What exactly is Bitcoin and how does it work?
In its simplest definition, Bitcoin is just another currency. A store of wealth and means of exchange that can be used to pay for goods and services. However, unlike more familiar currencies, Bitcoin is not a currency that you can hold in your hand. It is purely a digital currency (or cryptocurrency) that is stored in digital wallets, with all transactions being recorded on an online ledger known as the blockchain.
The Bitcoin network was in fact created by a person, or group of people, under the pseudonym Satoshi Nakamoto. After releasing a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”, Nakamoto implemented the necessary coding and software, before releasing it to the public in January 2009.
Existing in a deregulated marketplace without any centralized authority, like a central bank, the Bitcoin network is largely supported by its “miners”. No, not the usual fly-in-fly-out, miners, but rather specialized problem solvers who possess enormous computing power. The system is such that miners are rewarded with Bitcoin each time they solve a computational problem that requires them to verify previous transactions made on the blockchain. Therefore, Bitcoin mining is essentially the backbone of the entire network, relied upon for both security and transactional verification.
A final feature of Bitcoin, and certainly an appealing one from an investment perspective, is that its supply is limited. According to the protocol, only 21 million Bitcoins can ever be mined. And with over 18 million already said to be in circulation today, it’s estimated that the final Bitcoin won’t be mined until 2140, due to “halving events”1 that occur roughly every four years.
The case for investing in Bitcoin today
Over the last couple of years, we have seen a rising mainstream acceptance of Bitcoin, as both a legitimate means of payment as well as an investable asset class. This is a key difference between the environment we saw in late 2017, compared to the environment we see today.
A host of highly regarded institutional investors have made big investments into the space and payment platforms like PayPal and Square have recently updated their suites to allow for transfers and payments via Bitcoin. It’s also been reported that Goldman Sachs and JP Morgan, two of the world’s largest investment banks, have issued a request for information (RFI) to explore the possibility of digital asset custody.2 These are all major developments regarding the future of Bitcoin investment.
Furthermore, the unprecedented amount of money printing by central banks in response to COVID-19 has recently shone the light on asset classes renowned for providing capital preservation and a hedge against inflation. Whilst gold has traditionally played this role in portfolios over the past century, its argued Bitcoin has now entered the arena due to its limited supply, even adopting the nickname “digital gold.”
Signs of increased market adoption together with limited supply, no doubt forms a compelling supply-demand argument for price appreciation. However, there are other considerations we must first be aware of.
What kind of risk and return can we expect from Bitcoin?
When making investment decisions, we should always look to maximize our expected returns for a given level of risk that we can afford to take. Bitcoin makes for an interesting proposition in this regard, given that its expected return is effectively nil. Unless of course, you consider Bitcoin to be an inflation hedge, whereby you might expect a nominal return equal to the rate of inflation. But unlike other asset classes, Bitcoin does not produce earnings, nor does it pay dividends, interest or rent. The absence of any income stream also makes it challenging to value using traditional valuation methods.
One might point at the historical price return and question why we can’t expect this performance to continue? Firstly, we must appreciate that Bitcoin has only been around since 2009, and its relative infancy would prohibit making reliable return assumptions based on historical data alone. Secondly, Bitcoin is exceptionally volatile, which also makes it incredibly difficult to insinuate any expected future value. In its short existence, Bitcoin has already experienced three separate peak-to-trough drawdowns of over 80%. In comparison, the share market has only experienced such an episode once in all its history – during The Great Depression.