Tales from the Cryptocurrency: On Bitcoin and Bubbles

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If Bitcoin makes your eyes widen like that, maybe I should start mining some for the excitement factor alone. (Image retrieved from bitcoin.org.)

If you’re just hearing about Bitcoin and the term cryptocurrency—congratulations!—you’re behind the curve and have likely long ago missed the chance to make dream profits from a small investment in this force in online currency. Oh, well. Good luck keeping your eye out for that next big opportunity, eh? Just this year, Bitcoin, in particular, has seen its price explode from just under $1,000 at the start of 2017 to current values above $10,000 and even $15,000 today, prompting regrets from any number of amateur investors. Then again, how many of these same rueful sorts would have had the knowledge of the currency markets needed to inspire such an investment, let alone the foresight that such a meteoric rise would or even could transpire? These are the same kind of regrets that those who did not, say, invest in IBM prior to the ascendancy of computer technology may have confronted. Bitcoin’s jump in the markets is just the latest example of an opportunity based on an up-and-coming technology, and perhaps related to the GOP’s passage of the House and Senate versions of a tax reform bill that await reconciliation, those with the means to invest have seen the writing on the wall are wildly enthusiastic about the prospects of the growth of the cryptocurrency market.

I am certainly no expert in matters such as these, so for both our benefits, what is Bitcoin, and what is cryptocurrency? Concerning the former, and according to the FAQ page on the Bitcoin official website:

Bitcoin is a consensus network that enables a new payment system and a completely digital money. It is the first decentralized peer-to-peer payment network that is powered by its users with no central authority or middlemen. From a user perspective, Bitcoin is pretty much like cash for the Internet. Bitcoin can also be seen as the most prominent triple entry bookkeeping system in existence.

For the purposes of this post, we’re going to bypass the whole triple-entry accounting concept and focus on the essence of what Bitcoin is—and for that matter, what it isn’t. Bitcoin is a payment system based on a decentralized network, eschewing a central authority or other means of traditional ownership. It is an online currency, but as a completely digital form of money, it therefore lacks physical substance. You can hand $20 to the cashier when you buy lunch. You can’t do the same with Bitcoin. In terms of how bitcoins are produced and acquired, when not receiving existing them as payment, purchasing them at a Bitcoin exchange, or trading locally for them, bitcoins serve as a reward for bitcoin “mining,” which involves the use of special software to solve complex mathematical problems and therefore accrue value in relation to verifying transactions on the blockchain, Bitcoin’s public ledger of past transactions. There are more mechanics to bitcoin mining which I admittedly don’t understand, but suffice it to say that these computations are meant to be difficult and time-consuming to perform, necessitating an investment of energy and the technical capability (in terms of computing power and electrical demand) to produce the worth the process is designed to create. This means the requisite software and hardware, or the cash for a bitcoin cloud mining contract. If this is intimidating to you, it’s downright terrifying to me, I assure you.

Bitcoin is a form of cryptocurrency. OK, so what’s cryptocurrency? Generally speaking, cryptocurrencies are denoted by their digital or virtual reality and the use of cryptography as a security measure. Think codes and ciphers, and anything that uses encryption to prevent unwanted access. Bitcoin, in light of its surging demand, is the most prominent example, but there are a number of effective competitors within this market. Litecoin, Ethereum, IOTA, and Ripple are among the other larger names in cryptocurrency trading.

