Bitcoin has been grabbing a lot of headlines in recent weeks as its price has risen from $5,000 in mid-October to an all-time high of more than $16,600 last week before settling at $14,490 on Friday, according to Bloomberg.
While many people have heard the terms bitcoin, cryptocurrency and block-chain, far fewer know exactly what they mean.
So let’s start with some background. Bitcoin is a digital currency that was created in 2009 by an unknown person using the alias Satoshi Nakamoto. Transactions are made with no middlemen, meaning to banks. However, its place in popular culture is more of an investment vehicle than a means of transacting. However, according to BlockGeeks.com, bitcoin was a byproduct of the decentralized digital cash system that Satoshi was creating. The system was similar to peer-to-peer networks such a BitTorrent for file sharing. Where digital cash systems that came before bitcoin failed was in developing a payment network with accounts, balances and transactions that prevented “double spending,” where one entity spends the same amount twice. Previously, this was attempted using a central server who keeps record of the balances. But with a decentralized system, the need for a central server is eliminated. Instead, every single entity of the network does the job, which means every peer in the network needs to have a list with all transactions to check if future transactions are valid or if there is an attempt to double spend. This also requires an absolute consensus on the state of balances, otherwise the whole system breaks. Satoshi’s system was able to achieve consensus without a central authority. Cryptocurrencies are a part of this solution.
Cryptocurrencies are limited entries in a database that no one can change without fulfilling specific conditions, which is how you define the currency you hold in your bank account. A cryptocurrency like Bitcoin consists of a network of peers. Every peer has a record of the complete history of all transactions and thus of the balance of every account. When a transaction using bitcoin is performed, the payer’s side of the transaction is signed with their private key. After signed, a transaction is broadcasted to the network, sent from one peer to every other peer. The transaction is known almost immediately by the whole network but it takes a specific amount of time to get confirmed. This confirmation is the critical concept of cryptocurrencies. As long as a transaction is unconfirmed, it is pending and can be forged. When a transaction is confirmed, it is set in stone. It is no longer forgeable, it can‘t be reversed, it is part of an immutable record of historical transactions: the so-called blockchain.
Only miners can confirm transactions. This is their job in a cryptocurrency-network. They take transactions, stamp them as legitimate and spread them in the network. After a transaction is confirmed by a miner, every node has to add it to its database, thus becoming part of the blockchain. For this job, the miners get rewarded with a token of the cryptocurrency, for example with bitcoins.
Investing in Bitcoin
Starting Sunday, CBOE Global Markets Inc. started letting traders buy and sell bitcoin futures. By allowing investors to bet on or against bitcoin, this could impact its price. Volume in the futures contracts was modest the first day of trading and many believe it will take some time for momentum to build. However, futures trading on a regulated exchange will allow professional investors who may be prohibited from investing in bitcoin on unregulated markets to do so. Similar futures contracts are set to start trading soon on CME Group Inc.’s exchange.
AAII Weekly Survey Question
Given all the attention bitcoin and cryptocurrencies have been receiving, last week’s survey question asked:
Do you invest in cyptocurrencies such as Bitcoin?
Here are the results:
The vast majority of the 2,631 respondents said they do not invest in cryptocurrencies. Furthermore, almost the same number of readers said that they invest in cryptocurrencies as those who do not know what cryptocurrencies are (98 versus 90).
Weekly Special Question
With a jump in the value of bitcoin over the last couple of weeks, there has also been much discussion as to whether we are seeing a “bubble” phenomenon, similar to the Tulip Mania of the 1600s or the dot-com bubble of the late 1990s.
This, in turn, spawned last week’s special question:
Do you think Bitcoin and other cryptocurrencies are legitimate “stores of value” or is this the next Dutch Tulip Bulb Market Bubble in the making?
In all, we received 550 responses.
In all, nearly 74% of responses said they believe the bitcoin and cryptocurrency craze is a bubble.
Only 12.4% of respondents believe that cryptocurrencies are a legitimate store of value.
The remaining 13.6% of readers are not sure whether we are seeing the latest investment bubble or if cryptocurrencies will be a legitimate store of value moving forward.
Here is a sampling of the responses:
- “As a medium of exchange, bitcoin is currently much better than precious metals are, but this won’t last. A store of value it isn’t. As either currency or value, the fact that it is backed by no government, no national treasury and no national bank should indicate that markets will eventually ignore it.”
- “As Warren Buffett said never invest in something you don’t understand. So, yes, Dutch tulip bulb.”
- “No intrinsic value. No established market. It’s worse than the Dutch Tulip Bulb Market Bubble. At least the investor kept the flowers. Good luck holding on to vapor!”
- “A digital currency such as bitcoin is extremely unstable as shown by its extreme volatility over the limited time it has been available. The Kelly Criterion, used in gambling to set the maximum size of a bet, suggests that the maximum amount you should wager on it is less than 1.0% of your assets. I will wager nothing on bitcoin or other digital currencies because I want to sleep at night and have other investments that yield 20% to 30% annually with far less risk.”
- “A way to store value in times of high inflation. Provides a means to make payments in other countries than your country of residence.”
- “I have no idea what bitcoin is or how it works.”
- “I stay away because they are so easy to steal from an individual’s wallet. Most investors have no idea how easy that is to do and those that do usually put their wallet on a thumb drive that is easy to physically lose.”
- “There is a lack of supply in bitcoin and this is driving price appreciation as measured in dollars. The commerce side of demand is missing. I believe it is a one-sided equation that will collapse. A bubble in trouble.”
- “Your survey should have included the option ‘Not yet’ because that is where I am. Cryptocurrency is not the next Tulip Bulb Bubble. It is also still too opaque for the average investor to risk it as an investment.”
Everybody has an opinion! Why not give us yours? Participate in our weekly member poll, updated every Monday, and see the results online at www.aaii.com/memberquestion.