With all the recent interest in Bitcoin and crypto-currencies, many people have been moving money into the Bitcoin system and stories abound of people making a rapid fortune, or finding that forgotten wallets from the early days now contain life-changing amounts of money. This week has seen US Congress hearing information about opportunities and threats from digital peer-to-peer currencies. In the news, hopeful people have been quoted saying that they expect to be millionaires by next year after buying $100 worth of Bitcoin.
In this article, I examine the possible investment upside of virtual currencies, and Bitcoin in particular. I then discuss some of the threats that investors and adopters must watch out for during what is likely to be a rapidly changing landscape full of opportunities for drastic success and failure.
(Disclosure: I own some Bitcoin and Litecoin.)
A cryptocurrency is a peer to peer electronic cash equivalent. Unlike typical online financial transactions which involve commercial or government entities acting as the middle man or central authority, peer-to-peer currencies provide a way of moving value directly between two people in the same way that private transactions involving cash in hand or valuable items, such as gold, are done today.
Despite the fact that all Bitcoin transactions are made public in a shared ledger called the block chain, they are still relatively anonymous because it is difficult to match wallet addresses to actual people. This is because anyone can create any number of wallets at any time – a wallet is just a pair of large numbers computed by a software algorithm and acts as an address that is used to designate the location of a set of virtual coins in the block chain database.
To own the Bitcoins recorded in the block chain for a particular wallet, it is just necessary to know these two numbers, and so they can be stored on a computer, a USB key, or written on a piece of paper. They provide the identifying keys to allow the sending or receiving of particular Bitcoins between people. They are not in any way connected to any personal information. However the ownership of a wallet might be inferred by analyzing the publicly available network pattern of transactions with known agents if it is not too complex.
As of November 2013 there were 12 million Bitcoins in circulation with a price of around $800 each, giving a market capitalization of $9.6 billion. The price of coins has been rising extremely rapidly – one year ago the market capitalization was $130 million. Many people are saying that this is a bubble, or a Ponzi scheme. Other people are saying this is the start of a great new infrastructure or a radical upheaval in the way commerce is conducted; a change that is similar to the development of the internet, bringing many new business and investment opportunities. Probably it is all of these things.
To those people who believe this is a bubble which will burst and then go away, I would mention the amusing advice my father gave to me when I was first becoming interested in home computers in high school. He viewed them as a waste of time because “computers are just a fad, like color TV.” There are many people who discount the potential of any new change: born as it is in a barely functional form, with over-exuberant promoters, fraught with limitations, a toy, and obviously going nowhere.
I believe that virtual currencies in some measure will become an extremely important part of future commerce and many people will make a fortune investing in new infrastructure with the right technology at the right time.
Having said that, the frenzy of current Bitcoin investment is a massive chase after return that will surely enjoy some boom and bust cycles.
Bitcoin is not the only cryptocurrency. There is also Litecoin, Peercoin, and a host of lesser known rivals. At the moment, the Bitcoin infrastructure is the most well developed, with a sufficient number of businesses set up to transact between regular currencies and Bitcoin, and a growing number of merchants accepting payment using this method. New startup companies are forming all the time with some Bitcoin-related plan of operation. This progressive commercialization makes for an increasing system stability and introduces tangible value to the currency which it lacked at the start: You can actually use it for something! It becomes a real currency when speculation gives way to the mundane transactions of day-to-day commerce.
Like regular cash, Bitcoin facilitates criminal activity. It is often reported that law enforcement shut down the Silk Road drug marketplace this year, seizing 144,000 BTC (now worth $115 million). However, new marketplaces have now appeared modeling this “pioneer” of illicit trade. In the grey-market area, online pharmacies, such as CoinRX, are now taking payments in Bitcoins. It’s just human nature to not want every transaction with another person to be passed in front of a regulating authority.
I think that Bitcoin is rather like Friendster in the early days of social networking. It may be the first to market, but there are issues which will probably be solved as new virtual currencies come on line. For users this may mean a set of meteoric rises and falls in value as people switch from one system to another.
So how high can the price of Bitcoin go? It depends how much money people are willing to put into this new system in the worldwide economy. The market capitalization of Apple is $468 billion. If that much money went into Bitcoin, the price would be $39,000 at today’s count of coins in circulation. If we look at US GDP, which is $14 trillion and suggested that 1% of this went into the Bitcoin system, then the price would be $11,666 per coin. World total GDP is $70 trillion, and if 1% of that went into Bitcoin, the price would be $58,333 per coin. Based on these estimates, the current price of $800 has only around a factor of 30 to grow, so someone investing $100 today in Bitcoin is not going to become a millionaire.
It is hard to know exactly how much money will get moved into virtual currencies. Recently the Winkelvoss twins have applied to create an exchange traded fund in Bitcoin. If that becomes established, it will open the gates to ordinary investors and large scale fund money which could further drive up the price. The twins have estimated that the Bitcoin market could hit $400 billion, on a par with Apple and Exxon.
