Issue #49 – “Bitcoin & Crypto-Currencies”

“There are two times in a man's life when he should not speculate: when he can't afford it, and when he can.” 
– Mark Twain

Interesting Links from Around the Web:

Related:  The Baseball Card Bubble : The Economist
Technology :  Transition to self-driving cars in 13 years? to self-driving cars in 13 years? :  TechX
Investment  :  Jim Rogers expects big crash :  Business Insider

Ethereum, Ripple, NEM, Litecoin, and the hundreds of other digital currencies, nicknamed altcoins, are all variants of the original crypto-currency Bitcoin.  An investor who purchased $100 worth of Bitcoin in 2011 would have passed the $500,000 mark in May of this year, a 500x return on investment in six years. 

So what is a Bitcoin, how does it work, what is it used for, and how does it impact you – as a consumer and investor? This month, I dust off my computer science degree and boil down this game-changing technology.

What Are They?

The best way to understand the concept of digital or crypto-currencies is to think of them as foreign currency from another country.  For example, when visiting another country you most likely first convert some of your $CAD to use during your travels. 

Upon your return, you then convert your remaining foreign currency back to $CAD although the exchange rate may have changed. Similarly, enthusiasts argue that digital-currencies will become the currency of the internet, while the particularly dogmatic believe they are the first truly international currency.

As with any other currency, you must exchange goods, services, or other currencies to receive digital currency “tokens”.  Once obtained, you can save it, lend it, trade it, and/or spend it, so the tokens work just like regular dollars but without the interference of governments, banks, and other intermediaries.

Digital currencies are attractive for several reasons: most notably convenience, cost, and transparency.    Anyone who has sent funds internationally via money order companies can attest to the exorbitant costs and inconvenience of the existing channels.  Similarly, new business owners are always shocked to learn that credit card companies charge a 2-4% processing fee per transaction, while Interac systems are not much better!  These fees are further compounded by banking costs incurred by individuals every day.  From sending money to a friend using Interac E-Transfers to withdrawing money from an ATM, service charges to use your own hard-earned dollars are everywhere!

Money is vitally important for trade as the primary method of exchange, yet current financial structures are plagued with process inefficiencies and excessive fees which have long gone un-noticed, much to the profit of banks and financial intermediaries.  These added costs of doing business or gaining access to the monetary system are comparable to a toll bridge through which all transactions must pass, and for which a toll-person collects their due at each interaction.  Like other new disruptive technologies, digital currencies’ are changing the status quo and have set their sights on these so-called “tolls”.

Due to their more efficient nature, digital currencies can be purchased, sold, and transferred anywhere in the world in seconds and for a fraction of the “toll” levied by financial intermediaries.  This efficiency is due to a significant technological breakthrough uncovered during the development of crypto-currencies: the blockchain, discussed later in this article.

How Do They Work?

Digital currency users begin by opening an account with an “exchange” using a computer or smartphone app.  Exchanges operate similar to stock markets and list various currencies available for trade at market price which fluctuates every day based on offer and demand.    Once active, users connect their bank account and can begin freely converting currencies to buy goods and services, invest, or send to friends.

Bitcoin is the most prominent form of crypto-currency and is by far the easiest to purchase or spend.  Many prominent retailers including Microsoft, Dell, Shopify, and even Subway, albeit in limited locations, accept it.

Crypto-currencies are very secure and have stood up far better to hackers than conventional databases, due to an innovative way of storing and authenticating information online.  Rather than saving information on one centralized database, encrypted information is stored across the Internet on what is known as “nodes”. 

When money changes hands, you provide a secure key to confirm that the money is indeed yours to trade.  Once approved, the trade is propagated throughout the decentralized server.  In other words, a successful hacker would have to simultaneously crack thousands of encrypted databases spread around the world in order to “steal” funds:  a significantly more challenging task than cyber-attacking a conventional bank with centralized data storage.

How Does This Impact Me?

Unless you are dealing in the shady corners of the Internet where the anonymity of Bitcoin payments are paramount to its success or your computer was infected with the “WannaCry” virus that locked all your files and demanded payment in Bitcoin, your exposure to this growing movement has likely been limited.  Apart from the novelty of using this new technology, the volatility of the currency makes it unattractive for daily use and so the impact on every day consumers has been limited.

Typically, discussions around Bitcoins or the other crypto-currencies revolve around their breakneck appreciation and how much money could or has been made by buying early-on.  “I should have bought Bitcoin” is a familiar phrase whenever the topic is broached and justifiably so!  As I mentioned earlier, if you purchased $100USD of Bitcoin in 2011, it would be worth in excess of $500,000 today.1 Now that we have a fundamental understanding of what crypto-currencies are, let’s discuss them as an investment.

Investment Opportunity?

Merriam-Webster defines investment as “the act of putting out money in order to gain a profit”.  Undoubtedly, those who jumped in early on the Bitcoin bandwagon have been handsomely rewarded for their willingness to “suffer the slings and arrows of outrageous fortune”.  Over the past 30 days alone, an investor could have made or lost 25% depending on when they purchased Bitcoin.  In other words, it is very volatile!  Over the past four years, this market has seen its shares of booms and busts, and only the bravest of investors held on for the ride.

