Bitcoin - A Bit Confused?

March 01, 2021 | Marcia Zhou


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A Cryptocurrency Frenzy

Cryptocurrencies have been all the craze as of late. It’s hard to ignore when even the world’s largest asset manager, Blackrock, reported they have begun to “dabble into it”; and announcements of Tesla’s $1.5-billion purchase of bitcoin makes headlines. The recent surge in the price of bitcoin (see below) may be causing a case of FOMO (fear of missing out) from both retail and institutional investors alike. That said, cryptocurrencies are speculative investments, volatile, and may be difficult for investors to understand. As our team does not actively manage cryptocurrencies, this blog is not meant to promote investors to purchase cryptocurrencies, but rather to provide an introductory primer to the asset.

What is a cryptocurrency?

Cryptocurrencies are digital currencies that are only available online. They are created, secured, and maintained through a global network technology called blockchain. Just like any other currency, it can be used as a form of payment or held as an investment. This network is “decentralized” in that it is not regulated by governments or a central authority. There are over 1,500 cryptocurrencies currently available, with Bitcoin currently being the largest amongst them and valued around $1 Trillion in market cap. Below we focus on Bitcoin in particular.

Three Commonly Sited Benefits

1) Efficient: As a decentralized cryptocurrency, there are no intermediaries involved in peer-to-peer transactions, which can make the process cheaper. In other words, the ability to cut out the “middle-man” can help avoid transaction and conversion fees that are typical through traditional financial institutions.

2) Security: Bitcoin transactions are considered secure and private with the benefits derived from a “distributed ledger” technology commonly referred to as blockchain. In this network, independent members (aka. Nodes) work to manage, record, and verify transactions simultaneously. Any attempts to nefariously alter any data requires modifying an ever-changing ledger across every independent node of the network. This takes such an unfathomable amount of time, energy, and collusion, that it is accepted as an all but impossible exercise.

3) Store of Value: By its fixed code, there will only ever be 21 million bitcoin in circulation. Hence, bitcoin investors are attracted to its scarcity value and see it as a strong store of value which is traditionally a feature attributed to gold. Therefore, Bitcoin is considered “digital gold” for the next generation. As governments around the world have printed enormous amounts of money to backstop the Great Financial Crisis and the COVID-19 crisis (see chart below), many bitcoin investors feel traditional currencies will fall victim to devaluation. Some bitcoin investors believe that bitcoin would serve as a more stable global reserve currency.

What are the risks?

Even the most optimistic of bitcoin investors will concede that the price of bitcoin can be volatile. In the last 5 years, Investors have seen the cryptocurrency rise at neck-breaking speeds, only to collapse -85%, and then fully recover and make seemingly weekly all-time highs. The risks are many, we highlight a few below.

1) Complexity: There is still no consensus as to the best way to own and hold bitcoin. Purchasing coins directly from cryptocurrency exchanges is still complex for the average user, requiring the setup of a “digital wallet”. Although the blockchain is secure, one’s digital wallet is still at risk of being stolen or lost. There are ways to store one’s bitcoin in a physical device, however, this also requires a more tech-savvy user. There are financial products that can be purchased that are linked to bitcoin, however those can come with trading restrictions and high fees. Ultimately, a wide acceptance of bitcoin is delayed by its complexity

2) Regulation: Although governments are unable to shut down bitcoin, they can still make life difficult for bitcoin holders to discourage widespread adoption. They could easily impose energy restrictions on bitcoin miners that are essential to maintaining the credibility of the network. They could also ban individuals, businesses, and institutions from accepting bitcoin as legal tender.  They could even impose special taxes on the use or investment in bitcoin. As we are still in the early innings of regulatory discourse, more creative regulations can appear if governments wish to not embrace bitcoin.

3) ESG Factors: Investors are increasingly using environmental, social, and governance factors to screen for the sustainability of an investment. Currently, bitcoin does not rank well under an ESG lens which could lead to bitcoin falling out of favour.

Environment: Cambridge University reported that maintaining the Bitcoin computer network consumes 121.36 terawatt-hours a year, which is more than the annual consumption of Argentina. If Bitcoin were a country, it would be amongst the top 30 energy users worldwide.

Social: Much attention has been paid to the unequal distribution of wealth in our society. Although bitcoin is technically accessible to all-sized investors, at current prices, early adopters have been able to amass cryptocurrency fortunes. Although traditional wealth is also concentrated, critics would point out that bitcoin will likely maintain or widen that gap.

Governance: Bitcoin likely scores well on this factor as they have strong internal controls, and shareholders are protected from dilution as there is a fixed supply of coins. However, these ‘fixed rules of the game’ could also be viewed as a flaw given it is unable to react to the needs of society. For example, the millions of families and businesses harmed by the COVID crisis were able to be supported by their government’s ability to print money and influence the money supply. Given that no one can create more bitcoin, this would not have been possible under a global bitcoin currency regime.

Conclusion

While it’s difficult to say what will happen in the future, it seems undeniable that cryptocurrencies are gaining traction and are likely to pique investor interest for quite some time. Investors should speak to their advisor to learn more about the risks of cryptocurrency.