What’s the Buzz About Bitcoin?
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What is Bitcoin?
At the most basic level, Bitcoin is a digital currency. Unlike conventional currency, Bitcoin is not supported by physical coins or bills that can be saved or shared; Bitcoin only exists digitally. While more than 4,000 digital currencies have been created, Bitcoin is the original, the most well-known, and currently the most valuable. (See Chart 1)
How does it work?
One of the most celebrated innovations of digital currencies is the method by which transactions are tracked and validated. Whereas conventional payment systems rely on a third party, like a bank or credit card company, to track how much money someone has and whether the person can pay what they have promised, digital currencies instead work by leveraging a combination of an open-source architecture, cryptography, and a lot of computer science.
Bitcoin exists as an open-source network, which just means that everyone can see the underlying code for Bitcoin and every transaction that has ever been processed. Everyone who owns bitcoin has a “key” that identifies their official record, effectively like a Bitcoin bank account. When one user wants to send Bitcoin to another user, the transaction is grouped with other transactions and must be verified through a process called proof-of-work.
The basic idea is akin to balancing a checkbook – when you write a check, you make note of the amount spent, and then with some sort of regularity you review your bank statements to be sure they match with your records. Digital currency works in a similar way, but on a much broader scale. The proof-of-work process currently takes around 10 minutes to complete, and transaction fees can vary between $15 and $40. Once the proof-of-work is complete, multiple sources confirm that it is correct to verify the transaction and mark it as “official” in the public checkbook.
Why Does Bitcoin have Value?
Value for any currency is based on supply, demand, and trust.
For instance, you accept dollars in exchange for the work you do because you trust you will be able to spend those dollars to buy food, groceries, and housing. Bitcoin is no different.
Those who accept Bitcoin as payment or who store a portion of their wealth in Bitcoin believe that it will retain its value and that they will be able to use the Bitcoin they own to buy goods and services in the future or to exchange for a government-backed fiat currency.
Furthermore, Bitcoin was invented with intentional limits on its supply, so it’s likely that no more than 21 million Bitcoin will ever be “mined,” giving buyers confidence in its future value.
The returns on Bitcoin have been extremely high – why?
The supply of Bitcoin is limited to the number of coins currently in circulation plus any additional coins generated through the proof-of-work process.
Most Bitcoin is being held as a store of value; only about 4 million of the roughly 18 million Bitcoin created so far are currently circulating, with the rest largely being held in place. However, more users are joining the Bitcoin network and demand for the currency has increased significantly as more institutional investors make large purchases and more investors make speculative bets on the rising currency.
Demand has exceeded supply, and the price has risen. (See chart 2 below)
Is Bitcoin a good investment?
This is a hotly debated topic. Many cite four primary motivations for why Bitcoin could be a valid investment: an aspirational store of value that is independent of government-issued currencies, an inflation hedge, a medium of exchange for use in transactions, and the currency’s security.
However, Bitcoin and all other cryptocurrencies are still at an embryonic stage of their lifecycle and the future of the space is largely uncertain.
Generally, for folks who are growing their assets to meet goals like retirement, college, etc., Modernist recommends allocating a maximum of 5% of portfolio value to “hunches and bets” like Bitcoin. The technology driving them is likely here to stay, but for now, limit any purchase of Bitcoin or other cryptocurrencies only to what you are willing to lose.
