Bitcoin is all the rage lately. The price has jumped from about $952 at the beginning of the year to approximately $17,248 as of December 12, 2017 according to Bloomberg, including a spike of over 400% in the last three months. Can Bitcoin’s meteoric rise continue, and if so for how long? Now that everybody seems enthralled by bitcoin, the better question is, what is it? Bitcoin is a decentralized cryptocurrency. A cryptocurrency is a digital asset that is meant to be used to facilitate transactions and uses cryptography to ensure the transactions are safe. Theoretically, it is designed to be an alternative to money. The decentralization part of bitcoin is also an important feature. Centralized currencies such as the dollar, pound, euro, yen, etc. are issued by central banks and the amount outstanding is in theory infinite. As we have seen throughout history, fiat currencies are susceptible to devaluations.
Bitcoins are created by “miners” and in the case of bitcoin the maximum amount that can be mined and outstanding is capped at 21,000,000 bitcoins, which could give it a scarcity value. This is exacerbated because a large percentage of outstanding bitcoins that have been issued are concentrated in a few hands. Another feature is that it requires the owner to maintain control of the cryptographic key. If the owner loses the key, the bitcoin is forever lost. Additionally, maintaining ownership of the bitcoins requires keeping them secure. Hackers can and have stolen millions of dollars of bitcoins. Just last week, 4,736 bitcoins valued at around sixty-two million dollars at the time were stolen from the bitcoin mining exchange, NiceHash.
Bitcoins are generated by solving mathematical equations. Once the equations are solved, miners receive bitcoins for their troubles. This sounds simple, but as more bitcoins are mined, the equations become increasingly more difficult. The amount of energy required to mine bitcoin and other cryptocurrencies is growing rapidly and is substantial at this point. Miners need to locate their mining servers near cheap sources of power such as hydro-electric dams. Additionally, bitcoin mining generates a lot of heat and it is necessary to keep the servers cool to avoid them breaking down. Bitcoin mining is complicated and expensive and probably requires high cryptocurrency prices moving forward.
Once you understand how bitcoins and other currencies are created, the question becomes: are cryptocurrencies money? If they are not now, can they be in the future? This question raises the additional issue of what exactly constitutes money. At one time, crops and livestock were treated as money. So were shells. Eventually, coins of various metals became money, before being replaced by physical paper notes and cash stored at a bank. Today, a lot of the money people keep is in either checking or savings accounts in a bank, encoded with 1s and 0s. Fiat currency does not have any intrinsic value. Its value is a result of being “legal tender” of a sovereign entity.
Money has consistently had three basic functions: a store of value, a medium of exchange, and a unit of account. Money is a store of value, although it is not a flawless store of value. If you hold cash that is not invested in an income-earning instrument, it will slowly or in some cases rapidly be eroded by inflation. As a medium of exchange, it makes transactions possible without having to resort to barter. Restaurants, grocery stores, utilities, etc. agree to accept money for their services. Money is also a unit of account which means that it can be used to determine transaction value. If you make a small or large purchase, having the price set in dollars or yen or euros helps to facilitate the transaction. Bitcoin is clearly a unit of account, it can be divided, subdivided and added over and over to determine the price of a good or service. It is debatable whether bitcoin is a medium of exchange. Some companies accept bitcoin and that list is growing, but it is not widely accepted for goods or services at this point. As a store of value, bitcoin has maintained its value. However, it can be argued that the price of bitcoin is much too volatile to be considered a store of value. Nevertheless, it has been a better store of value than the Venezuelan bolivar. Whether bitcoin can be considered money depends on the definition of money.
The United States dollar has been the global reserve currency for about seventy-five years. The global reserve currency has transitioned from Spain to the Netherlands to France to Britain to the United States over the last five centuries. The only thing that appears certain when looking at history is that at some point in time, the United States dollar will be replaced as the global reserve currency. The question is: what will replace it and when? Could bitcoin be the next global reserve currency? NPP thinks it unlikely, but we can’t dismiss this possibility completely. If the dollar were to lose standing as the world’s reserve currency tomorrow, we’re not sure which country and currency would step in to fill the breach. The euro and yen have many problems, not least of which are terrible demographics and increasing central bank ownership of financial assets. The Chinese yuan is probably the most likely alternative, but even that seems unlikely at this point. Could gold become the reserve currency, or some currency backed at least partially by gold? This is possible and would again point to the yuan, but we think this is unlikely in the immediate future. Maybe bitcoin is digital gold, while ethereum and the other cryptocurrencies are lesser precious metals. If this is the case, bitcoin could continue to rise until its capitalization approaches gold.
The underlying technology behind bitcoin called blockchain may be transformative, but that does not ensure that bitcoin has any intrinsic value. It is worth whatever someone is willing to pay for it. Regulatory actions in the United States and abroad could potentially snuff out the run-up in bitcoin and lead to a cryptocurrency price crash. If bitcoin is not worthless, the global financial system may be primed for a massive change. Maybe millennials will migrate to crypto-currencies the way baby boomers migrated to equities. A growing distrust in government could lead to a desire for a reserve currency that’s free of meddling from ineffective politicians and bureaucrats. NPP is not sure what bitcoin will become. We think current bitcoin price action is consistent with a bubble, but cannot dismiss the possibility that bitcoin itself is truly transformative. Bitcoin is clearly a high-risk investment and only investors with large risk tolerances should own it. If you do buy it, we would suggest buying only a small amount. We feel the likely outcome for bitcoin is binary: either considerably higher from these levels or zero value. The former case would compound a small investment many times over, while the latter would result in a total loss. In the near term, it should be noted that these outcomes are not mutually exclusive. Bitcoin could go significantly higher from current levels before crashing to zero. No matter what the future holds, the evolution of bitcoin will be fascinating to watch unfold. Please note, this is not a recommendation, just our observations on a much talked about subject.