In many ways, Litecoin is looking like a better investment. For Litecoin it is still early days because the infrastructure is not quite there. However, it looks to be a more promising currency from the technical standpoint, e.g., allowing faster transactions and a longer time until the end of the mining cycle. Its current market capitalization is $215 million, giving a factor of 45 potential growth to simply catch up with Bitcoin. Since Litecoin and Bitcoin share much of the same software, existing business that handle Bitcoin should not have much difficulty also accommodating Litecoin.
So given that there is significant potential growth in this new wild west of digital currency, what are the risks?
- Eventually the value of new digital currencies will be related to what you can do with them, but right now a huge multiple is added by the emotion of the crowd in terms of expectations for future upside. This creates the potential for large selloffs in response to any negative news that undermines the credibility of the Bitcoin dream.
- Expect that different digital currencies will come and go. If a new currency comes out that fixes a slew of perceived issues with the old one, there will be a rapid flight of capital. Think Friendster, Myspace, Facebook. Digital currency infrastructures are not going to stabilize for years, and to make money in this area either with investing or through involvement with currency-related startup companies, you are likely to have to jump quickly between technology horses.
- Government response is uncertain, and is likely to involve knee jerk attempts to regulate, ban, or tax the new system. This arises because it is a threat to the established systems of monetary control and is perceived to play into the hands of organized crime. Negative reactions from established power structures will eventually be tempered by a growing business community that makes use of the new currencies and pushes back with lobbying dollars, but that will probably take time. In the short term expect that governments will want to closely monitor the inflow and outflow of money into the virtual money system and will attempt to de-anonymise, tax, and regulate the flow of electronic currency, particularly with regards to funds crossing national borders. A possible parallel is the response of the music industry to peer-to-peer file sharing. Right now politicians are interested in Bitcoin because they think that they can use it to get around campaign contribution limits. But that idea is probably not going to last.
- If you purchase Bitcoins, are you going to be able to cash them out? I purchased coins on MtGox, one of the popular exchanges, in early 2013. Later when there was a high point I decided to sell them but found that MtGox at that time was only letting people move money out of their accounts at a very slow pace. The limit was $1,000 per day or $10,000 total per month and their service was grinding to a halt and people were panicking. If you make millions of dollars are you going to be able to actually claim that money? Exchanges don’t want to see a run of dollar cash outs – they aren’t going to be able to handle that financially and probably are not legally regulated to maintain any particular cash balance. At the moment on Coinbase you cannot sell more than 50 BTC per day. You are really going to have to work hard to find a reasonable method to move large amounts of money out of the Bitcoin network and I doubt that you will be able to do it in a rush if the market suddenly crashes.
- Opening accounts on line and storing dollars or Bitcoins in on-line wallets is fraught with risks. There are many web sites and operators coming and going in the Bitcoin ecosystem. Some of them are shady. If you store Bitcoins in an on-line wallet then you are entrusting a third party with the secret information that you use to claim access to your money. In addition, if the operator gets into legal trouble, e.g., like MtGox has with the US government, and their assets are frozen or servers are seized, then you can kiss goodbye to all your money. One example is Instawallet which was closed due to hacking, and many accounts were taken off line. A long drawn-out claims process was set up to allow people to apply to recover their balances. Not good. Assume all on-line Bitcoin companies are likely to go out of business at a moment’s notice.
- If you store all your Bitcoins on your own laptop then you are safe from online troubles, but you are not safe from your laptop being hacked, or from it being stolen, or from data corruption. If you have a $2,000 laptop and put a Bitcoin wallet on there with $50,000 in it, then your laptop is now worth $52,000! One solution is to create a paper or USB key wallet which is isolated from the internet and then store this and backup copies in a secure location such as a fireproof safe or safety deposit box. The limitation of this method is that you have to jump through some hoops to get access to your coins if you want to sell them.
- If someone works out how to hack or game the Bitcoin system, then the value of coins will be rapidly driven to zero. Thankfully, even though various Bitcoin related sites have been hacked, the system itself has stood firm despite the potential multi-billion dollar reward.
- With any new technology that is poorly understood, the potential for scams on the public is large.
- Bitcoin has a mining system that produces a maximum number of 21 million coins at the end. Its really not clear what the long term viability of this exponential drop in mining activity will be and whether it will cause problems in time. It might turn out like designing in a Y2K bug from the beginning! Other virtual currencies play with these variables. Peercoin, for example, sets up a 1% inflation target and allows mining of coins forever. Somehow public opinion will decide between the merits of these different systems.
In summary, there is a large potential upside from investing in this disruptive technology, but the risks are very great. It’s not for everyone. My advice is to treat it like buying a lottery ticket. You should not put in more money than you would feel ok about losing completely, and if you come out ahead then you should be a little surprised.