With any technological advance, the fear of the unknown is bound to cause some concern. This much is understandable. Because of the unique structure of Bitcoin’s network and other cryptocurrencies, however, there are additional concerns that transcend mere lack of familiarity. As with anything, it bears mentioning with respect to Bitcoin that not all news reports and analyses of this currency are equally valid. By this token, not all worries surrounding cryptocurrencies are of the same merit. With all this in mind, let’s take a look at some of the risks associated with non-traditional digital currencies:

Volatility

Yeah, this is kind of a big one. Recall our earlier discussion about the rapid rise in the price of Bitcoin relative to the U.S. dollar. As even Bitcoin proponents will acknowledge, the total value of bitcoins in circulation is relatively small compared to what it could be. As such, small events can cause disproportionately large effects in terms of changes in price. If you believe these same proponents, as the currency matures, as acceptance of it grows, and as security measures are improved, the market for Bitcoin and other cryptocurrencies should stabilize. In the meantime—gee, wow!—it’s just going to be a wild ride until that point! OK, there is some inherent excitement in not knowing what will ultimately become of Bitcoin and how high it may go up. Touting Bitcoin’s thrill-ride unpredictability as a virtue, however, somewhat belies the trepidation that the average investor might feel, especially if his or her means are of the sort that any substantial losses might lead to severe financial consequences. Owing to the present lack of liquidity for Bitcoin and other cryptocurrencies, this characteristic is not to be dismissed, especially not in the short term.

Anonymity

Bitcoin has been said to be both anonymous and yet utterly transparent. How can this be so? All Bitcoin transactions are recorded on the blockchain, the aforementioned public record of the available supply of bitcoins. Accordingly, the receipt and sending of bitcoins is designed to leave a trail. How these transactions are denoted, meanwhile, is different from that of other methods of payment. While Bitcoin, for instance, ties transactions to a specific address, that address is not necessarily tied to a real-life identity, prompting some experts to refer to it as “pseudonymous” as opposed to purely anonymous. Even in the digital realm, traces are left for those that know how to find them. The big bugaboo about this relative anonymity is that it can and has been used in the service of illegal acts. Just enter an Internet search for “Silk Road marketplace” and you’ll begin to get a sense of why some observers are so concerned. Then again, cash is truly anonymous, and it is an essential part of our economy. Thus, to point to Bitcoin’s structure as nefarious and to say nothing of this arguable limitation of paper money is misleading. Cryptocurrencies aren’t more anonymous than cash, and furthermore, are designed to prevent financial crimes.

The Bitcoin Bubble

As explained on Bitcoin’s FAQ: “A fast rise in price does not constitute a bubble. An artificial over-valuation that will lead to a sudden downward correction constitutes a bubble.” The prevailing sentiment here seems to be that there are factors which contribute to the creation of a bubble, namely consumer confidence or lack thereof, a difference between price and value not based on the currency’s fundamentals, investor greed, and speculation fueled by press coverage. In other words, these are things that are beyond Bitcoin’s control—whaddya gonna do? Except that there is a lot of concern about the “Bitcoin bubble.” A lot of concern. In fact, a casual news search would almost seem to confirm a consensus as to the idea that Bitcoin is in the midst of a bubble and the “pop” is coming any moment. The ultimate question, in this case, is whether or not the burst of the bubble will mean disaster for the financial markets and the economy as a whole, and some analysts point to the notion that Bitcoin possesses small value and few present links with the rest of the economy. So, should we definitively be terrified of what happens with Bitcoin? Well, no. Should we be wary of what manifests with cryptocurrencies? I submit yes.

Regulation

The volatility and novelty surrounding cryptocurrencies like Bitcoin are reason enough for some investors and industry experts to approach them cautiously, but the lack of a central authority or governing body for these currencies is likewise worrisome for many. In the wake of the frenzy over online currencies, some countries, especially those like China and North Korea that are predisposed to scrutinizing consumer transactions, have taken steps toward possible restrictions of bitcoin sales. However, not all nations view firmly-controlled currency markets to be as virtuous as do the Chinese and Koreans, and this makes enforcing any rules or laws difficult without any widely-accepted standard. As alluded to earlier, the possibility that bitcoins traded on the Internet might be used in the service of illegal activities weighs on the minds of many observers, as does the concern cryptocurrencies might be used to finance terrorism. Again, it is not as if fiat money such as dollars and euros cannot be employed in the same way, so to isolate Bitcoin and say nothing of traditional methods of payment is a bit disingenuous. This notwithstanding, cryptocurrencies would probably benefit from some degree of oversight. An all-too-common reaction among conservative types to regulation is the sentiment that governments or other standard-makers necessarily stifle economic growth through their interventions, but too little involvement from state agencies, independent regulators, and law enforcement can be a detriment in their own right.

