Hardly a day goes by that we don’t read about Bitcoin. Despite its increasing coverage in the news, however, I would venture to guess that most people still don’t understand what it is. So here is a brief overview of Bitcoin, the technology that supports it, and its advantages and risks as an investment option.
1. What is Bitcoin?
Simply put, Bitcoin is a form of digital currency, also known as crypto currency. Unlike tangible currency like a dollar bill, crypto currencies have no central issuing authority, such as the Treasury Department. They also don’t require a centralized intermediary, such as a bank, to make sure the same dollar isn’t spent twice. So, in essence, these systems are based on trust.
Bitcoin works by using “tokens” that are transferred via a database. The transactions are verified using sophisticated software protocols called blockchain technology, which is a kind of decentralized online ledger system. One writer called blockchain a “supercharged version of Microsoft Excel.”1
Since its inception in 2009, Bitcoin has grown in fits and starts, with many businesses attempting to make money by facilitating it, including as an investment asset.
2. Why are Bitcoin and blockchain technology important?
As a business technology, blockchain is being explored beyond its use to verify Bitcoin transactions. For example, it can be used to update prices and transactions. For this reason, companies such as Walmart are looking into its possible uses.2 And, according to a recent report in the Philadelphia Inquirer, IBM Corp and Comcast’s venture capital arm are looking to jointly finance a fund that invests in firms looking to sell blockchain services to large corporations. 1
As an investment option, Bitcoin and other crypto currencies finally gained mainstream acceptance in 2017 when two of the world’s biggest exchanges – CBOE and CME – began trading Bitcoin futures. In addition, Bitcoin Electronic Transfer Funds are likely to be available this summer.
3. Please put it in perspective: why should the average investor care about Bitcoin?
Investors, no matter how big or small their holdings, should try to stay informed. This goes for their personal investments as well as market trends. As Bitcoin and blockchain technology grow – and some consider blockchain the way of the future3 - it’s important to keep up with their uses and potential.
4. What are the advantages and risks of crypto currencies for the average investor?
Crypto currencies as an asset class have a low correlation to almost every other asset class available to the average investor. They could, however, be prudently added to a well-diversified portfolio with the possibility of increasing return for the amount of risk taken. When stocks and bonds are down, crypto currencies have the possibility of being up. The inverse can also be true, because they tend not to move together. According to modern portfolio theory, this may have the effect of reducing overall volatility. But it’s important to stress that while there may be advantages related to added diversification there also pose very real risks.
For one thing, crypto currency prices themselves are incredibly volatile, and traditional methods of valuation have a hard time explaining why that is. Therefore, crypto currencies should occupy a prudent slice of a well-diversified portfolio if, and only if, the investor has done extensive due diligence on the currency of their choosing and well as the method by which they buy, sell, and store it. In addition, crypto currencies’ volatile nature makes them a poor medium of exchange. For this reason, investors should use them as a store of value, similar to what they would do with exotic investments like art or wine.
The risks mentioned above are why some financial firms, such as Merrill Lynch, have recently blocked clients and financial advisors from investing in Bitcoin. 4
6. What’s the bottom line?
Despite the fact that crypto currencies operate in an unregulated environment, many people and businesses are attracted to the underlying blockchain technology as way to communicate value in countless applications. We’ll have to wait and see where blockchain as a business technology goes.
As an investment, potential investors need to carefully consider the risks and where Bitcoin and its underlying technology are in terms of their evolution and application.