Bitcoin: what to make of digital currencies
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Bitcoins are just one of the over 900 new format currencies known as cryptocurrencies to have emerged over the past few years. As they have become more mainstream in their appeal the price of bitcoins and their crypto-cousins has skyrocketed, causing investors to wonder if they have been missing out. What then is a cryptocurrency, and should we consider these to be potential investments?
What is a cryptocurrency?
Simply put, a cryptocurrency is a digital global currency created outside of the well regulated confines of the global monetary system. It exists only in the online world, and not in the physical world. This puts it out of reach of central banks, regulators and other watchdogs, making it the first independent, global currency.
It has no physical form, existing only though unique online software code which gives it the attribute of limited supply, something alien to the online world until now. Think of any piece of digital information you may have – you can simply copy it and send it on, with the recipient in turn sending it on again. Digital information in this form has no value as its supply is unlimited (it can be replicated for free). The key part to the rise of the cryptocurrency has come as a result of what is known as “blockchain” technology – essentially the ability to isolate unique pieces of digital information/code/bitcoins/cryptocurrencies, thereby limiting their supply and enabling them to become a store of value – as is the case with any traditional currency.
Bitcoin can therefore serve as a global transactional currency, with huge potential benefits in terms of the efficiency of global financial markets, payment for goods and services, protection against fraud, and broadening the scope of who can access ‘foreign currency’ by lowering the cost of access to anyone with an internet connection.
Bitcoin first emerged as a new form of global currency in 2009 in somewhat mysterious circumstances, with the founder remaining anonymous. Much like the internet itself had a founder but then became public property, bitcoins (and the related blockchain technology) have also become public property. Early users included the murky underworld, seeing the opportunity to conduct illicit business using bitcoins without the authorities able to track their activities (which as it turned out was a poor strategy, bitcoin keeps a full transactional record and this has been used to lock up a number of perpetrators).
As these cryptocurrencies by design have no traditional central bank to exert control, they are maintained and administered by the market which trades in them – a group of buyers, sellers and ‘miners’. New cryptocurrency ‘coins’ are created through a process called mining which is essentially the use of specialised software to break computer codes. As the codes are broken, coins are created. This attempts to replicate the same mechanism as mining for gold, also a scarce commodity. A completely transparent and publically available set of accounting records (the blockchain) ensures that all transactions ever conducted in bitcoins are publicly recorded, reconciled and verified.
Rather than monetary power being held and determined in the hands of a few central bankers, bitcoins are governed by the open market – to many a disconcerting attribute, but to others the ultimate safeguard of monetary value. Central bankers and the countries they act on behalf of have shown us that centralised governance (such as the devaluation of a currency, or more recently QE) can have material negative consequences for financial instruments. The appeal of cryptocurrencies to many has been the decentralised nature of how it is governed, with no single party able to control it.
Bitcoins are limited in supply by design – to 21 million coins. At present there are around 16 million in circulation, which increases as the miners are able to crack the various codes required to mint new coins. This limitation of supply helps preserve their value, and results in an ‘exchange rate’ – as you would expect with any other currency. You can for example buy 1 bitcoin for around R44,000 at todays rate. You can then use this bitcoin to buy any goods or services (in the physical, ‘real’ world, as well as the online world), provided the seller is willing to accept it as payment. This acceptance of bitcoin as a mode of transacting is becoming more commonplace, with global names such as Microsoft and Dell gladly accepting this form of payment, the country of Japan recognising it as official exchange, and a number of the more tech-savvy retailers in South Africa also open for bitcoin business.
It seems that bitcoins and cryptocurrencies are here to stay. What should investors be looking out for?
Fundhouse Commentary – July 2017 Investment Review