Not much over the past couple of years has captured the imagination like Bitcoin has with the last few months being at an even more torrid pace of excitement. Bitcoin, the most well-known cryptocurrency, came on the scene in 2009. What is Bitcoin? Bitcoin is a digital, decentralized cryptocurrency and payment system. A cryptocurrency functions without a central bank or single administrator by using blockchain technology to fashion a currency that has no physical form and that can be transferred with nearly untraceable individual ownership. This is accomplished through an extensive network of peer-to-peer users that allow transactions to take place directly between users without oversight. Transactions are executed through networks, verified through cryptography and recorded through blockchain technology. Nobody knows who founded Bitcoin, but the person (or persons) who invented Bitcoin goes by the pseudonym, Satoshi Nakamoto. After being developed, the software was built in an open-source platform, thus making it broadly available and extremely difficult, if not impossible, to steal.
Bitcoin supply is created as a reward for a process referred to as mining. Mining is the process by which transactions are verified and added to the public ledger, or blockchain, using powerful computers solving complex, computational puzzles. According to a study prepared by the University of Cambridge, there are currently over 5 million unique Bitcoin users with over 100,000 vendors able to use Bitcoin as a method of payment. This seemingly clandestine currency has gone from a $0.01 per coin value in 2009 to an alltime high of almost $20,000 just a few weeks ago. The first recorded transaction was an exchange of 10,000 Bitcoins for someone to deliver a pizza in 2010, that pizza (at $10,000 per coin) would now cost $100 million. Can you imagine being that guy? I have passed on real estate deals and stocks only to see them go up, but from $10 to $100 million would rank high on the regret scale.
Early adopters of this cryptocurrency were rumored to be individuals with a certain moral flexibility that allowed them to satisfy their proclivity for illicit activities. Once the word got out how the currency worked and that it could not easily be stolen, together with the fact there was a growing demand, the value spread among the general public. Increasing value equates to more people becoming interested with this blockchain phenom. As recent as six weeks ago, Jamie Dimon, the CEO of JP Morgan, said Bitcoin was a scam. He has since recanted his statement and now views the cryptocurrency as a viable alternative that needs to be carefully examined. However, others, like the great Warren Buffet, have stated Bitcoin will more than likely end badly. In fact, some say it may be one of the greatest bubbles of all time, similar to the Dutch tulip mania of the 1700’s which saw tulips, yes tulips, go from pennies to thousands of dollars per bulb. But why do individuals behave this way during these types of events? In his book, The Madness of Crowds, Charles Mackay discusses how crowds can push prices very far, very quickly, only to have a similar correction after all, or most, of the potential buyers have entered the market. Basically, many buyers are only in a hot market because it’s hot, and even the slightest reversal can cause a stampede out of that same market. I once heard a New York floor trader compare this selling to watching a Labrador go through a cat door; It’s not that it can’t be done, but it will be painful. Since a picture paints a thousand words, I have included a chart from Bloomberg showing the rise of Bitcoin and the comparison to other so-called “manias.”
In my opinion, it’s not the size of the potential market, as the worldwide money supply is estimated to be over $75 trillion with Bitcoin occupying a mere $170 billion (less than 1/4 of one percent of the world market), but whether World Governments will sit idly by while Bitcoin (or any cryptocurrency) bypasses the current regulated monetary system. Although Bitcoin’s value seems less sensitive to forces that impact other currencies, such as deficit spending, trade balances and the strength of the issuer, the impact of potential regulation on Bitcoin’s value deserves the greatest consideration. I believe another major risk to Bitcoin’s future is the impact of competition. Bitcoin is a fascinating development and just like many other fascinating developments, success breeds competition. New technologies are notoriously littered with the failures of the first movers (think Netscape, Myspace or Blackberry) as competition almost always finds a better or cheaper alternative. The transactional difficulty of Bitcoin, one of the key attributes of any successful currency, could well be Bitcoin’s Achilles’ heel. Competition has already emerged in the form of Litecoin, Dash, Ethereum and Ripple, with others on the way. Although Bitcoin may be the winner today, there is no guarantee it will survive tomorrow.
In summary, when people ask me if they should buy Bitcoin or another cryptocurrency, I am reminded of Levi Strauss who decided not to look for gold, but to sell clothing to those who looked for gold. Jumping into the fray, after what can only be described as an almost incomprehensible move in valuation, seems to be a leap only the most informed or optimistic are willing to make. Given how the market has already experienced a 50 percent fall in many cryptocurrencies, one has to wonder if the pending regulatory hurdles are yet fully priced into the new currencies. Overcoming the government hurdles will, in my opinion, be the most difficult with possible new supply being a close second. As we continue to learn more about the potential of cryptocurrencies, we should remember to look for the possibly different ways one can benefit from their group and increased trading volume rather than obsess over an entry point. All in all, there are probably less risky ways to deploy capital and maybe approaching the notion from the thought process of Levi Strauss will once again be the winning approach. Often times it’s best to approach life and investing like a game of chess, where you try to anticipate your opponent’s move before it’s made.