A Bitcoin for Your Thoughts

Bitcoin has recently become the subject of much discussion and controversy. It has grown in market value by about 1,300% so far in 2017, going from just under $1,000 at the beginning of the year to now around $14,000 (at the time of this writing). Its advocates often proclaim it as a replacement to traditional currency that will revolutionize the way we do business worldwide. Its detractors lament it as the latest “bubble,” driven by euphoria, not fundamentals. A few questions need to be addressed at this point: What exactly is bitcoin? Why has the price suddenly skyrocketed? Should we own it in our model portfolios?

To answer the first question, bitcoin quite simply is a form of digital currency. Each bitcoin is generated through a system called “mining” and tracked using blockchain technology. Blockchain is essentially a decentralized, secure form of record keeping. Digital currencies (also known as cryptocurrencies) attempt to play the role that gold has played before, a global medium of exchange not fully controlled by any government or central bank, such as the U.S. Federal Reserve. The goal is for someone in the U.S. to be able to pay someone in India for goods and services without having to go through any form of currency exchange or clearing system. Since there is no third party involved in the transaction, cryptocurrencies are said to cut out the middleman and create a more efficient system. This global reach and simplicity is what gives them their appeal.

Bitcoin was actually created back in 2009 by a programmer, or group of programmers, under the alias of Satoshi Nakamoto (fun fact: nobody is really sure who Satoshi Nakamoto is). This begs the question, if the currency has been around for close to a decade, why is it just now receiving so much attention? While the answer is not obvious, there are a few clear factors contributing to its meteoric rise in price. For one, Japan and China have both recently passed laws that begin to treat bitcoin more like a legitimate currency. Regulators have a natural love/hate relationship with bitcoin and its siblings due to the somewhat anonymous nature of bitcoin transactions. Individuals use a bitcoin address to record transactions, but the individual behind the address can sometimes remain anonymous. The ability to conduct transactions digitally and anonymously has led some criminals to use bitcoin to avoid taxes or fund illicit activities. The most notorious case was in 2011 when the FBI indicted a man named Ross William Ulbricht who founded the Silk Road, a website used to sell drugs and other illicit goods. The website used bitcoin to help hide the identity of its merchants and customers. Cases like this have made regulators slow to accept the currency. This hesitancy has been a major hurdle for bitcoin’s road to global acceptance; therefore, when Japan and China passed favorable laws towards the currency this year, many saw that as a sign of a changing tide among regulators.

Another major factor contributing to bitcoin’s success is greater acceptance within the investment community. Until recently, bitcoin has been exclusively traded on a number of smaller, somewhat obscure exchanges. This has led to liquidity issues for traders. In addition, previous attempts to create bitcoin investment funds, which would offer a more mainstream way to invest in the currency, have been blocked by the Securities and Exchange Commission (SEC). This has limited the interest of large institutional investors. However, two large exchanges, the Chicago Mercantile Exchange and the CBOE, recently rolled out bitcoin futures contracts. This has provided the market with much needed liquidity, as well as giving investors more options to gain exposure to bitcoin. Further, many believe that this availability will eventually pave the way for the long sought after approval of the SEC. The increase in options available to investors has driven up demand. Since supply for bitcoin is somewhat limited, this has naturally caused the price to rise significantly.

Finally, there is the hype factor, sometimes referred to as “animal spirits.” Returns of over 1,300% in less than a year are bound to get people’s attention, and they have done just that. A quick google search for bitcoin will show articles about bitcoin’s recent performance from every major news organization. Some of this publicity is leading to more vendor acceptance of the currency, creating a sort of self-fulfilling prophecy for bitcoin’s future. A fair amount of this attention is leading to other investor motives, with no interest in actually using the currency as a store of wealth. In the mid-2000’s, a significant number of the people buying homes were simply looking to sell them at higher prices over a short time horizon. Since these speculators were not buying homes to live in them, but to “flip” them, it was inevitable that prices would peak and then decline precipitously, causing significant loss. Some of this same logic applies to bitcoin. If most investors are only wanting to sell the currency to someone else at a higher price and not actually use it as a medium of exchange, then demand will eventually begin to fall.

This leads to the last of our initial questions: Why don’t we own bitcoin in our client portfolios? One of the fundamental rules of investing is that risk and return are directly linked. Translating that to bitcoin, implies that a 1,300% return comes with significant risk. Cryptocurrencies have been notorious for their high volatility and unpredictability. Since its inception, bitcoin has already experienced two separate declines of more than 80%. The currency still has many hurdles to overcome before gaining acceptance as a mainstream medium of exchange. New regulations in China and Japan was a move in the right direction, but it has a long way to go to gain acceptance among all developed countries. A transaction using bitcoin can take up to 90 minutes to confirm, leading even its biggest advocates to admit it won’t be replacing cash any time soon. While vendor acceptance is on the rise, there is still a relatively limited selection of things you can buy using this currency. Finally, bitcoin is but one of over 800 cryptocurrencies, many of which have the same advantages of bitcoin without the astronomical rise in value. Waverly Advisors takes pride in staying up-to-date on all new opportunities for our clients, and we will continue to monitor bitcoin’s progress. However, for the reasons above, we do not think bitcoin is a good addition to our client portfolios at this time.