Bitcoin belongs to the class of crypto-currency or digital currency—an asset class that has become quite popular in 2014. Bitcoin is often spoken about but news and media hardly go in to any depth into what it is. Whereas real currency is printed and maintained by a country’s central bank, bitcoin is traded, created and maintained by market participants. Its highly speculative nature stems from its decentralized nature, trading on Bitcoin Exchanges around the world. Bitcoin can be exchanged for real currency, services or products.

Although not as popular as a nation’s currency, it serves the same purpose and is often used as a medium of payment because it bypasses the traditional 2-3% service fees that credit card companies impose.

The Transaction

As a function of it being online, it begs the question—how exactly is Bitcoin created? At any point of time, a bitcoin is being created or transferred between buyer and seller. Buyers and sellers enter into this transaction on an online Bitcoin Exchange and that transfer is recorded on an online ledger with a unique identifier. This transaction doesn’t happen instantly; instead it is added to a set of similar trades between other participants called the “block.”

Now we come to the process of mining—creating bitcoin. As there is no central authority or clearinghouse executing these trades, individuals can contribute processing power to execute bitcoin transactions for a reward of 25 bitcoins.

To summarize, an individual looking to acquire bitcoins can either mine for them or purchase them. There is currently 13 million bitcoins in existence with an arbitrary limit of 21 million in place. Protocol states that the 25 bitcoins reward for mining will be halved every four years until the limit is reached.

Risks

While Bitcoin is popular for transactions because of its ease of use and circumvention of traditional bank fees it presents some risks. An investor can access her bitcoins in her online wallet, similar to a stock portfolio, which can be accessed by two keys (passwords).

The public key is akin to an account number the private one is the user credentials.

As bitcoins are identical to one another it is imperative the investor keeps their private key safe because if it is lost or stolen that wallet along with all the bitcoins cannot be recovered.

Serious investors tend not to store their private keys online where they run the risk of being hacked and losing their key. Instead they tend to print them out and keep them offline.

One of Bitcoin’s strength is also a weakness—its widespread, decentralized nature. Due to its unregulated nature, bitcoin can be used for any purpose. In 2013, the US Federal Bureau of Investigation (FBI) shut down the Silk Road, the largest deep web market for illegal goods. Upon confiscation of the website, the FBI also recovered about $30 million in bitcoin.

The second problem that comes from its widespread nature is the perception issue. In 2014, Mt. Gox in Japan (the largest Bitcoin Exchange) was seized and shutdown due to Bitcoin price manipulation. This led financial experts to surmise that the rise in Bitcoin’s value in 2013 had been completely fabricated. This crime had a dual effect—the biggest exchange of Bitcoin had been shut down leading to a drop in price due to less places to buy Bitcoin and in the more long term it created doubt in investors’ minds whether or not Bitcoin could be a legitimate form of investment.

Moving Forward

Bitcoin is considered a highly speculative asset class. Opinions of what its value should be run from zero to tens of thousands of dollars. It is a misconception that its value comes from commercial transaction supply and demand, when in fact the majority of transactions are speculators hoping to take advantage of short term price movements. Countries around the world have different stances on Bitcoin. The United States is completely open to Bitcoin—many businesses have started accepting bitcoin as a form of payment. Meanwhile although China is receptive to Bitcoin, it still chooses to regulate the crypto-currency, which should not come as a surprise to anyone who is familiar with the Yuan.

Impact

Every few years, there is a craze for a new financial instrument. Like stock options were in 1990s, we have Bitcoin now. Like every other financial instrument, it is imperative that one understands it intimately before investing in it. Whereas the value of stocks is derived from the performance of a company, Bitcoin is supported by nothing. Many economists believe that the fair value of bitcoin is zero and it is heading in that direction because it is priced solely from supply and demand. Stocks are units of ownership and are essentially claims on future cash flows of company. Bitcoin’s price is determined by how many people want to buy it—a risky proposition for everyone but speculators.

Goldman Sachs released a report classifying Bitcoin as a highly speculative asset akin to IPOs and distressed debt (debt of struggling companies). Entering into a Bitcoin transaction would be a high risk investment and should remain a small percentage of an investment portfolio.

This article is the opinion of the author and is not shared by India Currents or any of its staff. All investors should conduct their independent analysis before taking any actions and should not make any decisions on the information provided in this article alone.

Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and is working in the technology industry as a financial analyst. If you have feedback or have a topic you would like addressed please contact Rahul at rahul89@gmail.com.

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