There’s recently been a massive influx in the value of Bitcoin—and it’s caught many people’s attention. If you’re among those considering investing in Bitcoin, there are a few questions you may need to ask before making your decision:

• What exactly is cryptocurrency?
• How’s it valued?
• What’s it used for?
• How’s it exchanged for goods or services?

It’s always a good idea to have a firm understanding of your investments—especially when the asset in question is highly publicized and somewhat unclear.

This Insight outlines the basics of cryptocurrency to help investors better understand the fundamentals of the technology, its potential benefits, and its potential risks.

What is a Blockchain?

To understand cryptocurrency, it’s imperative to begin with the concept of blockchain technology. Don and Alex Tapscott, authors of Blockchain Revolution, provide the following definition:

“The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.”

Blockchain Revolution, D. Tapscott & A. Tapscott 2016

Blockchain is a database of digital information distributed amongst thousands of computers around the world. Without a central controlling agent, like a government or an institution, no single entity is in charge of this technology. And without a hierarchy of control, all users are peers.

However, central rules apply to the blockchain, which all users of the technology must abide by. And because the database isn’t located in any single location, all records are public—and theoretically out of the reach of hackers.

Although blockchain is used for digital currency, other applications are emerging.

What is Bitcoin?

Bitcoin is a digital cryptocurrency and worldwide payment system that operates on a decentralized, peer-to-peer network. Bitcoin was created to allow transactions to occur without middlemen—such as banks or other counterparties.

That means transactions can be anonymous and aren’t subject to third-party fees, because operations are made without a central authority or bank regulation. Instead, network computers verify transactions using cryptography and record a public, distributed ledger called a blockchain.

The Bitcoin payment network is essentially an application that runs on blockchain technology. This currency’s success as new money suggests that new innovations designed to improve electronic interaction between disparate participants will predominantly use blockchain technology rather than centralized systems.

For example, one of the world’s largest stock market exchanges, the National Association of Securities Dealers Automated Quotations exchange, or NASDAQ, now uses blockchain technology. While it already executed its transactions electronically, it has replaced its former centralized system because blockchain technology is simpler, less expensive, and more transparent.

Determining Bitcoin’s Price

Relative to the United States dollar (USD), Bitcoin significantly appreciated in value in 2017—opening the year at $965.49 and ending at $12,783.94. While many factors have impacted its rapid appreciation, here are a few that stand out:

• Bitcoin has continued to emerge as a form of currency that’s accepted by retailers
  • Many major retailers, including Microsoft, Expedia, and Overstock.com, accept Bitcoin as a form of payment
  • The widespread ability to purchase goods and services is a critical component of any currency, and additional adoption by retailers will continue to improve Bitcoin’s stability
• Consumers’ increased use of Bitcoin is having an impact
  • Coinbase, a provider of digital wallets used for holding cryptocurrency, reported 11.7 million active users in October of 2017
  • Charles Schwab reported 10.6 million active users the same month
• There’s a finite supply of Bitcoin
  • The digital currency began 2018 with about 16.7 million coins mined to-date.
  • The Bitcoin supply is capped at 21 million
  • Unlike traditional currencies, the supply cannot be increased past this amount

Investing in Cryptocurrency

While cryptocurrency has some differences from traditional currency, it also has the following similarities, which can help consumers evaluate its investment merit:

• Cryptocurrencies don’t generate income in the form of dividends, but earnings can be generated from selling, and would be subject to typical taxes on gains or losses
• The return from investing in cryptocurrency is solely determined by demand for the currency relative to its supply, resulting in price changes
  • Recent price changes have been driven by investor speculation
  • Owning cryptocurrency offers diversification of currencies, lowering the exposure of risk to the devaluation of a single currency
• Cryptocurrencies have been highly correlated with equities, indicating the market views the currency as a risk-on trade—rather than a source of diversified risk, like traditional currencies

The chart below shows the performance of Bitcoin, the S&P 500, and the US dollar index—shown in blue, black, and green, respectively. Notice Bitcoin and the S&P 500’s similar paths, while the US dollar is mainly inversely correlated.

Cryptocurrency’s Potential Benefits

Cryptocurrency offers users a few benefits that traditional forms of currency can’t provide. Some of cryptocurrency’s benefits include the following, though the currency’s uncertain future and the likelihood of changes may ultimately affect its benefits.

• Potential insulation from geopolitical risk. When nations are shaken from factors such as war, internal politics, or natural disasters, currencies generally dip for an undetermined amount of time. Because cryptocurrency runs on a decentralized, peer-to-peer, censorship-resistant network, these geopolitical risks may not be able to derail its value.
• Potential insulation from traditional monetary regulations. Unlike the dollar, which has been long-considered the risk-free rated asset, Bitcoin is not yet subject to monetary inflation, seizure, or confiscation.

Uncompensated Risks

There are a number of risks associated with Bitcoin, for which the owner doesn’t receive compensation. A few of these risks, which are significant for long-term investors, include the following:

• Regulatory risk. There are a number of countries that have banned, or are planning to ban, the use of Bitcoin. If this trend continues and is enforced, it could have a significant impact on the currency and its continued use.
• Price inflation. As with all currencies, any rising cost of goods and services poses a risk to the long-term viability of holding a significant amount of uninvested currency.
• Theft. As the value of Bitcoin has increased, so have hackers’ attempts to steal large amounts of the currency. In December of 2017, NiceHash, a crypto-mining marketplace, reported being infiltrated by hackers and having more than $70 million stolen in Bitcoin.

Conclusions

Cryptocurrency has spotlight of the financial world—and for good reason. Among its advantages, many find the currency enticing because it presents a potential threat to the banking sector—long-considered to be taking advantage of customers and governments. More importantly, this technology has the potential to disrupt and strengthen industries.

For those seeking a quick return with less concern about risk, cryptocurrencies like Bitcoin may be the answer. But while there are potential upsides to cryptocurrency, the risks for long-term investors may currently be greater than the rewards.

As consumers invest, it’s important to remember financial trends—such as the 2008 financial crisis and the 2001 tech bubble. Both of these trends experienced trajectories at similar speeds to the 2017 rise of Bitcoin—and could point to cryptocurrency as the currency of the future, or as simply the latest trend.

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To learn more about cryptocurrency or the benefits and risks of investing in Bitcoin, please contact your Moss Adams professional.