Is the Beauty of Bitcoin Skin Deep?

30 October 2017  |  Adam French
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The latest investment trend has certainly caught everyone’s attention.
The price of bitcoin against sterling has more than quintupled this year and an increasing number of people rely on this virtual money. We want to learn more about how it works, what advantages it has and whether it really is suitable as a financial investment.

China was the pioneer. As early as the 11th century, the Chinese were exchanging their goods for colourful bills. They were the first to use paper money – at a time when everyone else was still using shells, rice, or, more advanced, silver coins. It was paper money that later conquered the world. It was promised that the bills could, at any time, be exchanged for real assets such as gold; a commitment made by the respective rulers, and later by the state central banks.

Banks are now no longer obliged to exchange paper money into gold or other values. The US liberated the Fed from this commitment in the early 1970s when the international currency system, Bretton Woods, failed. This means that our current monetary system is now based exclusively on trust. Anyone who accepts money as a method of payment relies on the ability to exchange it for goods elsewhere and at other times. The retention of value is also assumed, taking a small adjustment for inflation into account. It may, therefore, be wise to question whether the state and its central bank – which have monetary monopoly – are good guarantors for this value. Perhaps it would be sensible to create a currency that is independent of state institutions.

A Mysterious Inventor

As early as the 1970s, the economist Friedrich August von Hayek endorsed the ‘denationalisation of money’. But it would be four decades until the launch of bitcoin – the first independent, virtual currency – caused a global stir. It was created by Satoshi Nakamoto in 2008 – but the name is a pseudonym. To date, nobody knows the identity of the cryptocurrency’s founder. The first bitcoin software was released the following year.

Conventional money derives from interactions between the central bank, commercial banks and their customers. Bitcoin is quite different. There isn’t a single institution, company or person behind this virtual currency. You simply have to imagine the bitcoin money system as a global network of computers which log each transaction. This is similar to the internet itself, behind which lies millions of computers that process every request, not just one central computer.

The Dig for Bitcoin

In principle, a bitcoin consists of encrypted data blocks. The virtual coins are created via the computer network using a number of complex formulas, a process called ‘mining’. To prevent inflation, the upper limit of bitcoins anchored in the algorithm is currently 21 million – a number yet to be reached. Given anyone can ‘dig’ for bitcoins, it would seem to be just a matter of time before the inflation ceiling is hit, however, the digging has now become too complex for normal computer systems to manage. The cost of upgrading your computer and the power then required to run it exceed the potential financial gain. For those still tempted to give it a try, you can rent computing capacity in the cloud (data centres operated by professional vendors), but even cloud power isn’t guaranteed to be sufficient. In any case, if you do manage to generate enough power, any potential bitcoin profit is far from guaranteed.

Bitcoin Cash: A Quicker Alternative

A series of complex mathematical formulas should ensure that every bitcoin is counterfeit-proof. To prevent a virtual coin from being issued twice, all transactions are stored in a database, the so-called blockchain, which is stored decentrally on hundreds of computers. As an increasing number of users use bitcoins, it is becoming more complex to log all transactions. The blockchain currently creates just seven transactions per second which means that transfers take hours. Blockchain will be developed further and speed up, but until then, expect bottlenecks. To bridge this gap, some bitcoin enthusiasts recently launched a new virtual currency, bitcoin cash, which currently processes 50 transactions per second. However, at the moment, the bitcoin cash rate is far below that of the original.

Bitcoin cash isn’t the only other type of cryptocurrency. According to the portal coinmarketcap.com, bitcoin has a market capitalisation of approximately £80 billion. The second largest virtual currency, worth over £22 billion is called ethereum. Ripple rank third at almost £6 billion and bitcoin cash is worth over £5 billion. Dash and monero also have a market presence, along with a few others.

Demand Drives Price

So much for history, technology and a range of cryptocurrencies. It is the astonishing price rise that has really caught everyone’s attention. Four years ago, a bitcoin cost roughly £130. Over the past few months, the price has fluctuated somewhere between a staggering £2,500 and £4,500. The currency is traded on digital stock exchanges, and just like stocks, price is determined by supply and demand. This means that the price of bitcoin constantly changes and everyone can buy a virtual coin or a part of it.

The Steep Price Climb

The price of bitcoin over the past four years

The Steep Price Climb: The price of bitcoin over the past four years

Note: Past performance or future projections are not indicative of future performance; Source: Bloomberg

The price of the virtual currency has more than quintupled against sterling since the beginning of the year; such is the enormous demand. Anyone looking for the cause of this price explosion should take a look at bitcoin’s list of benefits.

The cryptocurrency is:

… easy to use: anyone can open a bitcoin wallet (which is where the virtual money is kept) without the approval of a banker or a credit check. In theory, anyone who has internet access can open a bitcoin wallet.

… global: A bitcoin can be transferred online to anywhere in the world. High bank fees are not charged. This benefits those who do business internationally or work abroad and send money home.

…anonymous: Wallet owners are anonymous. This doesn’t just appeal to criminals, there are a lot of people who prefer to make payments anonymously.

… independent: No bank or state controls the currency. This appeals to anyone who distrusts the existing money system and its sovereign guardians. This will draw the attention of any countries with unstable currencies, such as Argentina.

As important as these benefits are, speculation has driven bitcoin’s recent success. Globally, more and more people want to jump aboard this fast-moving train to try and make a quick pound, euro, dollar or yen. The press has picked up on the success too and there have been a lot of bitcoin-related headlines of late. The impressive stories that surround the virtual currency have increased its appeal. For example, take the story of the Norwegian student, who invested roughly £20 in bitcoin in 2009 which he then forgot about. Four years later, he realised that he was sitting on a small fortune: his 5,000 bitcoins were now worth £500,000. ‘Just like a fairytale – student gets rich overnight’, headlined the Norwegian news.

