Everything you wanted to know about Bitcoin (but were afraid to ask)

Normally people get excited by lower prices and discounts as it makes things cheaper to buy. In the case of quoted securities it potentially makes them more profitable and safer to own, as disciples of Warren Buffett and Benjamin Graham will argue that buying at low valuation can both increase your upside and protect your downside.

But one of the quirks of investment, and the greed and fear which frequently drive short-term price movements, is that rising prices attract more favourable comment (and often more money) and falling ones persuade financial market participants to look, or even run, elsewhere.

There is no finer example of this than the world of crypto-currencies in 2017.

Bitcoin is probably the biggest and best-known. Since 1 January this year one Bitcoin has surged from $997 to $2,765 (via its first ever move above $3,000 in early June), according to www.coindesk.com.

Bitcoin has soared in 2017

Source: www.coindesk.com

That is good going for something where the initial coin offering (ICO) came at one one-hundredth of a US cent (that is $0.0001) in 2009 and that only reached the $1 mark in 2011.

But there are other crypto-currencies too. Ethereum has surged from less than $10 to over $225 this year and Ripple has gone from barely half of one US cent to $0.1940 in 2017, albeit via a trip north of 30 cents.

According to the website www.worldcoinindex.com there are now over 500 crypto-currencies in circulation, ranging from Bitcoin, ‘valued’ at around $45 billion to Ethereum at $21.3 billion and Ripple at $6.6 billion, all the way down to the 3.53 million Clevercoins currently valued at just $336.

All of this begs two questions

  • Is Bitcoin, and are crypto-currencies, money?
  • Is Bitcoin, and are crypto-currencies, an investable asset?

Crypto-currencies explained

Before we address those issues, it may be worth quickly explaining what crypto-currencies are. (Those advisers and clients who feel they are already well versed in the topic can skip to the remaining two sections).

For simplicity’s sake we shall look at Bitcoin in particular.

In essence, Bitcoin is a digital asset and payments system, a virtual currency, where intermediaries play a very limited role and central banks and Governments none at all.

It is encrypted and the creation or transfer of every Bitcoin is kept on a ledger and archived for maximum transparency as to supply (although the encryption element ensures anonymity for users). This is all made possible by so-called ‘blockchain’ technology, a database that maintains an ever-growing list of records, called blocks. Each block is linked to its predecessor and bears a time stamp.

The concept was first outlined in a 2008 paper entitled Bitcoin: A Peer to Peer Electronic Cash System. The identity of the author, Satoshi Nakamoto, as well as his motives, remain shrouded in mystery but he issued (or mined) the first Bitcoins in 2009.

Bitcoin has by no means achieved universal acceptance (as investors cannot just walk into any shop or restaurant and spend Bitcoin) but its stunning price rise has spawned a host of rivals.

The table below outlines the ten-most actively traded crypto-currencies on Monday 24 July, according to www.worldcoinindex.com.

A growing range of crypto-currencies is now widely available

Source: www.worldcoinindex.com on Monday 24 July 2017

Money, money, money

Now we turn to the first key question raised by the rise (and rise) of crypto-currencies – are they money?

To ensure objectivity, and avoid any accusations of taking a view one way or the other, any argument will be met with a counter argument. Advisers and clients can then decide for themselves.

Do Bitcoin and crypto-currencies fulfil the function of money?

For: Money facilitates trade over time and distance and to do so it has to be trusted and readily accepted. Applying these criteria, the answer has to be yes, crypto-currencies can and do fulfil the function of money, given that anything from cowrie shells to cows, paper to metal and gems to plastic cards have done the job perfectly well since time immemorial. Japan is working on legislation which will make Bitcoin legal tender and Russia is thought to be working toward similar laws for 2018.

Against: Even allowing for developments in Tokyo and Moscow, Bitcoin and its rivals are not universally accepted and under these circumstances it is impossible to view them as money. Companies in particular still fight shy of using Bitcoin because it and other crypto-currencies are unregulated and accounting rules have yet to be finalised.

For: The price surge shows growing acceptance of crypto-currencies, where blockchain technology provides the transparent ledgers and archives which can also snuff out fraud and criminal activity to the benefit of the holder. The process is seen as safe and transparent, even relative to the wire transfers supplied by the likes of Western Union.

Against: The failure of Bitcoin exchange website Mt. Gox, which saw the theft of Bitcoin and has prompted legal action for embezzlement through the courts in Japan, will deter many from trusting crypto-currencies, especially those that have no official (central bank or Government) backing. In addition, few consumers will want to be using currencies whose value swings around quite so wildly. It is bad enough that the pound can rise or fall from say $1.20 to $1.50 in a year – but that is nothing compared to this year’s movements in Ethereum or Ripple. Unless clients (and corporations) have more visibility on what a crypto-currency is ‘worth’ they will be reluctant to use it.

