I have seen people who generally have no interest in stocks, never looked at a financial newspaper and perhaps never made an investment suddenly praying at the alter of Bitcoin and pledging to HODL forever.
If there was one indicator that signals a bubble, this is it. Even the most enthusiastic backers of Bitcoin think that what we are seeing now is a speculative bubble.
While it could indeed be a bubble and could get very big and ultimately pop, as Ruchir Sharma, the global strategist for Morgan Stanley, has pointed out, bubbles often get the direction right. For example, in 2000, Pets.com went from IPO to liquidation in just 268 days, incinerating over $300 million. Chewy, founded 11 years later doing the exact same thing, is now a $45 billion company.
So, we wanted to understand this better and dig a bit deeper. We will post a series of articles on crypto for Indian investors in the coming weeks. Also, joining us in these series of posts on Bitcoin will be a friend wants to be anonymous, who has been a cryptocurrency enthusiast to the extent that his stock portfolio is empty.
What is it?
Bitcoin is a product of rather clever computer science by someone unknown or some unknown group of people who go by the pseudonym ‘Satoshi Nakamoto’. Bitcoin was invented to solve the problems created by an archaic financial system.
For instance, anyone who has sent money or received money from abroad, knows its a problem. It takes days, the bank takes a big cut and it might involve visiting the branch to fill-in paperwork. Or if you sell goods or services online, the payment gateway still in some instances can take as much as 2% for transaction, when your margin might be just 8-10%.
The reason for this is many from regulatory factors, walled-in bank databases which requires verification and authentication to and absence of competition.
The solution devised by Mr. Nakamoto was to have a financial system which would function and information stored via millions of computers across the world. With no one in charge and completely peer to peer.
Source: Cryptoassets The Guide To Bitcoin, Blockchain, And Cryptocurrency For Investment Professionals By Matt Hougan and David Lawant
Ensuring this new financial system is bad-actor proof, robust, reliable, timely and database synced across the world is enabled by the blockchain technology which was invented originally for cryptocurrencies to function smoothly.
How does it work?
If I want to send 1 bitcoin to Shyam, I need to use a private key to authenticate myself and initiate the transaction and kept in a ‘waiting area’ for confirmation from third parties which are computers called ‘bitcoin miners’ who play a special role in settling transactions such as mine to Shyam. The miners that successfully settle a 'block’ of transactions are rewarded with new Bitcoin. This payment is incentive for miners to maintain the database and settle transactions.
The problems it solves:
1) Quick, efficient, and cheap way to transfer money especially Internationally.
Bitcoin is efficient, compared to an international transaction which can take days and comes with 1-8% bank fees for each transaction, Bitcoin takes few minutes to settle transactions and comes with only 0.0019% fee.
2) Medium of exchange in a digital world
Bitcoin and other cryptocurrency create a digital commodity that is recognized globally across platforms as something which everyone attributes value to, which is what money is. Everyone wants money because everyone else wants money.
So, Bitcoin allows individuals to transact, pay and receive Bitcoin in return for goods and services within the digital world in a more seamless way. So, whether it’s within a virtual world of a game or to music or porn or anything else, someone can transact across borders without bothering about exchange rates or setting up a payment gateway system which can be a pain to setup.
It also makes it easier to have universal system for earning currency in an online world. Say for example, within a game or an online referral system, the points you would normally reward to someone can be used within that limited world but can cryptocurrency solve that problem, where the reward could be some cryptocurrency which because of more applications is more useful.
And while the use case for this might seem limited but in an increased digital world as it grows, our online parallel lives might need a parallel financial system to keep pace with our evolution.
3) Store of Value:
It’s easy for someone to prove that they have Bitcoin because of the open ledger, and no one can take someone’s Bitcoin away from them without their authorization. So, your Bitcoin holdings are trusted by a counterparty and by yourself that they are safe, they cannot be hacked or stolen or confiscated.
Further, the reason why Bitcoin gets the 'digital gold’ label is because of scarcity built-into it, only 21 million Bitcoins can be ever mined and its scarcity that creates the allure. As the demand for it grows, the limited supply, will increase the perceived value of it, pushing the price higher.
Gold has partly valued because it’s limited by its supply, the only gold available in the world is what’s in the earth and that scarcity along with that global recognition as a store of wealth creates the value for gold. Notice that every time there is a crisis in the world, like 2008 financial crisis or the current pandemic, gold rallies, because it’s a haven for safety.
One of the bull-cases for Bitcoin is that the current limitless money printing in the developed world especially the US might make the dollar less worthy and Bitcoin and another cryptocurrency will become more prominent especially in a world where everything is digital and online.
4) Digital Contracts
Cryptocurrencies allow you to program certain rules and conditions to authorize and settle transactions. A few examples for these contracts are:
Escrow: Authorizing a payment after a work has completed to a satisfactory level.
Trust: Authorizing payments after certain amount of time has passed.
Wagers: Authorizing payments only if a certain event or result occurs.
These are just a few examples but there can be many applications without the need for a trusted intermediary. I mean this avoids the need for banks, accountants, lawyers and notaries in a 24/7, decentralized, cheaper and faster system.
Why is there more than one cryptocurrency?
Different cryptocurrencies are created to serve different uses. Bitcoin is the original, most known and has come to be regarded as a reserve currency within the cryptocurrency world.
For example, some cryptocurrencies can be created to be more programable to serve more complex cases than the ones mentioned above such as to raise money in an IPO or collateralized loan fundraising drives.
Ethereum is the second most popular cryptocurrency after Bitcoin and Ripple which till recently was close third but was recently indicted by the US securities regulator.
Source: Coinbase, Values as on 17th Jan 2021.
Does having more cryptocurrency diminish value Bitcoin?
Quite to the contrary, it adds to its value, more cryptocurrency increases the awareness and total value of crypto assets. Bitcoin being the best-known crypto currency can only benefit from it.
For example, when SEC, the US securities regulator indicted Ripple, Bitcoin increased in value because people who held Ripple moved to Bitcoin in a flight for safety as it dropped in value.
Also, the more complex a program is like Ethereum or even other cryptocurrency, more likely there is a bug or flaw in it, which increases the trust in a currency like Bitcoin which is a simpler program and time-tested.
Think of it also in the real world, where within borders, people might transact in domestic currency but internationally the US Dollar is king, similarly while people use different cryptocurrency for specific needs but for more universal applications, there might be a greater need to convert it to Bitcoin.
Should you invest in Cryptocurrencies?
Well, we’ll answer that question next week, make a case for it and then the week after, provide a more skeptical view of cryptocurrencies.
Please do listen to our conversation with our friend, is a guy just like us who believes in systematic investing and spent quite some time researching and investing in cryptos and knows lot more than us.
Most of the technical details in this post has been sourced from the CFA Institute’s Guide to Cryptoassets.
Our conversation with our friend below.