Content provided by Mark Matthews, Investment Research Analyst
A Commodity? An Equity?
Bitcoin continues to reach new highs, closing at $7,058 per share on November 2, 2017. But for many investors, bitcoin remains somewhat of a mystery. So, what is this highly popular digital currency, and why is it continuing on such a tear?
Bitcoin is not exactly an investable asset, such as a commodity or equity. Commodities derive their values from their use as raw materials to meet a need. Additionally, prices are determined by supply and demand as well as the overall financial climate, which includes interest and exchange rates. Neither are characteristics of bitcoin. An equity asset, meanwhile, generates cash flows in one form or another, or is expected to in the future. For instance, the basis of investment in an early-stage equity is the calculated assessment of future earnings power, while investment in a mature-stage equity is based on the predictability of future cash and dividend flow behavior. These too are characteristics bitcoin does not possess.
So then, what is bitcoin? The answer is it’s a currency — but not a very good one. The impetus behind bitcoin, per founder Satoshi Nakamoto (an alleged fictitious name for the unknown creator of bitcoin), was to provide a virtuously seamless electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other. The issue with this premise is that bitcoin is costly, not widely accepted, and lacks sufficient speed, which makes it cumbersome to transact with relative to conventional alternatives.
When accounting for mining of the blockchain (blockchain being the digitized, decentralized public ledge of all cryptocurrency transactions), transacting in bitcoin amounts to roughly $32.40 ($30 for mining and $2.40 in transaction fees) making it unsuitable for retail transactions. Most large online merchant payment processors in low-risk domiciles charge on average about 0.20%.
Additionally, transactions go through blocks that are mined every 10 minutes with no guarantee that any individual transaction will be included in a newly mined block. Thus, there may be a significant time lag between when a transaction is initiated and when it’s completed, at times as long as 30 minutes. These financial and administrative impediments to bitcoin have been monstrous roadblocks to its acceptance as a payment mechanism in retail and, especially, institutionally.
Other inhibitors include risk, lack of liquidity, and minimal-yield returns. Heightened volatility, although currently down from its peak, prohibits the use of bitcoin as a sustainable storage of value or pledgeable collateral. Aside from the volatility risks, the lack of infrastructure to prevent fraud, theft, or hacking poses an imminent threat. With no central authority, the system is only secure as long as honest nodes (users who create blockchains and enforce blockchain rules agreed upon by the mining community) collectively control more computing power than any cooperating group of attacker nodes. Further, the lack of an official third party to take custody and validate assets poses a risk that institutions are unwilling to take.
While liquidity continues to improve, it realizes only a fraction of the volume realized by equity, fixed income, and other currency markets. However, the Chicago Mercantile Exchange recently announced that it intends to create futures contracts for trading bitcoin, which will help increase its liquidity profile and encourage the adoption of the currency as a mainstream financial asset.
Lastly, the lack of adequate yield stands in the way of its wide adoption. Some bitcoin exchanges offer between 1% and 5% on time frames ranging from 14 days to one year. However, with volatility levels in excess of 50%, holding bitcoin over the course of a year is hardly an attractive arrangement.
So, What is Bitcoin Good For?
With no substantial argument for why bitcoin generates economic value, its investment use is merely a trading vehicle. But, it is a trading vehicle to be used with extreme caution as the driving forces behind its performance are speculative momentum and wide volatility distribution. Additionally, it can be seen as a portfolio diversifier because of its nonexistent correlation with traditional market weekly returns. This is no surprise since there is no overlap between what drives performance in the cryptocurrency and traditional markets.
As it currently stands, blockchain technology and its various uses appear to have more long-term validity and staying power than bitcoin. Should there be significant improvements to its infrastructure, wide acceptance of its use as a currency from creators and users alike, and enhanced transparency and robustness of the underlying algorithm, bitcoin could certainly emerge as a viable alternative to the prevailing fiat currency system we have today. If one of the several other existing cryptocurrencies, or perhaps a cryptocurrency yet to be created, doesn’t beat it to the punch that is.