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Bitcoin as a financial investment?

A lot of investors today question whether or not they should invest in bitcoin. They may be seeking protection against a possible collapse of the monetary system, or simply after financial gain. Anyone considering the purchase should weigh up the dangers:

1. Fraud risk

Software specialists estimate that there is a 10% risk of falling victim to cryptanal fraud. Most of the victims are ‘phished’, which means that victims receive fraudulent emails asking them to transfer their cryptocurrency to other wallets under false pretences. Anyone who keeps their virtual wallet on their computer is also at high risk of theft. The most secure way to store your cryptocurrency is by using a special, external hard drive without an internet connection – a kind of virtual vault.

Bitcoin exchanges have also been attacked several times – often successfully. The digital stock exchange Bithumb in South Korea was one of the most recent targets. This attack affected one-tenth of the world’s bitcoin traders. In this particular case, the computers attacked could secure virtual money up to the equivalent of almost £1 million.

Even more spectacular were the 2011 attacks on Mt. Gox. At this time, the Japanese stock market ran more than half of the global bitcoin trade. In June 2011, the price of bitcoin fell to just one US cent after someone accessed the passwords at Mt. Gox and assigned themselves bitcoins. When Mt. Gox filed for bankruptcy in February 2014, they discovered that over 750,000 bitcoins had been ‘lost’ by the stock market itself.

2. Regulatory risk

Governments and central banks around the world are watching bitcoin with the eyes of Argus. The possible regulation of the currency has been raised repeatedly – right up to its possible ban. The anonymity is a real thorn in the side of governments. Tax fraud, money laundering, organised crime: the bitcoin is almost purpose-built for illegal transactions. Even the use of cash is being questioned by some countries because those who use it can often escape the eyes of the state. Virtual currency offers much broader possibilities.

The second question is then raised: Why should governments give up their monetary monopoly? The central bank’s influence on monetary policy affects the economy. Governments are unlikely to quietly stand by and watch whilst such a powerful tool is taken away from them.

Alternative currency models are being worked on, some of which are based on the blockchain. Sweden is the pioneer of this work. They were the first to issue banknotes in Europe in the 17th century – and now, more than 300 years later, they want to be the first to replace physical currency entirely with virtual currency. “This is as revolutionary as paper money was 300 years ago,” said Cecilia Skingsley, deputy of the Swedish central bank. At the end of next year, we will decide whether to issue an official Swedish cryptocurrency. State currencies would lessen the attractiveness of bitcoin.

3. Price risk

Price is the greatest risk that bitcoin owners are subjected to. Investing in bitcoin requires nerves of steel. For example, in 2014 when the bitcoin stock market announced Gox’s insolvency, the price of the currency halved.

To compare risk, we have calculated the maximum drawdowns of bitcoin and other stocks over the past four years (bitcoin data has only been reliable for the past four years). The maximum drawdown is the loss that an investor would have experienced if they had entered and exited the market at the worst time.

The result: the maximum drawdown of bitcoin was 82%. Over the same period, the highest loss that the FTSE 100 experienced was 22%. Even the Amazon stock, which has had some huge price drops over the years, decreased by ‘only’ 31% over the past four years. Bitcoin may potentially offer high profits, but the risk of loss is huge.

High Risk of Loss

Bitcoin’s maximum drawdown* compared with other assets

High Risk of Loss: Bitcoin’s maximum drawdown* compared with other assets

* From 10 September 2013 to 30 September 2017; Note: Past performance or future projections are not indicative of future performance; Source: Bloomberg.

Bitcoin ETF: Pending

At the moment, investing in bitcoin is out of the question for us at Scalable Capital. We invest exclusively in exchange-traded index funds (ETFs). An ETF on the virtual currency isn’t yet available, although there are some attempts being made across the Atlantic in the US. Some investors, including the Winklevoss twins – known for their eye-catching litigation with Mark Zuckerberg – have filed an application for the approval of a bitcoin ETF. None have been successful, yet. We would also want to ensure that trading with a bitcoin ETF was sufficiently liquid before we integrated it into our investment universe.

However, even if this bitcoin ETF was to launch soon and be sufficiently liquid, it would be some time before bitcoins migrated into our clients’ portfolios. This is mainly because the virtual currency lacks long-term performance history – bitcoins were launched in 2009. For our risk management algorithm to be able to process this cryptocurrency, we would need reliable price data, preferably going back a few decades. Another reason for our abstention from the asset.

In Conclusion

The rise of virtual currencies is an exciting trend. It is possible that they will eventually be widely used by private individuals and regulated by the state. It is probably helpful for everyone to build up a bit of experience with the cryptocurrency.

However, in its current form, the chances of the virtual currency becoming a globally accepted method of payment are slim. The only thing we can be almost certain of is that its future price trajection will be volatile. Investors will need nerves of steel and should only invest as much as they can afford to lose.

“Sooner or later, paper money will return to its intrinsic value – zero,” the French philosopher Voltaire has said. Virtual currencies are also vulnerable to this risk.

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Adam French
CO-FOUNDER & DIRECTOR
Adam spent the last 8 years working in London in the financial services industry. As Executive Director of Commodities Trading at Goldman Sachs, he was responsible for the Commodities Structured Products franchise. Prior to this, he worked in Derivatives Trading where he was responsible for electronic trading for private clients in fixed income, currencies and commodities products. Adam studied Business Mathematics and Statistics at the London School of Economics.