What exactly is Bitcoin? Maybe it’s a question you’ve been dying to ask, because you can’t turn on the news without seeing headlines blaring Bitcoin values. As of this writing, the exchange rate is almost $58,000 per coin, which is around 828% the price in March 2018 (Statista, 2021). Quite the shock-and-awe gains. But what is a “bitcoin,” anyway – and at what price could those gains be delivered? Bitcoin is a type of digital currency called cryptocurrency and there are more than 5,000 different types of digital coins (Ashford, 2020), and even more reported elsewhere.
The theory behind digital currency is to create a decentralized currency system, free from central bank manipulation. Bitcoin is unique because it operates using “blockchain” technology. (Deep breath…) What is blockchain? Imagine a company owns 10,000 networked computers which hold all of their client information. The company is responsible to secure the computer as well as the information contained on the computer. This company has a centralized control and storage system. What Bitcoin has done is create a way to store information on thousands of computers owned by thousands of individuals – with no direct personal connection. In this way, the “network” is decentralized; no person, organization or country has control. Bitcoin’s blockchain network is often used to create a record of financial transactions. This record is a permanent marker- so every time a bitcoin is used, or ‘spent’ a permanent record exists. Alarm bells should be going off because a record like this could be good or bad- depending on control.
No, really, what is it? Cryptocurrency is money. It is money.
What makes this thing money is the fact that users of cryptocurrency believe it is useable as money. Seems odd, but this is true of anything used to create or store value. We could trade classic cars, stamps or a Monet for something of value. In each case, some people believe these items have real value and are willing to accept an item they own as fair trade. That’s all money is, really, an acceptable trade. But if Bitcoin is to be used as practical money, the violent swings in value hinder its usefulness. Imagine going to a casino and purchasing chips. You trade “real” money for something that has value. However, the chips are not valuable outside of the casino because the agreement of value does not extend outside that property.
I could not take $150 worth of Bellagio chips and trade them for a soda at Harrah’s, though the chips have a clear denominated value printed on them. Unlike casino chips, which have a predetermined value, cryptocurrency has a fluctuating value. Imagine cashing out $150 of chips after a day’s worth of excitement. Cha-ching! The cashier hands you $42 in cash; bit of a buzzkill. With Bitcoin, this type of fluctuation is not only possible, but has occurred recently. Of course, it is also true that sometimes the price change would be in your favor. So in cashing out those casino chips worth $150, suddenly you would receive $300 back – double the fun! Users of Bitcoin might get more than excitement to overcome this extreme risk. They might feel a sense of belonging in being a part of something “bigger.” Or, they may feel that their investment follows personal convictions: users are laying stepping stones into their envisioned future with each coin purchase. As serious investors, we must ask if these side-benefits are worth the money used to purchase. And is this challenge to the status quo good for the currency which likely backs most of your nest egg?
Excitement at What Cost?
Bitcoin’s explosive rise in value is bad for its future as a currency. Part of the reason for the rise in cryptocurrency prices (particularly for Bitcoin) has been… the rise of the price.
As redundant as that sounds, this asset class has benefited from momentum: as the price rises, more people became aware and money began flooding into the new place for investment. But investment is always a product of available capital and alternatives. To invest in Bitcoin often requires selling other investments to free-up cash.
As this investment grows, it may not be all positive because the move to free-up cash is larger to purchase one bitcoin. It is fun to look back at the meteoric rise and imagine, ‘what if…’ but as a single coin price approaches $60,000, the purchase requires moving a much larger percentage of assets to create a relative position within a portfolio. In other words, it takes a larger sale of currently owned assets to raise the necessary cash to purchase Bitcoin. This follows, because unless you’re Warren Buffet, most of us would sell one investment to buy another.
Imagine that your investment portfolio is $800K and you buy a single Bitcoin for $10,000. This position represents just over 1% of your total, but what about when Bitcoin trades at $60,000? This single position is now more than 7% of your total invested assets. Generally, that is not great for an asset or risk management. If the value of Bitcoin dips to pre-mania levels, losing 7% of your assets isn’t fun. You may whisper, “But prices always come back.” While generally true of broad U.S. markets (yes, Bitcoin is the dominant coin – much better position for the long term), the element of time is important to consider.
This is not to pick on Exxon, the large oil company, but an investment in Exxon 10 years ago would have almost no gains (it pays a dividend) – and would be worth less – because for the past 10 years, the stock has fallen or been basically flat. Even at this point (where we have a loss in stock value due to inflation), the scenario yields minute losses when comparatively, prospective losses in Bitcoin could be virtually all of it.
