Investors would have to be living in a cave to have not noticed the meteoric rise and recent pullback in the price of Bitcoin over the past year. Anyone who trades has to be intrigued by (and possibly skeptical of) any widely held asset that exhibits that kind of price volatility.
But is it a fad, a bubble, or a legitimate investment opportunity?
Spoiler Alert: It’s all of the above.
Bitcoin as a crypto-currency was born out of the ashes of the financial crisis of 2008. Initially a response to the idea of governments “printing money” – expanding the balance sheets of central banks – in order to bail out troubled financial institutions and stimulate the economy. It was an attempt to de-centralize the notion of currency.
Invented by a reclusive and mysterious programmer with the pseudonym Satoshi Nakamoto, the concept was to separate the control of the supply of money from the government and central banks and hand it to the market participants who use it as a store of value and a medium of exchange. Nakamoto also intended to remove the friction from financial transactions, allowing vendors and customers (or anybody) to transfer money directly to each other instantly and electronically without the participation of middlemen like banks or credit card processors.
The actual identity of Nakamoto is not known, and it may in fact not be a single person. This doesn’t really matter as the source code was intentionally made available to anyone and “Nakamoto” has ceased interacting with the public or the bitcoin network.
The revolutionary aspect of Bitcoin was the establishment of a distributed ledger in which transactions are verified and recorded by multiple parties in a vast peer to peer network. Every participant records and stores every transaction that has ever happened, broken down into manageable chucks of data called “blocks.” Every participant must agree that they have an identical copy of the previous set of transactions and that the new trade belongs at the end of the list.
Because all participants must agree on the sequence of transactions, it would be functionally impossible for anyone with nefarious intent to add a fraudulent transaction to the chain (or delete a legitimate one) since the change would have to happen simultaneously in thousands of places. This also means that the network literally gets more secure with every transaction processed - as the list that would have to be altered grows ever larger.
The participants who process transactions and store the data of the blockchain are called Bitcoin “miners”, so named because their incentive is to be rewarded with new bitcoins for their efforts. The network has them process a very computationally difficult math problem to complete transactions. New bitcoins are awarded to the miners who solve the problem first. The fact that the problem gets continuously more difficult ensures that a large number of participants devotes a massive amount of computing power to the network, making it faster.
With the runup in the price of bitcoin over the last 4 years, the incentive to mine coins successfully has spawned huge operations using sophisticated hardware who are competing with each other for the increasingly valuable coins. Initially, mining could be accomplished by an individual with a fast personal computer, but migrated quickly to arrays of graphics cards that could solve the problems faster and then to dedicated mining “rigs” which are commercially available and designed for the singular task of mining bitcoin and other crypto currencies.
The electricity to run all of these powerful computers and also the air-conditioning to cool them is the biggest component of the cost structure for miners. As the arms race for the fastest computers continues, mitigating the energy costs associated with mining is the miner’s holy grail.
So How Can You Invest in Bitcoin?
There are many ways to gain investment exposure to crypto currencies:
There are now numerous online marketplaces that allow you to buy bitcoin (and numerous crypto currencies) fairly easily. You deposit U.S dollars and once the fund transfer is verified, you can buy bitcoin, participate in the price appreciation or depreciation and turn your bitcoin holdings back into dollars whenever you wish.
Buy Bitcoin Futures
Futures contracts on Bitcoin are traded on both the Chicago Mercantile Exchange (CME - Free Report) and the CBOE Global Markets (CBOE - Free Report) . Trading bitcoin futures allows an investor to participate in price appreciation (or depreciation – they can be sold as well) without any risk of interacting with an upstart exchange. Trades on both the CME and CBOE are backed by the assets of extremely well capitalized clearing corporations, so there is no risk of the exchange being hacked and losing crypto currency as has happened in the past – albeit infrequently – with online crypto exchanges.
The advent of listed futures contracts also provided traders with the first simple way to short the price of bitcoin, and many have done so. The decline from $19,000 to $7,000 over the past six months is widely attributed to the existence of liquid, shortable bitcoin securities. This is actually healthy for the market since instruments that allow market participants to easily express both long and short sentiment tend to restrain bubble-type price activity.
Buy Blockchain Companies
Many companies now sell equipment and software designed specifically for mining crypto currencies. Recall that only the miners with the fastest and most efficient technology are able to process transactions quickly and efficiently enough to profit from the activity. Miners are constantly in search of processors and peripheral hardware that put them at the front of the line when new coins are minted and issued.
From upstart companies producing equipment designed for the sole purpose of mining to more traditional hardware manufacturers like Nvidia (NVDA - Free Report) whose existing products are commonly used for mining, a tremendous amount of hardware is being purchased and utilized for blockchain-related activity.
Buy the Forward Thinkers
It is commonly believed that the real value in bitcoin is not necessarily the price of the coins themselves (which need to exist to compensate the processors on the network), but in the blockchain itself. Future applications of the distributed ledger technology could be used in any field where data needs to be transmitted electronically and stored securely.
Financial transactions, legal documents and medical records are obvious candidates for blockchain processing.
Some traditional finance companies including Goldman Sachs (GS - Free Report) and Northern Trust (NTRS - Free Report) have devoted significant resources to developing systems for blockchain transactions and will be the first to benefit if and when the technology is applied to other areas beyond currencies.
Stay tuned to this same space Tuesday for a look at one new ETF that seeks to provide investors a one-stop shop for all of these blockchain investment concepts. I’ll be at the New York Stock Exchange to discuss the product with the founder and manager of the fund and will report back tomorrow.
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