Making Sense of Bitcoins

Are bitcoins the next best get-rich investments or a roller-coaster ride of hype? Our financial experts weigh in. 

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Data analyzing in exchange stock market: the candle chars on display. Analytics price change cryptocurrency BTC to USD (Bitcoin / US Dollar), the most popular pair in the world. Big Bitcoin logo.

Advice from Steve Bokor, CFA, a licensed portfolio manager and Ian David Clark,a certified financial planner with Ocean Wealth at PI Financial Corp. a member of CIPF.

Bitcoins, what the heck are they? As financial advisors who provide investment advice that should reflect our clients’ financial planning goals, we tend to see bitcoins and other cryptocurrencies as very risky investments. However, there are some people who would disagree. So in the interest of debate, here’s our two cents’ worth on the topic.

 

What Exactly is a Bitcoin?

A bitcoin is an electronic digital currency. For something to be considered a currency, it must meet three requirements. First, it must be a store of value, which means it can’t be copied (this is where blockchain technology fits in, but more about that in a moment). Second, its quantity must be finite, which is not the case with many fiat currencies (legal tender whose value is backed by the government that issued it) around the world. Third, it must be accepted as a medium of exchange.

It might help to think of bitcoins as electronic “Monopoly money” linked to a technology called blockchain that makes it virtually impossible to forge it. But unlike Monopoly dollars, each bitcoin comes with an uber-long electronic ID password.

How it works is that bitcoin users set up a wallet that gives them a unique address, similar to an email address, allowing them to exchange bitcoins with other bitcoin wallets around the world. Every transaction is recorded on an “open and unforgeable ledger” known as the “blockchain” which is the driving technology behind bitcoins and other cryptocurrencies.

 

Where Does Blockchain Fit In?

Blockchain is basically a secure peer-to-peer electronic ledger and record-keeping system that bypasses middlemen such as banks and credit card companies. Bitcoin uses blockchain technology to keep and record the electronic ID of every “unit of currency” stored and transacted. Every new transaction generates an electronic signature that is sent out to a global network of computers. Those computers then have to verify every new transaction and record it on the blockchain.

Blockchain creates a permanent electronic record of all trades for cash or goods and services stored on a bitcoin. So voila, we have a paperless currency that cannot be counterfeited, stolen or frozen by governments or central banks, right?

Well, that’s the theory.

But, you see, while you cannot hack a bitcoin, you can hack the electronic exchange or the electronic bank that holds the bitcoins — and many an investor has lost plenty. Just do an internet search for “Mt. Gox” or “Bitfinex.”

What is a Bitcoin Worth?

That’s always the big question. Here’s the answer: the mysterious founder of bitcoin decided his currency would only ever issue 21 million coins. There are currently just over 16 million bitcoins in circulation. At $12,000 per bitcoin, the market cap is in excess of $192 billion.

But bitcoin prices are volatile. In fact, right now, in our opinion, price does not equal value. In 2009, a guy named Koch bought 5,000 bitcoins for $27 bucks. In August 2011, bitcoin hit $31 per coin so his investment grew to $155,000. Unfortunately, by December 2011, it had crashed to $2 a coin, reducing his investment to $10,000. That’s about a 95 per cent plunge. From there, bitcoin has been on a bit of a rollercoaster ride.

 

How Does a Transaction Work?

A Risky Ride

To financial advisors like us, bitcoin is trading like an unregulated commodity with speculators buying for no other reason than the belief that the price per coin will go higher. In 2017, bitcoin started the year at $976 per coin. It peaked 12 months later at over $19,000 a coin. By the third week of 2018, it had plunged to below $10,000.

Indeed, we believe there is a speculative bubble that is driving prices all over the map. Granted, bitcoin has grown into a currency used by more than 100,000 merchants globally, including Microsoft, Expedia and the Golden Gates Hotel and Casino. Some people even believe the blockchain technology behind bitcoin could help shape the future of the global banking industry. However, there’s no guarantee of the survivability of bitcoin or any other cryptocurrency — and there are risks.

The investment risk
We believe cryptocurrencies are hyper-volatile assets. Remember, they’ve been created out of thin air and have spawned a modern day gold rush. In fact, if you are not happy with owning bitcoins, you have the option of buying any of 1,100 different cryptocurrencies. The value of bitcoin, however, like that of equities, can go to zero. Remember Nortel? Even if your gamble is successful, keep in mind that bitcoin has fallen by more than 80 per cent on five separate occasions, which is exceptional volatility.

The operational risk 
So how do you store these cryptocurrencies securely to ensure that they are not stolen or corrupted? When users are issued with a bitcoin address, they are also issued with a bitcoin private key. It is usually a 256-bit number, which is the golden ticket that allows an individual to spend his or her bitcoins. You need to store that bitcoin key in a secure and safe location. If you lose that key, you lose everything. Everything!

The regulatory risk 
Bitcoins and other cryptocurrencies operate outside the purview of governments and central banks, so there are no regulations and no oversight. How long will that last?

The competitive risk
The bitcoin as a medium of exchange is just one of myriad cryptocurrencies out there. There is nothing preventing eBay, Amazon, Google or Apple from creating their own cryptocurrencies, which might prove more popular or seem more trustworthy because of the associated brand names. Remember how fast Google pushed Netscape and other browsers out?

Making Sense of the Mania

We believe bitcoins and other cryptocurrencies are a mania similar to the dot.com craze of the 1990s. However, blockchain, the technology behind bitcoins, could be a transformational peer-to-peer technology (like the internet was in the early days) that will revolutionize the way businesses operate in the 21st century. Theft, counterfeiting and inventory leakage will be greatly reduced as businesses adopt blockchain technology.

Having said that, blockchain is a technology that is almost 10 years old — and first entrants are not always the survivors. If you’d like to know more (and there’s plenty more to know), we strongly recommend you visit PwC.com and read the PwC report “Making sense of bitcoin, cryptocurrency and blockchain.” This is not something you can avoid doing your homework on.

This article is from the April/May 2018 issue of Douglas.