If you’ve been following the financial news recently, you may have seen stories about the cryptocurrency Bitcoin reaching all-time highs. You might be wondering, is Bitcoin for real? Should investors pay attention to it? Our opinion is that enough money is now flowing into Bitcoin that investors should consider its potential role in portfolios.
What is Bitcoin Designed to Do?
Bitcoin is technically described as a decentralized, distributed-ledger digital currency that facilitates peer-to-peer payments. Those words may not mean much to you. They didn’t to me when I first read them. So let’s try to understand Bitcoin by using analogies to things we already understand about money.
Let’s say one afternoon I decide to dig a hole in my backyard. As I am digging, I hit something solid, and lucky me, it’s a one-pound nugget of gold. Because gold trades for about $1,800 an ounce, I can quickly calculate that my nugget is worth around $29,000.
With my gold nugget, I decide to buy a car. I take that gold to the car dealer and ask the dealer if they will accept my gold nugget for the car. The dealer agrees. I give the dealer the nugget and they give me a car.
This transaction could be described as the use of a decentralized currency (gold) in a peer-to-peer transaction (I handed the gold to the dealer). Gold is decentralized because no government controls it. Anyone can mine for gold and the price is set by the market. This transaction is peer-to-peer because I gave the gold directly to the dealer, and no intermediary, like a bank, credit card company, etc., was involved.
People have been engaged in decentralized, peer-to-peer transactions for thousands of years, as gold served as the most common currency in the world up until about one hundred years ago. But gold is hard to work with. If the car dealer had been in Florida and I was in Colorado, transferring that gold would have been difficult. Bitcoin is designed to solve this problem. Bitcoin serves as a form of “digital gold/currency” that allows people to engage in peer-to-peer transactions using a non-government form of currency whose price is set by the market (like gold).
Bitcoin takes the old way of doing things – mining for gold (creating Bitcoin is called mining) – and uses it to transact business, and modernizes it by creating a rare digital asset that can be used in peer-to-peer transactions.
How can something that is just a data entry have value or be rare? It’s easy to see how gold is rare and thus has value. But what’s hard to understand is how something digital is rare. With advances in computer technology and cryptography, a digital entry can be rare. And if people assign value to it, then it can operate as a currency.
It would be like trading rare baseball cards. Let’s assume all new baseball cards are in a digital form that cannot be copied or counterfeited. If I had a card worth $29,000, I could email you that card and you could sell me a car. And there are baseball cards worth $29,000. In fact, they go up into the millions. So in theory, one could see how a digital asset could be rare.
Think about your Social Security number. That is a digital asset. Hackers are happy to pay for Social Security numbers. Thus, they are digital assets that are rare (everybody has just one), hard to create or fake, and they have value. A recent article in Forbes reported that social security numbers sell for about $4 on the dark web. If a hacker had 1,000 social security numbers, they’d have about $4,000 in digital assets.
Why Use Bitcoin?
Let’s adjust my car example a little and assume the dealer says they only accept two types of payments: Visa or Bitcoin. I get to choose. A Visa credit card is simple to use. While a credit card transaction is not exactly peer-to-peer (the credit card company processes the transaction), it is close. If I can pay digitally and conveniently with services that already exist, who needs Bitcoin?
If all Bitcoin offered was a digital way to pay for things peer to peer, it probably wouldn’t get very far. We already have stuff that comes close to doing this, like Visa, Paypal, and Venmo. It’s the decentralized nature of Bitcoin that has value. This is the part about Bitcoin that is unique.
Decentralized means that Bitcoin is not controlled by a government or any other institution. The price of Bitcoin is set by the market, and governments have no role in it. Moreover, Bitcoin is limited to 21 million coins. No more coins can be created. That makes Bitcoin more like gold, something rare, whose value is set by the market. This makes it a potential hedge to things like inflation or currency devaluation.
Because of all the central bank intervention in markets, investors are getting concerned about the value of dollars used in traditional money systems, like Europe, Japan and the U.S. They are concerned that the wealth they hold in government dollars may be damaged by either inflation or deflation.
Let’s look at the phenomenon of negative interest rates, which did not exist until the financial crisis of 2008. A negative interest rate means you are charged for holding your wealth in the form of government sponsored deposits or bonds. If the interest rate is -1% (as it’s getting close to in Europe), that means if you put $100 in government bonds, next year it is worth $99, the next year $98, and so on. Your government money is guaranteed to decline in value. Things like negative interest rates are driving investors to look at alternatives stores of value, and Bitcoin is gaining a following.
The most important thing about money is it must be limited to have value. Prior to 2008, it was fairly limited and harder to get. But after 2008 and particularly after the trillions of dollars printed this year, investors are concerned that central banks and governments won’t limit the printing of money and they’ll make it too easy to get (like 0% interest rates for borrowers). Through Bitcoin, investors are taking steps to create their own limited currency.
How Big Could Bitcoin Become?
More institutions, hedge funds, and individual investors are looking for investments that allow them to hedge the risk that government-controlled money will be devalued. This is creating more demand for Bitcoin, as it’s the largest and most widely held non-government controlled digital currency. The number of investors who hold Bitcoin is very small, but if global investors decide to allocate just 1% of portfolio values to Bitcoin, the value of Bitcoin could increase 10x.
Bitcoin is a fascinating alternative form of money and store of wealth, but it’s very early in its lifecycle. No one knows if it will have staying power, but it’s large enough that investors should take note of what’s happening.
The value can swing wildly, but over time it has been increasing. Arguably, it’s not too different from how investors view stocks. The values can swing wildly, but over time they have been increasing. Bitcoin may become an asset class like equities or commodities that investors own to hedge risks associated with holding government backed currency.
There are many unknowns, but given its size, the expansion of platforms to access Bitcoin, and the continued printing of government currency to finance huge global deficits, we’d say the odds are probably 40% to 50% that it will have some meaningful role in global finance going forward.