Bitcoin mania is back and bigger than ever! The original cryptocurrency has been on a tear this year and has gained over 100% in 2017. First, for those who are wondering just what I am talking about we’ll review what Bitcoin is, and then try and explain what may be contributing to the massive recent rally.
Bitcoin is a digital payment system that has been around since 2009. Its exact origin is not really known, but it was released by a programmer (or group of programmers) under the pseudonym Satoshi Nakamoto. There has been a great deal of intrigue into finding out who this person is, but for now that is beside the point. Whoever he is, he (or they) gave the world a new way of processing payments as bitcoin is based upon blockchain technology that utilizes direct communication between users and does not require an intermediary to process transactions.
Typically, when you buy things today using something other than cash, a financial middleman is always involved. When paying for gas at the pump and using a credit card, that transaction will pass through a privately-owned payment network (Visa, MasterCard, etc.) and be recorded in your account held at the bank. Monthly bills that are automatically debited from your checking account are processed by the Federal Reserve’s Automated Clearing House (ACH) system. Even buying stocks and ETFs on an exchange require a settlement process that occurs through custodians and clearing partners. The bottom line is that the current financial system is based upon various networks that require administration by an honest and trusted intermediary. Bitcoin on the other hand is very different.
Rather than operating as a centralized processor, Bitcoin operates by publishing a complete ledger of all transactions that take place. This listing is referred to as the blockchain and as transactions occur they are added and then verified through a “mining” process that occurs on a network of volunteer servers. Participants are encouraged to “volunteer” as “miners” as they can be rewarded with newly minted bitcoin. Approximately every 10 minutes a reward is handed out to one machine. One of the ingenious aspects of bitcoin is that as more computers look for the “reward” the harder it becomes to find. Therefore, as more computers process on the network, the difficulty of verifying increases and the overall rate of distribution remains relatively stable at roughly 10 minute intervals. By design the bitcoin algorithm will only generate 21 million individuals “coins” and there is currently just over 16 million in circulation.
It is easy to get into the weeds quickly when talking about the details of how bitcoin operates. However, at the end of the day this digital currency has been able to deliver on two critical aspects of money: scarcity and security. Furthermore, it provides these attributes in completely different ways than most current forms of money. U.S. dollars in physical form have a variety of sophisticated security measures to prevent counterfeiting and ensure scarcity and these are simply not needed in the publicly verified ecosystem of bitcoin.
Many of bitcoin’s supporters also point to the finite supply that is inherent in its design as a positive aspect and as a direct contrast to the current monetary system in which central banks can produce cash at will. This also provides one of the explanations to the recent surge in price. At the beginning of the year it took about $1,000 to buy one bitcoin and as of today it now takes approximately $2,400. This increase has occurred as central banks in Europe and Japan have continued to expand their balance sheets through the purchases of assets and the creation of new money. Bitcoin offers an alternative to those who are worried about the effects of recent central bank actions as it operates as an independent system.
The independence of bitcoin though leads to one of its greatest criticisms. Bitcoin is not backed by anything. There is no underlying pool of assets that ownership of bitcoin entitles you to and ultimately there is no authority behind it. Bitcoin has value because people believe it has value. Proponents of bitcoin like to say the same thing about other currencies including the U.S. dollar. However, the dollar is a liability of the Federal Reserve which has assets of mostly U.S. Treasuries. While that is not comforting to many given the high level of debt that the federal government has, U.S. Treasuries are backed by the full faith and credit of the United States which has taxing authority over its citizens. Bitcoin simply does not have that and it is therefore simply worth what others will pay for it. For now, given an increase in demand against a relatively small group of overall users, that appears to be a lot.
Nicholas Case, CFA®
Senior Investment Analyst