Bitcoin: A Genuine Investment, or a fad?

INTRODUCTION

“The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A.” — Milton Friedman, 1999.

This 18-year old quote by Milton Friedman, an American economist known for his advocacy of free-market capitalism and reducing the need for a third party in monetary transactions, foresaw a form of currency which is presently making the headlines everyday — Bitcoin.

The world’s first completely decentralized digital currency, bitcoin’s journey begun way back in 2008 with the anonymous Satoshi Nakamoto proposing an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

So how do bitcoin and blockchains work? Olga Kharif from Bloomberg says: “Think about what happens if you make an online transfer using a bank. It verifies that you have the funds, subtracts that amount from one spot in a giant database it maintains of accounts and balances, and credits it in another. You can see the result if you log on to your account but the transaction is under the bank’s control. You’re trusting the bank to remove the right amount of money, and the bank is also making sure you can’t spend that money again. The blockchain is a database that performs those tracking functions — but without the bank or any other central authority.”

The Reluctance

The basic idea of bitcoin, as proposed by Satoshi Nakamoto, is its non-dependability on trust of any one body to keep its promises; instead, the only trust required is distributed trust, or trust in the network. In other words, it operates outside of government control. This caused a lot of concern for banks, financial institutions and financial regulators across the world, with the Reserve Bank of India being among the many institutions who have warned about the risks of investing in bitcoin.

But why does this widespread reluctance against bitcoin exist?

As any new disruptive technology brings with it, bitcoin too has the promise of opening up unprecedented avenues, which in turn seeks to weaken the influence that large corporations have on things such as, in this case, cash flow. Bitcoin’s net market valuation is about $250 billion, which seems immensely tiny compared to that of the global asset market of stocks and bonds and loans — which is nearly $300 trillion. For now, promise is all that bitcoin has — hence the skeptic reaction all around the world. This, coupled with its extreme volatility, are cited by experts as bright red “danger” signs against investment.

Another issue that is the subject of many cryptocurrency debates is the “intrinsic value” of bitcoin; more accurately, the non-existence of an intrinsic value for it. So what does one mean by the intrinsic value of a good, service or a business? Intrinsic value is the inherent worth of a company, investment, or asset based on its fundamental characteristics and earning power. For example, lumber can be used to build houses, grain can be used as food, and oil is turned into energy. Juxtaposing these common commodities with bitcoin — which is completely virtual — we can see why many respected investors in the world confidently assert their opinion that Bitcoin has no intrinsic value. Bruce Flatt, CEO of Brookfield Asset Management Inc., says “It has no intrinsic value, I don’t know what it is. But it has no intrinsic value in our definition of intrinsic value. If someone else wants to speculate on it or invest in it, it’s for them. It’s not for us.”

Economists across the world have termed Bitcoin a classic example of a financial bubble, with legendary investor Warren Buffett going to the extent of calling it a “real mirage”. The meteoric rise of Bitcoin inadvertently brought on comparisons with the Tulip mania of the 17th century. The introduction of tulip — which was different from every other flower known to Europe at that time — brought about intense speculation about its perceived value (many considered owning it as a sign of novelty) making its price reach extraordinarily high levels. This rise in price reached to a point where people were trading their land and life savings to get more tulip bulbs. Soon, some prudent people realized that the humongous price of the tulips was not an accurate reflection of its actual value, and began to sell them quickly before the price drops. As others began realizing the same, a domino effect of progressively lower and lower prices was triggered, as everyone tried to sell while not many were buying and Dutch commerce suffered a severe shock. The primary parallel that can be drawn between the tulip mania and the rise of bitcoin is the fact that the rise in both cases was driven by a fear of missing out. Stephen Innes, head of Asian trading at currency broker Oanda, believes bitcoin bubble could go the same way — “Prices will become so out of reach of the common man that ultimately demand fades,” he said.

The Promise

Is that the final judgement? Zachary Karabell of Wired.com begs to differ. In his article, he argues that almost nothing in the world of trading and money has intrinsic value. Even gold — the investor’s favorite standard — is limited in supply and has no value per se, other than that ascribed to it by humans over time. He asserts the fact that any new form of currency is bound to have skepticism by bringing out the example of the crusade brought out by the 19th century populist United States presidential candidate William Jennings Bryan against the erosion of value perpetrated by Wall Street financiers and their gold-backed paper money, at the expense of true value measured by the work of labourers.

The fundamental technology behind bitcoin brings with it many unique advantages, such as:-

  1. Complete freedom from the limitations that come with banking — there is no such central authority in the bitcoin network. These limitations include minimum balance, waiting for business hours, account approvals, etc.
  2. Since the system is purely peer-to-peer, there is no possibility of third party interruptions, such as frozen accounts or transaction interruptions.
  3. Negligible transaction fees.
  4. NO TAXES!

Having seen contrasting viewpoints about the investment nature of bitcoin, the question that is imminent now is this- should YOU invest in bitcoin? Again, it depends. You can either follow the wise words of Wences Cacares, who says “First, own only what you can afford to lose. For most people, this is 1% of your net worth. Buy bitcoin with it, and do not touch it for 10 years.” Or you could choose to swear by Jamie Dimon, the boss of JP Morgan Chase — America’s biggest bank — who said “The currency isn’t going to work. You can’t have a business where people can invent a currency out of thin air and think that people who are buying it are really smart.”

The choice is yours.