A Bit About Bitcoin

03/27/21 | Birchbrook Team | Birchpapers

The value of a single bitcoin has increased dramatically in just the past seven months. On September 1st, the price was $10,787.62. Bitcoin reached an all-time high of $61,749.81 on March 15th and is currently worth $57,220.97. Given this renewed interest in bitcoin, we thought we would explain what it is, why it has gained so much traction lately, and why we have opted to not include it in client portfolios.

Bitcoin is a digital currency, created in 2009 by a person (or possibly a group of people) using the pseudonym Satoshi Nakamoto. It only exists electronically; you cannot hold a physical bitcoin in your hand. It is also a cryptocurrency, which means that ownership records and transactions made using bitcoin are encrypted i.e., anonymous. Bitcoin is not issued by a central government, which makes it harder for governments to manipulate its value (for better or for worse) through monetary and fiscal policy. This also makes it harder to regulate.

Bitcoin’s security centers around its use of blockchain technology. Blockchain is a type of database that holds copies of data in blocks across a decentralized network of computers, or nodes. Each node has a record of the same collection of blocks, known as a blockchain, and each time a new block of data is made, it is added to this chain. The chain is constantly being reconciled across the network of nodes. Therefore, if someone were to try to change the data in a block in one computer, the reconciliation process would pick up on the fact that something fraudulent is occurring.

With bitcoin, blockchain serves as a transaction ledger. When a new transaction occurs, each node validates the transaction. Some nodes are owned by what are called bitcoin miners. The miners compete to package validated transactions into blocks by using computers to generate a fingerprint unique to that block. New blocks are added to the chain of prior blocks. Each block is time-stamped, and each node is updated with the current blockchain so there is a permanent, unchangeable record of transactions, preventing people from double-spending their bitcoin. Bitcoin miners can be awarded with new bitcoin for being the first to generate the block.

By design, the supply of total bitcoin has been limited to 21 million coins. Currently, there are 18.6 million coins in circulation. Even though it only took 12 years to mine the first 18.6 million coins, the 21 million coin limit is not expected to be reached until the year 2140. This is because, again by design, the reward for mining bitcoin is cut in half every four years. These design elements help to keep bitcoin relatively scarce, providing some support for the currency’s value.

This scarcity is in contrast with other currencies, such as the U.S. dollar. The U.S. government can increase the supply of dollars in circulation, leading to inflation. This begs the question, could bitcoin, because of its scarcity, be considered a hedge against inflation? Strictly speaking, we simply do not have enough data to know whether the demand for bitcoin, and therefore its price, rises in times of high inflation, because bitcoin has only existed since 2009.

People often compare bitcoin to gold, and gold is widely considered to be an inflation hedge. Gold, like Bitcoin, has limited supply and is valued by the interaction of supply and demand. Gold’s price also cannot be readily manipulated by governments. Bitcoin has one advantage over gold in that it is much easier to use as a currency given that it is digital and its storage costs are minimal. As we noted in a prior blog post, we do not favor gold as a hedge against inflation because there is no direct mechanism by which inflation causes its value to rise, as in the case of stocks and real estate. Bitcoin poses the same problem.

If it is unclear whether bitcoin has utility as an inflation hedge, what about its use as an actual currency? In this regard, bitcoin’s usefulness has been limited, in large part due to its volatility. It is difficult to price products with an unstable currency, and bitcoin has been known to experience daily swings in value of anywhere from 5-10%. For this reason, vendors are often wary of selling products in exchange for bitcoin, because the value of bitcoin received upon settlement could deviate significantly from the value of the product or service at the time of sale. How does a seller price a product, like a car, using a currency that varies so much from day to day? How does a buyer know what a fair price might be, if that price is always changing? Bitcoin is also relatively illiquid, which further detracts from its use as a currency and amplifies its volatility.

That said, one of the reasons bitcoin’s price has soared in recent months is that large companies have increasingly decided to accept it as payment, at least to some extent. PayPal announced in October of 2020 that its 361 million users worldwide would be able to buy and sell bitcoin and use it to make purchases from any of the 28 million merchants that use the PayPal platform. Tesla also made headlines in February after it announced that it had bought $1.5 billion in bitcoin, roughly 8% of its total cash position at the time. Tesla plans to accept bitcoin as payment for its products “on a limited basis.” If companies increasingly move in this direction, bitcoin could perhaps become a more accepted medium of exchange.

Financial institutions have also started to take bitcoin more seriously. If this trend accelerates, then this could help improve bitcoin’s accessibility, tradability, and liquidity. BNY Mellon, for example, announced in February that it will hold, transfer, and issue cryptocurrencies such as bitcoin for its asset management clients, citing increasing demand. Currently, people must hold their bitcoin in specialized accounts outside of their other investment portfolios. Starting later this year, BNY Mellon will allow bitcoin to be held alongside stocks and bonds.

While there are some signs that bitcoin is gaining institutional acceptance, the jury is still out on what its future will look like, including the extent to which it will become widely adopted. As with all currencies, Bitcoin will only continue to be valuable if people believe that it has value and believe that it can act as a viable medium of exchange. There are numerous other cryptocurrencies in existence, and it is possible that one of these could overtake Bitcoin in popularity one day. Governments have also begun to consider using blockchain technology for their own currencies, which would make bitcoin’s accuracy and security attributes a bit less unique. Hedge fund manager Ray Dalio has suggested governments could go so far as banning it if they come to feel threatened by the competition. While this is a worst-case-scenario, prominent officials such as Treasury Secretary Janet Yellen have expressed concerns that bitcoin could be used to trade drugs or fund terrorism. There is at least a real risk that governments will try to increasingly regulate it. As tempting as bitcoin’s returns have been over the past few months, we view it as a highly speculative asset. We continue to believe that investing in assets with a claim on the cash flows of cash-generating entities, such as stocks and bonds, are the best building blocks of an investment portfolio.