup could send Bitcoins into a tailspin that would leave them nearly worthless.
Is there any reason to own Bitcoins or transact in them?
We’ve established that Bitcoins are legitimate enough to buy NBA basketball tickets or Overstock.com items, but this does not mean they’re a smart place to put your money. Don’t fall into the trap of believing that Bitcoins would serve as a stabilizing force in case of a US dollar crisis, inflationary or otherwise. Speculation that Bitcoins would be a “safe haven” in the event of a financial disaster is at best premature and probably completely unrealistic.
We said above that we aren’t recommending you purchase or transact in Bitcoins; now we are specifically recommending you do not buy Bitcoins as a speculative investor, as Bitcoins aren’t even of high enough quality to be a speculative investment. Even a speculative startup business will, if successful, provide you with dollars that can buy your food and pay your rent. Any holdings you have in which Bitcoins are the underlying currency carry both the usual business risks plus an additional risk premium (likely a massive one) to account for the uncertain future of Bitcoins.
While we don’t recommend you transact in Bitcoins, and certainly don’t think you should treat them as an investment, we aren’t saying avoid them at all costs. Personally I might consider buying one or two Bitcoins to play with, maybe to buy some basketball tickets or do some light online shopping, just to see how they work. It may be fun to have a couple physical bills or coins, but you should treat this as a “fun” activity, one that may cost you some or all of the money you spent on them.
It will be interesting to see where Bitcoins end up, both in terms of their long-term value and their viability as a currency. We recommend you join us on the sidelines.
Dr. Ken Waltzer MD, MPH, AIF®, CFA, CFP®
Founder and President – Kenfield Capital Strategies (KCS)
Director of Business Development – Kenfield Capital Strategies (KCS)
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