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January 10, 2018

Bitcoin Explained

Very few topics have grabbed as much attention in the financial media as Bitcoin has done lately. Google produced over a billion search results on Bitcoin recently, including 35 million news stories. As you attempt to make sense of the Bitcoin craze, here are answers to five of the most frequently asked questions we have received from clients.

What is a Bitcoin?

It depends on who you ask, but it is referred to as a cryptocurrency, virtual currency, digital cash, or peer-to-peer electronic payment system.

Bitcoin does not have a central bank behind it like traditional currencies, or valuable by itself as a commodity like Gold, however many people are willing to accept it as a form of payment. The transactions take place between users directly without an intermediary such as a bank, and are recorded in a public ledger called blockchain. The decentralization of the money movement and seamless electronic transfers across borders with faster payments and lower transaction costs are what makes Bitcoin and other virtual currencies with similar blockchain technology appealing to the early adaptors.

There are over a thousand digital currencies such as Ethereum, Ripple and Litecoin, each one trying to grab a larger share of the market with a technological twist. Most of them may not be around for a long period of time though.

How is a Bitcoin created and used?

Bitcoins are created through a process called mining, which entails solving a set of difficult mathematical problems, which get progressively more challenging. It was initially created in 2009 by an anonymous person under the pseudonym of Satoshi Nakamoto, who published an online paper on Bitcoin and detailed the concept of the peer-to-peer blockchain technology.

Miners play a critical role for Bitcoins. They act as auditors by securing the network and verifying all the transactions. Miners collect all of the pending Bitcoin transactions and turn them into mathematical puzzles. The first miner to find the solution announces it to others on the network. The other miners then check to see that the user of Bitcoin has the right to spend it and that the solution to the puzzle is correct.

Once approved, the transaction is added to the blockchain ledger and the first miner to solve the puzzle gets 12.5 bitcoins as an award. Miners create value (and are rewarded) for validating transactions and keeping the network secure. Each Bitcoin transaction is validated within the blockchain to verify that the user of the Bitcoin is the actual owner of it by tracing all of the transactions retroactively to eliminate risk of fraud.

The total number of Bitcoins that can be created is limited to 21 million coins. Each Bitcoin is associated with a Bitcoin address that is stored in a digital wallet and has a private key associated with it. In order to spend the Bitcoin, the owner must know the corresponding key. Although all Bitcoin transactions are made public, the owners’ identities are not, hence all transactions and exchanges are anonymous. There are several online exchanges where you can buy Bitcoins, such as Coinbase, Kraken, and Gemini.

They can be exchanged for other currencies, or used to buy products and services. It is estimated that there are over 100,000 merchants who accept Bitcoin as a form of payment. There are millions of users around the world who use Bitcoin and other cryptocurrencies for transactional or investment purposes.

How is the value of a Bitcoin determined?

Just like any other financial asset, the value of a Bitcoin is determined at the intersection of supply and demand on a daily basis. Since the supply is limited and the demand is currently high, Bitcoin prices have seen steep appreciation over the past 12 months.

How is the latest price movement justified? Think of it like the App Store. By creating a network of apps that integrate closely with iPhones and iPads, Apple was able to create tremendous value for the products in its ecosystem and it brand. Another example is Facebook; as the number of people in the social network expands, it makes the product even more valuable. Bitcoin is benefiting from the same network effect.

However, Bitcoin prices are very volatile in comparison to traditional currencies or asset classes. The large swings in the daily prices are mostly driven by speculative, rather than fundamental reasons. The recently launched futures trading and pending Bitcoin ETF products could help find the true fundamental price, or intrinsic value. If one day however, people decide not to accept Bitcoins due to regulatory concerns or technological constraints, its value would collapse.

Is Bitcoin a safe investment?

While Bitcoin can be viewed as an uncorrelated asset which offers store of value and is a legitimate investment, especially for the technologically savvy investors, it is far from a safe investment.

Governments around the world are already considering regulating Bitcoin and the broader cryptocurrency universe, which could result in significant loss of its value. Online theft is also a serious concern.

Price changes of 20-30% (in a single day!) is not uncommon in cryptocurrencies. A crash in Bitcoin prices has a high likelihood in the future, and potential investors should expect the high volatility to continue until the legal and regulatory murkiness is cleared.

Does Beacon invest in Bitcoins?

The short answer is no, and here is why.

Bitcoin is a relatively new online innovation and there’s limited operating history for us to evaluate. We are fundamental investors and it is difficult at the moment to separate the intrinsic value of a Bitcoin from the speculative premium built into the Bitcoin price. Safety and price stability are two virtues we always look for in investments, and Bitcoin does not currently offer these qualities.

Sure, the underlying blockchain technology, which we truly believe in, will revolutionize the way we pay for products, services, and transfer money, however we are most likely in the early innings of the cryptocurrency cycle and we will have many opportunities to participate in the emerging theme, once the regulatory framework is established and the extreme level of speculation we see today subsides.

Asset bubbles have a way of defying most expectations and can go on for long periods of time. There are many investors who list the fear of missing out as the sole reason to invest in Bitcoins, which further drives prices up. The launch of financial derivatives and possible ETFs will only add to the craze.

However, we only need to remind ourselves of the devastating impact of the bubble bursts and devaluation of successful businesses before we consider investing in Bitcoins. Here is a quick reminder: Amazon, which is arguably the most successful consumer company today, lost 94% of its value during the dot-com bubble burst between 1999 and 2001, a period described by most economic historians as a much smaller bubble than Bitcoin today.

As always, if you have any questions about this or any other investment topic, please reach out to your Beacon team members.

Erman Civelek, CFA, CAIA, CFP
Investment Strategist

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