It’s clear by now that Bitcoin and cryptocurrencies, at large, have captured the public imagination and a lot of people are now seriously considering or have already invested in Bitcoin. The exact reasons why likely differ from person to person. Most people have heard or know someone who has won big! Or maybe you’re a nerd like me and think blockchain technology is cool. Or maybe you believe in conspiracy theories and think that Satoshi Nakamoto is a revolutionary who’s bent on undermining the world’s financial markets - effectively sticking it to the Man!
Regardless of your (invested) interest, or disinterest in bitcoin, I think it’s important to understand the basics of bitcoin and blockchain technology, especially if you’re thinking about investing money in bitcoin or another cryptocurrency.
Let’s start with a bit of history first. It is thought that Nakamoto started developing the code for bitcoin in 2007. Then in October 2010, Nakamoto published a white paper entitled Bitcoin: A peer-to-peer electronic cash system that outlined the principles of what is now known as the blockchain.
Before I get sidetracked by the technical details (which are very cool), it’s important to understand why a distributed ledger is such a radical idea from a monetary perspective. Most governments around the world have a central bank that controls the supply of money in the market. It’s an important role because too much money can result in hyper-inflation, think of hyperinflation in Zimbabwe in 2009 that forced the government to issue 100 billion dollar notes! Too little money in the system and people won’t have money to spend to drive the economy.
However, the centralisation of transactions wasn’t always the case. In the beginning people traded goods in a decentralised manner: for example, I’ll give you a goat if you fix my roof. However, in order to solve a fundamental issue of timed demands, for example, I may not want a goat right now, I may need some maize. Money was introduced to simplify the flow of value from one person to another. Money meant that you could pay me to fix your roof in a token that was recognised by another party as having intrinsic value, which meant I could use it to pay for other goods and services at a future point in time.
The crux of money is it just requires enough people to believe that the token of monetary exchange has value for it to have value. That may sound like a circular argument and it is. I mean think about it, why do we collectively believe that the notes in our wallet have value? Because the Government says so, or because we trust that people will accept it as legal tender when we want to buy something?
Basically Bitcoin is as arbitrary as paper money in terms of a token of value. The trouble is getting enough people to believe that it is, as well as satisfying the necessary requirements for transactions; Visa and Mastercard process about 5,000 transactions a second. So at the very least, Bitcoin would need to be able to do the same, if we want to replace cash with Bitcoin. Although there are some technical challenges facing Bitcoin in this regard, there are other cryptocurrencies that are tackling these challenges head on; Algorand, for example.
The larger problem sits with Governments at this stage. For better or worse, we are wedded to democratic structures that have the power to regulate business and the financial markets. This means that although you might want to use Bitcoin for all your purchases, you may be hamstrung by the regulations in the country you live in. For example, only 3 days ago the Chinese government declared that all crypto currency transactions are illegal – effectively banning Bitcoin.
This brings me to my last point about whether or not it’s a wise idea to invest in Bitcoin. The most convincing argument I’ve heard by investors is that Bitcoin should not be viewed as cash but more as a store of value similar to gold. Gold has always been a safe haven of value in times of volatility and uncertainty. And gold has been a relatively stable store of value over the last 40 years. However when experts compared Bitcoin vs Gold as a safe haven of wealth they found that although Bitcoin does respond to market distress in the same way as gold, it’s volatility (how much the price changes over time) does not resemble any conventional asset class from an economic perspective. In other words, it has crazy swings in price that have not yet been observed in the traditional financial markets.
Now although you may think that there-in lies a huge opportunity. I mean, if only you’d been smart enough to buy R15,000 worth of Bitcoin in 2010 you would have over R4.3 billion today! The problem, as we’ve tried again and again to point out, is that hindsight is 20-20 whereas foresight is impossible to predict. So knowing that your R15,000 investment is going to have the same return today is complete guesswork.
The problem is that there is no currently intrinsic value underlying Bitcoin at this stage. You’re effectively betting against other people’s perception of value on something that could be declared illegal tomorrow. Not to mention the risk of your account being hacked! Is that a risk you really want to take with all of your savings?
My advice, for what it’s worth, invest 1% of your savings in Bitcoin but only if you’re comfortable with losing all of it. That way, if the price of Bitcoin drops 50% as it did in April 2021, you don’t have to worry about it and can just ride out the wave.