Following Bitcoin’s latest tumble, Mark Ward, head of trading at Sanlam UK, has examined why the virtual currency is so volatile and shared the three reasons that will shape the future of the cryptocurrency.
Seldom a week goes by without mention of Bitcoin in the news – from commentators predicting it to be the swindle of the century, to others forecasting its value to increase another hundredfold – but what actually is it? How can you buy into it? Is it safe? And who decides its value?
Seven years ago, a young developer exchanged 10,000 units of a (then) newly created digital currency called Bitcoin, to buy two Papa John pizzas, worth around £20. As of November 2017, the value of those Bitcoin is around £85,000,000. In the last year alone, Bitcoin has risen nearly 1000%, and is now priced at around £8,500 per whole unit.
Bitcoin is the most famous of all the so-called Cryptocurrencies, but there are many alternatives – Ethereum, Litecoin, Peercoin, Zcash, Dash, to name but a few, however Bitcoin leads the way in terms of market capitalisation, popularity, and sheer amount of users.
What a Bitcoin (and its rivals) is, can be thought of just as virtual money, used to buy and sell items, as you would in a shop with a five pound note – they are simply a means of exchange – it allows barter to occur online, in a virtually fraud-proof way. Whereas a central bank stands behind and stabilises traditional currencies (in the past one could exchange notes for gold should you ask the Bank of England, and UK bank notes still contain a “promise to pay the bearer” from the UK government itself), there is no bank, corporation or government acting as a backbone to Bitcoin. This is why the value of cryptocurrencies are so volatile – its value derives from the confidence in the market that tomorrow, the Bitcoin will not be worthless.
A Digital Tulip Mania?
Bitcoin is not truly a currency, at least not yet, and is best thought of perhaps as a commodity. The Dutch Tulip Mania in the 1600’s saw the price of a special type of tulip bulb rise to more than the cost of a house with an acre of land in the Netherlands, yet the intrinsic value and usefulness remained essentially nothing. But, as with cryptocurrencies, if people decide something has value, then it has value, and only time will tell if Bitcoin is another tulip-mania in the digital world, or will deliver on its promise to displace central banks and hard cash as the primary means of exchange in the future.
The first houses in in the UK priced in Bitcoin have officially gone on sale in 2017. A brand new four bedroom house in Colchester is on sale for either £375,000, or 82.55 Bitcoin. There is also a six-storey Notting Hill mansion for sale only in cryptocurrency – valued at £17m, it can be snapped up for 5050 Bitcoin – they will not accept cash. It creates complications on how the purchaser will pay the £1.95m stamp duty, as they are not actually buying the house for any tangible monetary value – something that HMRC is probably not too thrilled about. Bitcoin also facilitates transactions that can occur on the internet with no traceability, which allows the trade of illegal and illicit goods and services to occur – most famously on the Silk Road dark net marketplace, which was closed down in 2014.
To this day, no one knows who actually released the technology, only known as the mystical Satoshi Nakamoto, all we have is the computer code that allows Bitcoin to be “made” or created via a process called mining. Anyone with a computer and internet connection can participate in the mining process, and be rewarded with Bitcoin, however, home PC’s are now generally not powerful enough for it to be worthwhile. In very basic terms, people’s computers are used to analyse data from recent Bitcoin transactions and solve a very complex puzzle, and whoever’s computer solves the puzzle first, is rewarded with fresh Bitcoin. There exists a widely used technology which Bitcoin uses, called Blockchain; essentially a decentralised online ledger, which records transactions. This is distributed across multiple computers, so you can not alter just one – they all need to be altered simultaneously. When the winner’s computer solves the puzzle (essentially approving the transaction), recent deals settle, a new “block” is added to the chain, the transaction completes, and a Bitcoin is claimed. It allows people who don’t know each other (and thus, don’t trust each other) to create a tamperproof record of a transaction that keeps track of who owns what.
There is a finite amount of Bitcoin that can ever exist – only 21 million can be created during its lifecycle. The freshly minted Bitcoin available to winners of the blockchain puzzle solving also halves every four years. Initially the reward was 50 Bitcoin, and it is now down to 12.5. This will continue to half for around 100 years, when all 21 million have been issued. Bitcoin are broken down for transactions of a lower value – so if you were to purchase a pizza now with Bitcoin, it would cost, for example, one 0.0025 of a Bitcoin. One Bitcoin is divisible down to 100,000,000 pieces, or 8 decimal places. If you want to sell (or buy) a Bitcoin, you can do so via the online Bitcoin Exchanges, and receive traditional currency to your bank.
Unfortunately, the sheer number of computers involved in this process, means a Bitcoin transaction takes days to occur and settle. It also means that if you don’t secure your Bitcoin appropriately and only store it locally on your computer and it crashes and dies, or gets stolen, the Bitcoin can vanish.
In November of 2013, a laptop of a Welsh-based Bitcoin miner was accidently thrown out with the rubbish, with 7500 Bitcoin on it, worth £63.75m today, and was never recovered.
Should you invest in Bitcoin?
One question that we often get asked at Sanlam is – “I don’t know how to mine Bitcoin, I don’t actually want to use it as currency, but I want exposure to it”. The easiest way to gain exposure to Bitcoin would be via an Exchange Traded Fund (ETF). That said, we at Sanlam do not recommend Bitcoin as part of an investment strategy, as it has many characteristics of a bubble and something that we view as purely speculative.
As for the future of crypto-currency, it largely comes down to three factors:
- whether or not Central Banks and governments release their own versions and make them the only legal tender, or indeed
- officially endorse a crypto-currency like Bitcoin,
- whether or not transaction processing speeds up from the current average of four days, and if the price volatility can be stabilised.
CEO of JP Morgan, Jamie Dimon, stated in September that Bitcoin is a huge fraud, and that any one in his organisation trading it will be fired on the spot.
In October, Jordan Belfort, of whom the Wolf of Wall Street movie was based on, said that Bitcoin is “the biggest scam ever”.
Is Bitcoin the future?
However, Warren Buffet has noted that “Bitcoin is exciting and better than currency for large transactions”. Eric Schmidt (Google Chairman) says that “creating something not duplicable in the digital world has enormous value”.
Whether Bitcoin falls to near-zero like the aforementioned tulip, continues to rise like diamonds have over the past century, or simply holds steady once the market finds the level it can tolerate, is anyone’s guess at the moment, but it is certainly one to watch as it becomes better understood by the mainstream.