Bitcoin: What Is It and Should You Own Some?

By David DeBellis, CFA & Portfolio Manager

To say that the markets have become ‘frothy’ is an understatement. We are seeing daily swings in market prices and share volume that have not been seen in quite a while. And I don’t want to say that the market is reaching its peak, but there are some signs that I think could indicate the best returns have been earned in this market cycle. One sign of this could be the rise in popularity of some very nontraditional investment vehicles. You may have heard or read about things like Cryptocurrencies, Special Purpose Acquisition Companies (SPACs) or, most recently, Non Fungible Tokens. And while I have not been asked about the latter two, I have had several clients and even nieces and nephews ask me about whether or not they should be buying bitcoin, the most popular of the cryptocurrencies.

Before I can answer this, I think it is important for everyone to know exactly what bitcoin is. To start, let’s first define what a cryptocurrency is. At their core, cryptocurrencies provide an electronic payment system that enables paperless transactions from one party to another through blockchain technology (a digital ledger). The transactions are secured with cryptography and are entirely anonymous. They also bypass middlemen such as banks and credit card companies. There are hundreds of digital currencies, but as mentioned earlier, bitcoin is the first and largest of them. How big you might ask? The current market capitalization of bitcoin is near $1.1 trillion dollars, that’s up from just $110 billion a year ago and bigger than the three largest US ba n k s combi ne d (JP Morgan, Bank of America and Wells Fargo). It’s also more than five times larger than the next biggest cryptocurrency, Ethereum.

There’s a couple more things that I think anyone considering buying bitcoin should know. First, bitcoins are not minted like the dollars and coins that we use on a daily basis. Instead, they are produced by people and businesses running computers to solve a very complex mathematical problem (known as mining). The formula is freely available, but the computing power needed to solve it is very high and costly. Next is perhaps the most important thing that a potential investor needs to know.
How is the value of bitcoin determined? Simply put, the price of a bitcoin is determined by the supply and demand on the exchanges where it trades. In other words, it’s worth what someone else is willing to pay for it.

This is very different from traditional currencies, where the value is influenced by factors such as central bank monetary policy, inflation and foreign currency exchange rates.

Bank of America recently published a research piece titled “Bitcoin’s Dirty Little Secrets”. In the piece, BofA did not pull any punches at bitcoin prices, saying that they are not backed by hard fundamentals but by fund flows, big-name buyers and miner rewards cuts that will result in decreased supply. The author of the article said that there is no good reason to own bitcoin, unless you think that prices will continue to rise. They went on to explain how much of the 1,000 percent rise in the price was thanks to increased institutional and corporate interest along with speculative demand.

They pointed out that much of the increase was due largely to thin liquidity, arguing that gold needs around $1.86 billion worth of transactions to increase by 1% while bitcoin only needs $93 million worth to move a similar amount. Adding to this liquidity issue is the fact that bitcoin output is capped at 21 million coins.

Here are a few more facts about bitcoin that I think make it a poor choice as an investment vehicle. According to the analyst at Bank of America, bitcoin’s ownership is very concentrated with just 2.4 percent of addresses owning approximately 95% of total bitcoin in circulation. This makes the use of bitcoin as a payment mechanism very impractical.

As more and more institutions adopt the use of bitcoin, it is likely that we’ll see regulations created around it. Christine Legarde, the president of the European Central Bank, recently called for regulation to address “the funny business associated with cryptocurrencies”. Regulations are unlikely to enhance the value of the asset. Along with this, a number of central banks have begun discussing the idea of launching their own digital currencies that might use mainstream technology and operate on mainstream payment systems. If this were to happen, it is highly likely that bitcoin would lose it spark and fizzle out.

And lastly, there is an environmental reason not to invest in bitcoin. The mining of bitcoins takes an incredible amount of computing power and energy. It is estimated that the bitcoin network emits about 60 million tons of carbon dioxide, or about the same amount as the entire country of Greece.

Bitcoin’s 498% one-year increase was bound to draw the attention of all investors, especially those who read articles about people becoming wealthy through investments in it. But there were 100 stocks with market capitalizations of $1 billion or more that had returns equal to or greater than bitcoin. Most of these companies have earnings and can be more easily valued than cryptocurrency. And it is with this fact in mind, along with the points above, that we do not recommend a strategic holding in bitcoin, but instead view it as a speculative, high risk investment.