Bitcoin 101

Brad MeeksBrian Torbech

“Blockchain”, “cryptocurrencies”, and “Bitcoin”…what do these terms mean? Given the voluminous headlines and recent surge in prices, we have received questions from clients interested in learning more about digital assets.  Is it an emerging asset class or a bubble to avoid? There is not clear agreement across the investment community.  And with the heightened volatility of digital assets, investment success or failure can change rapidly. Below we highlight the framework underlying these digital assets and provide opposing views on one option – Bitcoin.

Let’s start with the fundamentals: what is a “blockchain”?  A blockchain is similar to a database, a collection of information that is electronic and provides easily accessible data. This is a relatively new way of capturing data and differs from traditional databases in the way they structure and collect data.  Traditional databases collect data in a table format, where the user retrieves data based on inputs.  A blockchain, however, collects data in groups, or “blocks”, and once a block fills, it attaches in a “chain” to the previous block. As new blocks add to previous ones, the chain creates a permanent and unalterable activity timeline.  Many rationales for using blockchain center around performing secure transactions but the technology can also lend itself to other forms of information like contracts, property records, product inventory, etc.

Blockchains can operate in a decentralized fashion where user groups add to a block, or privately where a company controls the storage of this data.  As for the blockchain surrounding Bitcoin, it is a decentralized chain that approves and processes Bitcoin transactions. The uniqueness of this technology stems from the lack of a third-party institution–the transactions are processed and stored in a ledger that no one party controls. It is a revolutionary technology with the potential to make transaction processing more efficient and disrupt industries like insurance contracts, trading, and escrow transactions. We are in the nascent stages of discovering the true extent of blockchain’s applications.

What is Bitcoin?

Bitcoin is a digital asset, also known as a cryptocurrency. The first of its kind, Bitcoin, was created in 2009 by an anonymous person using the alias Satoshi Nakamoto. While the focus has been on the price of Bitcoin and its ability to be traded on the open market, there are over 9,000 cryptocurrencies in circulation today, many of which will have no viable or functional use.  Bitcoin’s prominence and maturity in the crypto space has helped it gain credibility for use as a form of payment.  In fact, today Bitcoin can be used to buy furniture on Overstock.com, book rooms at Expedia, or buy Xbox games at Microsoft.  To the extent Bitcoin gains more widespread adoption, it could be a useful surrogate for efficient transaction activity, with an instant and secure settlement, while cutting out the middle man.

Bulls Say:

Proponents of Bitcoin argue that it has the possibility to transform the payment system as we know it, becoming the preferred method of global transactions. There is no central bank or government serving as a backstop to Bitcoin, so no centralized party controls the amount in circulation (thus increasing/ decreasing the currency value). There is also a finite amount of Bitcoin available. The creator of Bitcoin hardwired a set amount (21 million) into the system prior to Bitcoin’s creation, and once these are all in circulation, there will be no more Bitcoin “created.” We are not yet at this point, but it is important to note as some investors use Bitcoin’s hardwired scarcity as a justification for its value.

Although Bitcoin dominates investment headlines, most Bitcoin is used in a transactional nature outside the United States. Driving its acceptance in these countries is people’s need for a currency or “store of value” they believe they can trust. Frontier countries like Zimbabwe and Argentina’s governing bodies made economic decisions that resulted in runaway inflation, which devalued their local currency. The result is global market participants feeling a lack of confidence in these countries’ currency acting as a credible store of value. The decentralized nature of Bitcoin and other cryptocurrencies is enticing to citizens with these traumatic monetary experiences, as they are not at the mercy of centralized monetary policy/influence.

Bears Say:

Bitcoin skeptics typically are wary of it as an investment, not necessarily of the applications’ blockchain technology. Bitcoin Bears point to three arguments: 1. Lack of intrinsic value; 2. Does not serve as a store of value; and 3. Safety and criminal concerns.

    1. Lack of Intrinsic Value

Bitcoin does not create a product, produce cash flow, and is not guaranteed by an institution such as the United States Government. Therefore, from a traditional investment perspective, it is hard to truly value. AllianceBernstein recently wrote, “Since last March’s coronavirus-induced low of around $5,000, the bitcoin price has risen 12x to around $60,000 just one year later. From its creation in 2009, it’s been the best-performing asset in the world. With a value of $1.1 trillion, bitcoin alone is roughly as large as the venture capital asset class, has one-third the value of all gold held by investors, and has 6% of the total US money supply.”  For perspective, at a valuation of $1.1 trillion, Bitcoin is valued higher than 99% of the companies in the S&P 500. The question becomes, is it susceptible to the “Greater Fool Theory,” where its value is worth what the next person is willing to pay for it?  Additionally, how will an investment in cryptoassets be taxed and viewed by the government?

    1. Store of Value

For a currency to be used on a large scale by multiple vendors, it needs to hold its value. On a basic level, a consumer needs to have confidence that what they get paid on Friday will have that same value when buying groceries on Sunday. Imagine buying a new Tesla with Bitcoin, but immediately as you pay for the car, the value of Bitcoin appreciates or depreciates by 10%. Did you overpay in rich currency?  Is it a good value now, given the timing? Bitcoin has shown itself highly volatile, swinging up or down by over 10% in a day, which can become a massive issue for its use case as a store of value and as a currency.

    1. Safety & Criminal Concerns

The safety of consumers’ Bitcoin and its use for illegal activity is a concern as well. Bitcoin’s decentralized nature makes it impossible to track and see who is on the other side of transactions. Some argue it is perfect for illegal activities such as money laundering or drug trafficking. While it is becoming rarer, there have been some significant incidents involving hackers separating users from their Bitcoin. Possibly the most infamous being the hack of the Mt. Gox exchange, where roughly 650,000 bitcoin worth over $350 million at the time was lost. Additionally, since there is no centralized exchange or operator of Bitcoin, there is no way to retrieve one’s “key” or private password should you forget it.  This level of security is also its downfall with an estimate that 20% of Bitcoin is irretrievable due to lost passwords.

Summary

While blockchain is an exciting development with many potential applications, at Madison we believe there are still too many unanswered questions needing to be addressed before we would recommend investing in Bitcoin or other cryptocurrencies. We believe that we are still in the very early innings regarding cryptocurrencies with much to be discovered in the coming years.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Madison Wealth Management does not provide tax, legal or accounting advice. © 2021 Madison Wealth Management