Cryptocurrencies – in particular, Bitcoin – have captured the attention of investors lately. Strong performance in late 2020 and early 2021 has fueled the frenzy. Yet, amidst the excitement, many people struggle to understand the complexity and nuance of this investment. To add some clarity, this article explores:
- What is cryptocurrency/Bitcoin?
- What is blockchain technology and how does it support Bitcoin and other cryptocurrencies?
- How has Bitcoin performed?
- What do investors need to consider before they enter the space?
What is cryptocurrency?
There are few similarities between cryptocurrencies and traditional currencies (such as dollars or euros). You can use both to purchase goods and services. However, that’s pretty much where the resemblance ends. For example:
- Unlike dollars, you can’t hold cryptocurrencies in your hand. They are completely electronic.
- Cryptocurrencies are global, they are not backed by a specific country or government.
- Transactions are largely anonymous, although everything is tracked and records are kept in vast databases.
It can be confusing trying to figure out how the world of cryptocurrencies work. To explain, let’s take a deeper dive into Bitcoin. It was the first and is now the largest cryptocurrency in the world.
What is Bitcoin?
A 2008 white paper by Satoshi Nakamoto laid out the plans for Bitcoin. The currency was designed to support a platform where individuals could securely hold, send, and receive items of value digitally – without the need for a trusted intermediary like a bank. The solution lay in the creation of a distributed, decentralized database to help manage and authenticate transactions. This is called a blockchain.
What is blockchain technology and how does it support Bitcoin and other cryptocurrencies?
Imagine a physical chain where every link is a group of transactions (or block). As transactions occur, they’re timestamped and then added to the chain in a new link.
On the surface, the concept of the blockchain is simple. However, the true ingenuity of the system rests in its use of a decentralized network. Bitcoin uses a network of thousands of computers to store its blockchain. Unlike many databases, these computers are not all under one roof. Also, each computer or group of computers is operated by different parties. Called “Bitcoin miners,” these parties verify every transaction in the blockchain.
Bitcoin maintains the integrity of its network by providing economic incentives for its miners to behave honestly. While more details are beyond the scope of this article, the important takeaway is that it works. Since Bitcoin’s blockchain was launched over 10 years ago, it’s been operating securely, with nearly 100% uptime. What’s more, the Bitcoin blockchain has never been hacked and regularly processes more than $2 billion in daily transactions. All without a central administrator.
Price of Bitcoin (USD): calendar year % change
Source: RBC GAM, Bloomberg. Bitcoin price in USD as of January 1, 2010 to January 31, 2021. *2021 calendar year % change as of January 31, 2021.
The investment characteristics of Bitcoin have raised many questions over its suitability as a currency for day-to-day purchases. Consider the data related to:
- High returns. The price of Bitcoin has risen in eight of the past 10 calendar years, posting triple digit or greater returns in six of those years. Though current price levels diminish the movements outlined in the chart above, Bitcoin’s impressive track record is highlighted by a 5,428% gain in 2013. Yet the question remains: what does the future look like for Bitcoin? The next 10 years is not likely to look like the past 10.
- Price swings. Achieving these high returns has not been easy. The price of Bitcoin has experienced six different peak-to-trough declines of more than 70%. What’s more, high levels of volatility are often seen from day to day. Most recently, in January 2021 the price of Bitcoin fell in excess of 25% in just 32 hours.
However, despite the price swings, some investors are interested in the potential for Bitcoin to serve as a form of “digital gold.” This is supported by several factors:
- Scarcity and value. Bitcoin was designed to have a set number of coins – 21 million. It will reach this level through ongoing minting by 2140. Like gold, Bitcoin is a widely trusted and sought after asset.
- Liquidity and ease of verifying ownership. With proper custodial practices, anyone can prove they own Bitcoin and sell it at any time.
- Low correlation with other asset classes. The Bitcoin market is largely driven by factors that have little-to-no impact on traditional asset classes. This includes changes in how widely it is traded and regulatory developments. For investors, this is desirable in the same way that a low correlation between stocks and bonds can help reduce volatility in an investment portfolio. However, extremely high volatility with Bitcoin leaves questions over how well it can deliver the benefit of diversification.
High levels of volatility have been long associated with cryptocurrencies. This is not likely to change anytime soon.
While the Bitcoin database is very secure, the history of crypto is plagued with stories of fraudulent entities stealing funds and major exchanges being hacked. This has led to significant losses for investors with little recourse, as owners are anonymous by design. Ownership is established through a private key or password. If that key is lost or stolen, the associated crypto is also lost. This underscores the importance of working with best-in-class partners to avoid potential fraud.
The venues where cryptocurrencies trade on are not as regulated or mature as the exchanges on which other financial assets trade. As a result, there is a potential risk of market manipulation. This may be difficult to monitor and correct under current rules.
The regulatory environment for cryptocurrencies is constantly evolving. Enhancements – particularly related to anti-money laundering – are required to bring crypto regulations closer in line with those of other assets. These changes could impact the ease of trading and the price of certain cryptocurrencies. There have been some attempts from government agencies to regulate and monitor the flow of cryptocurrencies. However, their anonymity and global portability may make added regulation difficult.
Though crypto headlines tend to be dominated by Bitcoin, there are over 6,000 cryptocurrencies in the world today. Each one relies on the breakthroughs made by Bitcoin’s blockchain network. However, they are individually optimized for different uses. The list includes:
- Ethereum, which offers added functionality through the use of smart contracts
- Ripple, which offers increased capacity by running its blockchain on a more centralized network.
Despite the progress and growth we’ve seen in recent years, it’s still relatively early days for cryptocurrency and blockchain. While the future is not clear, it’s becoming increasingly apparent that the underlying technology offers many benefits. In fact, many large public companies are exploring uses for blockchain technology. These innovations may offer investors another way to participate in the cryptocurrency arena.