Is Bitcoin the new Gold Rush? We think would-be investors should tread carefully.

Many investors are interested in Bitcoin because of the incredible performance of the virtual currency, but few of them fully understand how it works. In this article we consider what Bitcoin is, and some of the opportunities and obstacles to its development. In today’s era of tightening monetary policy, we believe investors should view this new instrument with caution.

Bitcoin is a “cryptocurrency” powered by a digital ledger software code called Blockchain. The distinction between cryptocurrencies such as Bitcoin and the underlying technology of Blockchain is essential. Bitcoin is a decentralised payment network. It is a peer-to-peer version of electronic cash that allows online payments between parties, without using intermediaries such as financial institutions. Blockchain is the public record that details all the transactions, where users can verify the validity of each transaction. Many experts today believe such technologies could change the future of the financial industry. Blythe Masters, widely credited as the creator of the credit default swap, is convinced that Blockchain is comparable to the rise of the internet in the early 1990s and that it is analogous to e-mail for money.

Many investors see Bitcoins as a source of investment diversification, even if cryptocurrencies are highly volatile. Bitcoin transactions are irreversible, because no intermediaries can block a transaction. Every Bitcoin user has a virtual “wallet” and transactions follow a transparent method. New Bitcoins are created every 10 minutes by a “mining” process. Mining involves compiling recent transactions into virtual blocks. When a miner finishes compiling a series of blocks, he or she is rewarded with Bitcoins. This helps process transactions, secure the network, and incentivise miners. Anyone with an internet connection and the appropriate hardware can become a miner. Investors can also buy Bitcoins on the open market. Only 21 million Bitcoins will be ever created, but as a Bitcoin can be divided into sub-units, there is no limit in practice to the number that could potentially exist².

Acquiring Bitcoins without mining is similar to obtaining any other traditional currency. There are several ways to buy Bitcoin using traditional currencies, but trusted exchanges are the most reliable way. When selecting Bitcoin exchanges such as Bitsquare or Coinbase, due diligence is advisable in terms of credibility, safety, security, privacy and funds control.

There are several advantages of using Bitcoin as a payment system. Transactions are possible anywhere in the world, at any time, and with anyone. Fees are low compared to traditional payment methods. It is also a secure and transparent payment network: every user can potentially verify every transaction in the virtual ledger, with no central bank or government to intervene in the process. Bitcoin is a transparent floating currency determined solely by supply and demand. The system holds no personal information on its users, but only addresses that consist of two parts: a “public key” and a “private key”. Anyone can send Bitcoins to a public key but only the user knowing the private key can spend them.

A number of key challenges exist to Bitcoin’s expansion. The currency is accepted by relatively few businesses, even if many large companies, such as Whole Foods or Microsoft (Windows store), are starting to accept it. Its volatility is also a major drawback. Cryptocurrencies have no intrinsic value, since they are not based on any underlying asset, such as gold reserves. As the total value of Bitcoins in circulation and the number of corporations using them are very limited, the price of Bitcoin can be substantially affected by the actions of just a few users. In theory, Bitcoins could also become worthless under certain economic circumstances, such as hyperinflation. Authorities have also raised concerns regarding Bitcoin and illegal activities such as money laundering. While the virtual currency is not totally anonymous – Bitcoins leave public records – it can be hard to verify users’ true identities. In future, the system will probably be subject to regulations that exist for equivalent financial systems. Competition is also an issue: Bitcoin currently represents more than two thirds of the volume of virtual currencies, but competitor currencies, including Ethereum, are rapidly emerging.

While Bitcoin has hit a series of record highs in value this year, surging to over USD 2,900 in June 2017³, we recommend that would-be investors tread cautiously. Volatility and rising competition are both fundamental concerns, and it remains extremely hard to value cryptocurrencies. We also believe that part of Bitcoin’s current success can be attributed to excess liquidity generated by major central banks, via a combination of ultralow rates and asset purchase programmes. As global monetary policy conditions – in the US, Europe, and farther afield - tighten, we believe Bitcoin’s performance could suffer.

In our view, Blockchain, the disruptive technology which powers Bitcoin, may represent the more exciting opportunity. For investors keen to put money to work in this risky and rapidly changing space, we believe emerging payment technologies could be a more interesting way to access the game-changing trends of the future.

¹Source: Bloomberg, 5 July 2017
²Source: Bitcoin official website
³Source: Bloomberg

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