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The Investment Merits of Bitcoin, Part 2

Click here to read the first part of this article.

In the world , as we know it today, money is no longer backed by anything tangible , such as a commodity. The system of fiat currency relies on the trust that everyone needs from their bank and the financial system overall, to look after their money and make it accessible. However, the Global Financial Crisis (GFC) imparted a shock to the foundations of this 35-year structure, as a lot more attention was paid to “de-risking” cash. Simply translated, this meant not having a current account or assets under custody with a bank that may fail. The focus on return on money for a while changed to the return of money! And it was in this environment that a white paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” was released, authored by “Satoshi Nakamoto” – the name is in inverted commas because no one really knows anything about the person/group!

At this point, trying to explain the technicalities that seem to engulf the whole concept of cryptocurrencies, whilst trying to keep it simple and avoid jargon, has tripped up many an author, both disciples and non-believers. So rather than do that, I will do my best to summarise the salient points. Bitcoin, and cryptocurrency generally, has three pillars or reasons for being.

  • It is peer-to-peer, person-to-person. It bypasses intermediaries and regulators. Therefore, it is “trustless,” an important term in the Bitcoin bibliography and circles back to people’s declining confidence and trust in the financial system, banks, intermediaries etc., after seismic events like the GFC.
  • It is an alternative exchange network that does not exclude anyone based on rules like nationality, financial standing or regulators’ parameters. It is, therefore, decentralised, again a term of regular use and importance, often referred to as DeFi, an abbreviation for Decentralised Finance. “Democratised” is a term that could be used for a similar description.
  • It is secure. How this is done is by cryptography and the proof-of-work concept. Cryptography is essentially the conversion of plain text (ordinary information) into unintelligible form. This is encryption and underlies the process of securing the internet, social media apps, etc. Taking this security one notch up, three cryptographers by the name of Diffie, Hellman and Merkle wanted to solve the problem of sharing secrets in one place (imagine a lockbox) without sharing one public key. This became known as the Diffie Hellman Key Exchange and underpins how each individual user has a unique code for their Bitcoin activities.

There are three ways that an individual can receive Bitcoin:

  1. Buying it – perhaps on an exchange, for example, of which there are now many.
  2. Getting paid for goods or services if the buyer has Bitcoin and is willing to use it in this way.
  3. Mining for new coins.

In the Bitcoin system, the mining process is directly linked to how transactions are executed. To transfer and store bitcoins, the user typically needs to download software that installs a digital wallet. This software generates a “public address” for the wallet, which is disclosed to anyone who wishes to transfer bitcoins into the wallet. This software also generates a password known only to the owner of the wallet, then used to gain access to Bitcoins. In simple terms, anyone can transfer bitcoins into your wallet; only you can take them out and use them.

To transfer Bitcoin from wallet A to wWallet B, a transaction will be generated which includes critical “public” information, such as details of the wallet, date and time, and certain unique identifiers to eliminate the possibility of duplication, and double spending the bitcoin etc. This is then broadcast to the Bitcoin network, to be validated. This authentication is carried out by other bitcoin users and is facilitated on the data structure upon which Bitcoin and other cryptos are built, which is known as Blockchain.

Each pending transaction appears as a set data stored as a block in the Blockchain structure. This must be checked to authenticate each transaction within that block. Once verified, the transactions are executed, the block is sealed off – effectively added to the chain – and the data it contains can never be altered. This distributed ledger is not owned by anyone and is autonomous in nature; there is no authority that can lay legitimate claim to it. Here we can close the loop on DeFi, disintermediation and security.

There are now more than 10 000 different cryptocurrencies in existence, with Bitcoin remaining the “big name”. Many factors and hypotheses can explain the popularity and rise of cryptocurrencies. There is no doubt that “counterculture” is high on the list—the triumph of being able to bypass financial intermediaries and democratise finance.

But how do we stack this up and reach a conclusion if Bitcoin / Cryptocurrencies are a good investment or not?

  • There seems to be no doubt now that cryptocurrency should be recognised as an asset class. It has received an incredible amount of press, hype, and a growing number of investors.
  • It falls into the category, at the moment, of a speculative asset. The volatility in the price of Bitcoin as the “grand-daddy” of the family is proof of that.
  • It is very hard to value. There is no fundamental underpin that I can see. It is willing buyer, willing seller valued.

If its permanent existence is reliant upon the financial system’s failure or the demise of the US$, then I would not be attracted. If the argument were more based on the fact that Decentralised Finance is coming, and the advantages of democratising the system are very apparent and easily reachable to most, then perhaps it does warrant a place in a portfolio …. But not for retirement purposes!