Ethereum and Ripple have both seen big price pull-backs this summer

Source: www.coindesk.com

For: In an era of central bank profligacy, record-low interest rates and electronic creation of money through Quantitative Easing, Bitcoin and crypto-currencies are a better store of wealth than our current currency system, which was only set up as recently as the early 1970s with America’s demolition of Bretton Woods and the gold standard. Bitcoin creation by so-called Bitcoin miners is scheduled to halve each year until around 2040, when in theory the number of available Bitcoins will be frozen at around 21 million.

Against: The proliferation of initial coin offerings (ICO) suggests that crypto-currencies are no better at managing supply and providing sound money than the central banks. August promises to be a key month for Bitcoin in particular as fans debate whether segwit, segwit2x, BIP91 or BIP148 should be introduced so Bitcoin can be scaled up in the most efficient manner possible and smoothly handle growing volume transactions. In theory, Bitcoin Improvement Proposal 148 (BIP) is losing out among Bitcoin miners to BIP91, resulting in a ‘soft fork’ programming change rather than a ‘hard fork,’ which could even split the currency.

Investment parameters

Now we turn to the second key question raised by the rise (and rise) of crypto-currencies – are they an investable asset, like say stocks, bonds, commodities, properties or even items such as collectibles, like vintage cars, art and wine?

To ensure objectivity, and avoid any accusations of taking a view one way or the other, any argument will again be met with a counter argument. Investors can then decide for themselves.

Is Bitcoin, and are crypto-currencies, an investable asset?

For: The absence of central bank involvement or Government interference means crypto-currencies are an ideal investment in an era of Quantitative Easing, monetary policy experimentation and a rampant growth in the supply of money which can only devalue it over time.

Against: The Mt. Gox disaster and the forced shutdown of the Silk Road and now the Alpha Bay websites for their involvement in criminal activity both suggest that the authorities are taking a closer look at some areas where Bitcoin and crypto-currencies are widely used. In addition, it is thought that one big reason for the surge in prices earlier this year was demand from Chinese nationals who were buying Bitcoins onshore and selling them offshore so they could salt money out of the country. Who is to say China does not move in a clampdown or even unveil its own crypto-currency via an ICO?

For: Bitcoin and crypto-currencies are an even better bet than gold at a time when Governments are too happy to print cash to buy votes and too frightened for their own jobs to stick to sound money principles. Even gold supply increases every year, whereas Bitcoin supply is designed to be finite.

Against: Even if you take such a dim view of central banks and Governments, Bitcoin and crypto-currencies may not be the answer for four reasons. First, the number of alternative currencies has mushroomed. Second, the debate over ‘soft’ or ‘hard’ forks for Bitcoin processing development shows that this is not a straightforward topic – and no adviser or client should invest in anything unless they thoroughly understand it. Third, US President Franklin D. Roosevelt’s Executive Order 6102 which criminalised the possession of gold in 1933 shows that the authorities could still get involved if they wished to do. Finally, Bitcoin, like gold, offers no yield and generates no interest or cash. As such, advisers and clients would be buying Bitcoin (or gold) in the view that they could get someone else to pay more for it, not because it has the ability to provide consistent coupons on return. Some would argue this is simply a further example of the Greater Fool Theory at work.

For: Bitcoins and crypto-currencies are now liquid and cheap and easy to trade. Bid-offer spreads are small and there are no pesky intermediaries charging fees, let alone central bank involvement or regulation. A growing number of online brokerages facilitate Bitcoin trading and some even offer the opportunity to trade derivative instruments which are based on the crypto-currency.

Against: There are intermediaries involved and they are the Bitcoin miners, who create Bitcoins, monitor and record and archive transactions. They will charge a small fee. Just because you can trade derivatives does not mean that advisers and clients have to buy them or even the underlying asset – the Financial Conduct Authority is already cracking down on spread betting and contracts for difference. And the US regulator, the Securities and Exchange Commission, rejected in April an application for approval for the Winklevoss Bitcoin Exchange Traded Fund (ETF), owing to concerns over the volatility in Bitcoin prices and whether the price could be in any way manipulated to the disadvantage of advisers and clients, given the lack of regulatory surveillance of the underlying asset being tracked by the ETF.

This third and final point perhaps echoes legendary US investor Warren Buffett’s quote: 'If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.’

Any adviser or client determined to start trading Bitcoin or any of its rivals needs to do their research every bit as thoroughly as they would for any individual stock, bond, commodity or fund and ensure that any purchases or sales fit with their overall investment strategy, time horizon, target returns and appetite for risk.

Appetite for risk is best understood in this context as a willingness and ability to lose money in the attempt to earn it by investing it – and the Ethereum price chart above shows what could happen both on the way up and on the way down.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.