Security

In theory, the use of cryptography in Bitcoin’s workings is designed to make this technology more secure than traditional currencies, but vulnerabilities do exist. Proponents of Bitcoin chalk this up chiefly to user error. In other words, blame the bitcoin player, not the bitcoin game. The recent theft of an estimated $70 million worth of bitcoins from NiceHash, a bitcoin mining operation, however, definitely raises some eyebrows. Ethan Wolff-Mann, writing for Yahoo! Finance, explains that bad digital habits such as passwords that contain personal information or are not changed frequently enough may increase risks of using Bitcoin and other digital currencies, and two-factor authentication (2FA), already adopted only by a minority of average Internet users, may not even be sufficient for safeguarding the contents of one’s electronic wallet. As Wolff-Mann puts this, in short, most people are not ready for Bitcoin. Then again, the same investors who would dabble in cryptocurrencies might not fully comprehend other financial instruments more familiar to veterans of finance. Once more, the individual is advised to be careful when trading in digital currencies, while we all are encouraged to be mindful of the possibility that thefts and bursting bubbles could produce more dramatic ill effects than we might otherwise would believe.


Going back to the notion of whether the feverish demand for Bitcoin and other cryptocurrencies, and the associated price spikes, constitute a bubble, that there is a desire for digital currencies isn’t subject to debate. Whether or not this yen for Bitcoin et al. is simply a phase, or something that reflects a shift toward non-physical means of creating value, is more questionable. Many people who get paid money to render their opinions regard the Bitcoin craze as little more than a fad, or worse, a parlor trick designed to deceive gullible investors. Still others see the fervor for Bitcoin as indicative of the times in which we live, and another reason to blame—three guesses!—millennials for their buying and investing habits. Supposedly, the rise of bitcoin is indicative of their disinterest and mistrust of traditional financial institutions. Damn young people! Driving up the price of Bitcoin and eating avocados! Beyond the notion this viewpoint seems decidedly hard to prove, it’s a facile argument to make anyway. If Bitcoin is attracting younger investors, that’s the market’s problem, and this logic assumes these dumb yuppies don’t know what to do with their time and money. The customer is always right—except when you can look down upon his or her inferior knowledge or intellect.

Dismissing the enthusiasm and possibilities behind cryptocurrencies appears to be as fruitful as dismissing the viewpoints of younger voters because they did not vote more strategically to back Hillary Clinton. Once more, it is incumbent upon the solicitor to make his or her case for your support. Hillary, as experienced and as preferable to Donald Trump as she was for so many Americans, didn’t do that. Donald Trump, the consummate snake-oil salesman that he is, did. Regarding Bitcoin and its supposed dangers, rather than hoping to shame millennials into better choices or trying to appeal to their sense of risk aversion, perhaps a better tack would be to offer the advice that Bitcoin, like any investment vehicle, comes with certain risks, but if you understand this principle, and especially as an asset to hold for appreciation over the long term, it might be worth the concession, and certainly worth familiarizing oneself with from the standpoint of the financial adviser. Even proponents of Bitcoin would be quick to assert that this currency should not be seen as a means to get rich quick, but rather as a tool to facilitate online transactions and to diversify one’s pool of investments. Besides, and this evidently bears repeating, for all the concerns about security and volatility associated with cryptocurrencies, cash and other more traditional modes of exchange present their own challenges in these respects.

From what I can assess, Bitcoin and other cryptocurrencies are neither inherently good nor inherently bad. They may be useful for some investors and unwise for others, and a well-apportioned amount of regulatory oversight in how it is used, particularly in transactions across international lines, is of worthy consideration. Amid the ongoing craze, both consumers and analysts alike would do well not to overreact to the changes.

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