So, while it is generally true that broad U.S. markets do often continue to grow, individual investments do not. Investing is always a decision of relative options, so the decision to wait on a position or investment to “come back” has real consequences. Those dollars are not available for other investments. Bitcoin has shown amazing price increases over the past five years, but also huge price drops.
The Worst Knock-knock Joke, Ever
Let’s set aside the investment questions for a moment and focus on the fun part. Assume you bought Bitcoin after it dropped 72% and you are now the owner of two digital “coins.” The price just hit $60,000 and you sell… great! What’s that, now? Do you hear that knocking on your door? It’s Uncle Sam.
According to Kyle Nagy, CPA, there’s good news here and bad news. The good news is the $100,000-plus profit; the bad news is a pretty hefty tax bill. Bitcoin is not a traditional investment, so the tax treatment is not the same as traditional investments. And while taxes are a reality of profit… investment is always about relevant alternatives. This includes alternatives with varying tax treatment. It would be incorrect to argue against Bitcoin because of the larger tax bill. However, it is also unwise to ignore the reality of taxes.
“But I Still Just Want to Use Cryptocurrency”
Just how many digital- or cryptocurrencies are there? According to Coinmarketcap.com, there are now more than 9,000. This is not the same as saying there are 9,000 so-called “fake” types of money. True, the vast majority of these coins will not exist in the next few years. If called to task, we can say that Bitcoin seems to be unique because of the decentralized nature and the total value of the market. Bitcoin total value (or market cap) is currently north of $1 trillion, while the total cryptocurrency market is around $1.6 trillion; this market share shows inklings of stability. Above all, the ultimate challenge remains in using cryptocurrency in everyday life.
Cryptocurrency requires an exchange from “real” money. You create a coin wallet, or a coin account, and fund it with dollars from your checking account. So far, so good. But what happens when you want to take err… some of a bitcoin and pay your car payment, go out to eat, or have any function of utility in your life? The coins must be transferred back to your bank. And this is where we believe Bitcoin will have a challenge broad household adoption: using this as currency currently ultimately requires denomination in dollars. Go anywhere in the world and you can present a U.S. dollar in trade for goods or services. Bitcoin, while spendable at a few select retailers like Microsoft, does not have the same utility.
Because Bitcoin – or any cryptocurrency – must be exchanged back to dollars, this currency is subject to control by other currency systems. If central banks around the world wish to eliminate cryptocurrencies, they would shut off access to other currency systems. And that is ultimately the reason we do not believe cryptocurrencies have potential for broad-based usage. However, the other side of the coin (pardon the pun) would also be true. If central banks wish to create absolute control (a system where every transaction is recorded… a cashless currency system) and this aligns with your personal interests, then Bitcoin is for you! Not to offer baseless conspiracy, but we do not believe this would be effective as an ultimate plan. It does seem to be one of many outcomes. And this outcome provides central banks the ability to continue to exert control on monetary systems and policy.
No Heart-Eyes from Dictatorships
Interestingly, China has effectively banned Bitcoin from their currency system. Not necessarily because of the destabilizing effect within a currency system, but for a much more mundane reason: the cost to create or “mine” Bitcoin. The cost is extremely high because of the computing power required to create the so-called “blocks” along the Bitcoin network. In other words, the superpower didn’t want a high electric bill. It’s hard not to laugh, but we shall indulge.
Is it an investment? It depends on your definition. Are baseball cards, rare wine or Nike Air Jordans an “investment?” There are significant risks, but this is universal. As typically the case, you must overcome more risk for the higher possible return and account for a high possibility of loss. Barring the slight nod toward overthrowing-governments-of-ultimate-control which may underlie the typical Bitcoin decision (ironic), we consider this a hobbyist investment. Part of the return is your thrill in owning a coin, “value created out of the desire to create.” Who can put a price on that?
All cryptocurrencies. (n.d.). Retrieved March 28, 2021, from https://coinmarketcap.com/all/views/all/
Ashford, K. (2020, November 20). What Is Cryptocurrency? Forbes Advisor. https://www.forbes.com/advisor/investing/what-is-cryptocurrency/
Best, R. (2021, March 26). Bitcoin price 2013-2021. Retrieved March 28, 2021, from https://www.statista.com/statistics/326707/bitcoin-price-index/
Bitcoin price index – coindesk 20. (2021, March 26). Retrieved March 28, 2021, from https://www.coindesk.com/price/bitcoin
Exxon – 51 year stock price History: XOM. (n.d.). Retrieved March 28, 2021, from https://www.macrotrends.net/stocks/charts/XOM/exxon/stock-price-history