A Bitcoin primer

Dressel 150 x 150Ryan Dressel, Investment Analyst

There is a famous scene in Seinfeld, where outspoken character George Costanza pitches a TV studio executive “a show about nothing.” When pressed to elaborate, he simply re-iterates “nothing!… that’s the show!” I jokingly refer to this scene when people ask about Bitcoin, and if it’s a good investment. The parallels to “nothing” are plentiful: Bitcoin is not tangible, it is hard to find, nobody is responsible for its success or failure, and the buyers and sellers in the marketplace are untraceable ghosts. If the above is true, how can one explain Bitcoin’s meteoric rise in price and press coverage?! The price of one Bitcoin has risen from approximately $1,000 to $13,600 over the past year. The number of searches for Bitcoin on Google has exploded by 4,200% since July.

What is Bitcoin and why are people so interested in it?

Bitcoin is one of many digital currencies that have gained popularity since 2009. It has no value by itself; it only has value because an ever-growing community of Bitcoin adopters have agreed to trade goods and services in exchange for a higher amount of the digital currency, to which the community has trusted each other to do the same. This basic concept is no different than the use of fiat currencies such as the US dollar or the British pound. But that’s where the similarities end.

Today’s fiat currencies are managed by central banks around the world. The US dollar is regulated by the Federal Reserve, the Yen is regulated by the Bank of Japan, and the Pound Sterling is regulated by the Bank of England, to name a few. Conversely, Bitcoin is autonomously managed within an open source network of computers known as “blockchain.” Think of blockchain as a community of referees that allow two parties to make an exchange. The rules that the referees use to enforce an exchange can be reviewed by anyone that is part of a network. Every transaction prior to the one being made must be reviewed before it can take place, hence the term “blockchain,” which is intended to make the network more secure with each transaction.

To visualize the application of blockchain, think about a transaction at a farmer’s market. If you use a dollar to buy a vegetable, the farmer puts his faith in you to truthfully hand over a dollar that can be used to buy other goods & services and assumes it is not fake and that you won’t just steal his vegetable. On the other end of the transaction, you put your faith in the farmer that his product has all the properties of a vegetable as advertised, and does not contain defects such as poisonous pesticides. Additionally, nobody but you and the farmer knew that transaction occurred and nobody reviewed the accuracy of the exchange except you and the farmer.

Conversely, a digitalized farmer’s market transaction using blockchain would be reviewed by every computer that is part of a network (consisting of digital farmers and digital vegetable buyers). The predefined rules of the blockchain are also reviewed to ensure that all qualifications are met by both parties before one item is exchanged for another. If any criteria are not met, the exchange will not occur. After all criteria have been met, each party is rewarded their contractual obligation. This technology can be used to exchange Bitcoin, as well as a seemingly infinite amount of applications involving two or more parties i.e. physical property exchange or even corporate mergers.

blockchain 2Graphic Source: Thomson Reuters

Why adopters love blockchain

The primary benefit of blockchain technology is that it breaks down the barriers of trust, allowing any two parties to transact directly with each other without the need for a third-party to broker a deal. This creates transparency that we simply do not have today. Our third-party brokers take many forms, ranging from banks to cashiers, to Facebook, to Lawyers. These intermediaries act as agents of two or more parties, but you cannot see every message, transaction, or exchange that happens within them. Blockchain provides complete transparency for all to see.

In the example of the farmer’s market exchange, the dollar that was used to buy a vegetable is an example of a central repository holding information. The dollar had a state-sponsored (US government) serial number on it that is part of a taxable transaction. In the case of Bitcoin, no third-party owns the record, there is no third-party manipulating the data or supply of a good or currency. Cryptocurrencies rely on this benefit and offer additional benefits such as the ability to make transfers without geographic limitation, the finality of settlement, lower transaction costs compared to other forms of payment, and the ability to publicly verify transactions.

Today’s fiat currencies are also underpinned by central banks, tax systems, judicial systems, militaries, and any number of other connections to a governing body. The freedom from these agencies is very enticing to Bitcoin users. In areas outside of the developed world, this technology could be life changing due to corrupt governments manipulating currencies or transactions.

Buyer beware

History has shown that innovation and competition are great for markets and consumers. If credit cards weren’t accepted, we’d still be using paper and coins to make purchases. Prior to paper and coins, different societies used items such as beaver pelts or stone carvings as currency. Without currency, one would have had to travel great distances to make physical exchanges with their personal items of value.   Despite the innovative allure of Bitcoin, it is important to recognize its shortcomings as well.

To date, no cryptocurrencies have been registered with the SEC, whose stated mission is to protect investors, maintain fair, orderly, and efficient markets, and to facilitate capital formation. As such, no licenses are required to sell Bitcoin, which makes the cryptocurrency market subject to volatile market manipulation and scams such as scalping, “pump and dump,” and other types of fraudulent schemes.[1]

Cryptocurrencies such as Bitcoin are not backed by any government body, and thus are not regulated and could be subject to illicit transactions. Buyers and sellers remain anonymous, which holds nobody liable if a transaction fails on either side (Kim Jong Un has even been linked to the marketplace[2]). The ability to exchange Bitcoin for traditional currency is subject to change at any time, without notice. Cryptocurrency networks are also subject to malware and hacking.

Even though the number of exchange platforms is emerging, it is still not very easy to trade Bitcoins for goods and services. Bitcoin and other cryptocurrencies are also extremely volatile, which displaces one of the most important features of fiat currency: a stable store of value. How can buyers and sellers expect to make a transaction if the exchange rate of Bitcoin changes substantially every 2 minutes?

Despite the innovative advances in blockchain, it is important to remember that the technology is in its infancy. Both improvements and loopholes are being added every day. Bitcoin shares features of a currency, commodity, or a security, but is nothing more than a figment of our human imagination. One might say it’s a show about nothing!

[1] https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
[2] http://money.cnn.com/2017/12/12/technology/north-korea-bitcoin-hoard/index.html

 

Investment Insights Podcast: One market has made some major headlines in recent days: Bitcoin

Rosenberger_Podcast

Andrew Rosenberger, CFA, Senior Investment Manager

On this week’s podcast (recorded May 30, 2017), Andy discusses how Bitcoin isn’t necessarily something that we consider a long-term investable asset for our client portfolios, but it’s certainly been an attention grabber as of late.

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Quick hits:

  • After crossing the $2,200 per bitcoin mark on Monday, I had no less than 3 separate conversations after an article was released on how if you had purchased $100 dollars worth of bitcoin in 2010, it would be worth $72.9 million dollars today.
  • Bitcoin is a digital currency, not backed by any central government or entity, and it relies on a community of supporters to maintain the infrastructure.
  • The underlying technology behind bitcoin is getting the attention of many major players including banks, credit card companies, and technology giants.

For Andy’s full insights, click here to listen to the audio recording.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change. Brinker Capital, Inc., a Registered Investment Advisor.