There are three primary ways to make money on crypto-currencies:

The first is similar to traditional stock markets and involves buying, holding, or actively trading the big established currencies like Bitcoin and Ethereum on the alt-coin markets discussed above – trying to buy low and sell high! 

The second is to get in early when a new crypto-currency is launched, known as an initial coin offering (ICO), and is similar in nature to an initial public offering (IPO), the initial offering of shares on a stock market.  Naturally, doing so grants the greatest prospect for quick riches if the coin you invested in becomes widespread then you could capitalize on a meteoric rise similar to Bitcoin.  In an effort to personally profit from the massive flood of speculative money into this space, hundreds of new crypto-currencies are being launched with at least 25 ICOs slated for the month of June, 2017.  Those interested in learning more about ICOs should read this article (Link)2.

Finally, those willing to contribute computer resources to the cause can sign up as a “node” and participate in the network.  In exchange for renting their computer’s processing power, crypto-currencies offer a fixed number of new coins every year which are “mined” as a kind of lottery system.  For example, every time your computer works through a difficult problem, you are awarded a ballot and so the more processing power you dedicate, the more chances you have of winning newly minted coins.

As with any venture, the prudent investor tries to ensure a return on their capital regardless of market sentiment.  In other words, finding a company, property, or asset that can produce a profit and return it to investors regardless of whether the stock market is up or down. 

In an effort to explain my views on investing in Bitcoin or other crypto-currencies, I offer the following analogy.

Imagine a rental property with tenants from whom you collect rent over time. If you plan to continue receiving rental income to live from, then it does not matter what the real estate market is doing: up or down, you still earn a rate of return on the money you put in.

Conversely, someone who buys a plot of land and holds onto it in the hope of selling it a profit later must rely on the real estate market appreciating in order to earn a rate of return.  An individual who purchases an item with the belief that they can turn around and sell it later for more than what they paid without any intrinsic justification for that belief is known as the “Greater Fool Theory”. 

To better illustrate this point, consider someone who buys a hockey card for $1000 (or Beanie Babies for those who remember them!) and expects to be able to sell it for $2000 in the future.  It is irrational to buy a piece of paper (or a stuffed bear) for $1000 as it has very little intrinsic value.  Economic value is solely realized when another person purchases that item.  In doing so, that person is likely making the same assumption as the first person did but ascribes a higher value to it, like buying for $2000 and hoping to sell for $3000.  In all cases, the only way to sell this piece of paper for more money than you purchased it for is to find a “Greater Fool”. 

At this time, given all the information I’ve been able to find on Bitcoins and crypto-currencies, they are currently more similar to hockey cards than rental properties.  It is completely possible that these alt-coins will transform the world and become the currency of the internet, and in so doing increase significantly in value and make many people rich in the process.  In fact, I would love to see that happen as the technology is truly impressive and could reduce the cost of doing business while bringing currency into the 21st century.

However, it’s important to note that it is equally likely that these gains may not materialize, or that a crypto-currency other than the one you invested in will be the one that takes the crown, perhaps even one not yet invented!  Should one of these scenarios occur, it could result in a total loss of your invested principal as there is no reason to buy a useless currency.  For this reason, I would contend that a venture for profit into the realm of crypto-currencies cannot be considered an investment, but rather should be seen as speculation. 

For those who have the willingness to lose all the capital they invest, crypto-currencies are certainly worth considering.  Of all the alt-coins, I prefer Ethereum as a complimentary platform to Bitcoin due to its ability to carry out smart contracts3 which could have a tremendous impact on all our lives without us ever realizing it.  For the rest of us looking to save for retirement or to steward money for the next generation, I believe it’s best to stay on the sidelines and watch this play out.

Conclusion

For all its promise, crypto-currencies are very exciting for what they bring to the table.  Like many other industries before it, the world of finance and banking is long over-due for a tech disruption similar to the manufacturing sector in the 20th century or those set to happen in the transportation sector with self-driving vehicles.  In particular, the advent of the blockchain is set to revolutionize data storage, record keeping, and according to some, the internet as we know it. 

Of all the articles I came across on the subject however, I would recommend reading Jon Evans’ column in TechCrunch Blockchains are the new Linux, not the new Internet.4

 

Jean-François Démoré
CIM, CFP, MBA, HBCCS

1. If you had Purchased 100 bitcoins 2011:  http://www.investopedia.com/articles/investing/123015/if-you-had-purchased-100-bitcoins-2011.asp
2. WTF is an ICO:  https://techcrunch.com/2017/05/23/wtf-is-an-ico/
3. Smart Contracts:  The Blockchain technology that will replace lawyers  https://blockgeeks.com/guides/smart-contracts/
4. Blockchains are the new Linux, not the new Internet:  https://techcrunch.com/2017/05/28/double-double-cryptocoin-bubble/

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The information contained herein was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. This report is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell any securities mentioned. The views expressed are those of the author and not necessarily those of ACPI.

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