Cryptocurrencies and the Bitcoin Phenomenon

  • Bitcoin’s use as medium of exchange is growing, but limited
  • Bitcoin is a speculative trading vehicle which we do not recommend purchasing since it’s impossible to value
  • Cryptocurrencies and blockchain are in the early stages of development and could revolutionize finance

Bitcoin is a digital currency that was developed as an alternative to government-backed currencies such as the US Dollar, Euro and Japanese Yen. The currency was created by a dedicated cadre of computer programmers to reduce the frictional costs associated with moving money between parties by creating an ingenious verification mechanism. The Bitcoin system is distributed over almost 60,000 servers which maintain a ledger of all transactions of the currency since inception (this ledger is referred to as a blockchain).

Bitcoin can be exchanged for other currencies and tangible goods and services in the real economy. Even though this electronic form of money was developed to serve as a currency, the volume of non-investment exchanges of Bitcoin is limited. Payment processor BitPay reported in late 2017 that it expects to transact $1 billion worth of business on its platform for the full year. This amount is inconsequential relative to dollar-based transactions; however, Bitcoin volume grew over 300% in 2017. Bitcoin is also growing explosively in Japan where it is viewed as legal tender and accepted by 260,000 merchants. For comparative purposes, roughly $2 trillion worth of transactions took place across Visa’s vast network in 2017.

While Bitcoin’s use as a currency is growing, it will be difficult for it to become established as a widespread currency since its value is so volatile that it is impossible for sellers to price their goods and services accurately. There are also technological limits to the number of transactions that can occur within a certain time frame which impedes Bitcoin’s full-scale adoption as a currency (other cryptocurrencies have addressed this technical limitation).

At the beginning of 2017, one Bitcoin traded for $968. After an incredible runup that gained momentum in the last quarter of the year, the cryptocurrency ended the year at roughly $14,000 per unit. This phenomenal appreciation has led to extensive media coverage, most of which touts the gains without much discussion of the forces driving the appreciation or the merits (or demerits) of cryptocurrencies in general. The supply of Bitcoin is limited by design. There are currently 16.8 million Bitcoins in circulation and an algorithm limits the increase so that the total number of tokens will never exceed 21 million. Therefore, Bitcoin’s price is almost completely determined by the by demand for the currency.

Bitcoin has no intrinsic value beyond what the market determines since each “coin” is only a digital token with a unique identifier. Unlike stocks and bonds, Bitcoin does not produce dividends or interest payments to reward holders of the currency with a steady stream of cash flows. Unlike earlier versions of paper money, Bitcoins are not backed by a quantity of gold or silver. Investors generally buy Bitcoins because they believe the price momentum will continue and the value of the token will keep increasing. These investors expect that the demand for Bitcoins will increase and long-term holders will be able to sell their Bitcoins to others for a higher price. Bitcoin is also one of many cryptocurrencies. Ripple and Ethereum have smaller market capitalizations, but their values actually appreciated at a faster rate than Bitcoin last year. Any one of these currencies or another digital token could supplant Bitcoin and render it worthless.

Given these risks, we view Bitcoin as a speculative vehicle, but not an investment. The price of the token may continue to rise if more and more speculators join the bidding; however, there is no valid methodology to ascertain its value. Therefore, we do not recommend purchasing Bitcoin, or any of the cryptocurrencies as investments.

On the other hand, we view cryptocurrencies themselves and the blockchain technology that undergirds the currencies as incredible developments that could revolutionize finance. Bitcoin and other cryptocurrencies address a number of inefficiencies and potential problems with government-backed currencies as they exist today.

All of the developed countries carry very high levels of debt relative to the sizes of their economies. For instance, Japan’s debt level is over 2.5 times the size of its economy. Governments typically debase their currencies to repay debts by printing money. Unlike with Bitcoin and certain other cryptocurrencies which limit their supplies by design, the supply of dollars, Euros and Yen is not limited and is controlled by the central banks. Therefore, a credible cryptocurrency could serve as a store of value in a world where governments could be tempted to weaken their own currencies to pay their debts.

It is also very expensive to process payments in the current environment. Visa, MasterCard and American Express have built incredible businesses processing payments; however, their fees are high especially for smaller purchases. For instance, Visa charges 1.5% plus $0.10 for each credit charge transaction. The rationale for the fee is to ensure that the money for the transaction is sufficient to cover the purchase. This verification role is not necessary in the cryptocurrency world since blockchain itself has validated that a holder of cryptocurrency actually owns that value. Therefore, frictional transaction costs would decrease to much lower levels.

Blockchain ledgers can apply to many different arenas beyond currencies. Any financial security such as a stock or bond, could be sold through blockchain technology to reduce frictional costs. Blockchain could also be used to sell physical goods. For instance, WalMart is operating a pilot program to apply blockchain technology to trace Chinese pork and Mexican mangoes from their source to the grocery store. This technology may help track food borne illnesses in the future.

Blockchain and the cryptocurrencies are in the early stages of their development. We do not have a guess which cryptocurrency will dominate the market and how these currencies will co-exist with government-backed money. However, the financial resources and intellectual capital directed to their advancement ensures that the pace of change will be rapid. While we view the current Bitcoin explosion as a speculative frenzy, we are excited to see how the technology evolves and hope to take advantage of investment opportunities as they mature.