1. Home
  2. >
  3. Bitcoin For The Wary

Bitcoin For The Wary

Paul Azzoparti

Bitcoin was the first of the cryptocurrencies, which now number around 1,500. They were labelled "crypto" because Bitcoin, at first, was deemed hidden and secret. But since each bitcoin consists of both a public identifier number and a private key, the different bitcoins and their transfers are now being tracked by investors and the authorities. A new company, Chainalysis, of New York, specializes in just such tracking. Today, it seems that most of the secret transfers are done by simply passing to another person the private key, consisting of a long series of numbers and letters. Once the receiver tries to place a trade on a Bitcoin exchange or convert bitcoin into dollars, however, a trail is created, and trails can be followed.

Nearly every day, we see promoters of Initial Coin Offerings (ICO) touting coins with different twists: some offer more anonymity, others claim they are based on improved technology, others offer iron-glad guarantees of limited supply.

 

Blockchain

Bitcoins’ initial use as a means of effecting secret payments relatively cheaply and quickly has now been largely vitiated not only by being tracked but also because the blockchain, to which blocks of new bitcoin transactions are chained, like wagons full of transactions to a train, has become very heavy and transfers rather expensive and slow.

Transactions in bitcoin are grouped together to form a block. Blocks are linked together to form a chain. A blockchain, therefore, is essentially a chain of blocks of transactions much like financial transactions listed in a ledger. The blockchain ledger, however, is distributed amongst all the users. All users can see all past transactions. The technology is therefore called Distributed Ledger Technology (DLT).

Furthermore, Bitcoin operates via consensus of the Bitcoin community - but who forms this community? Any holder of Bitcoin? The miners who, through massive computer effort, earn the right to link another block of transactions to the Bitcoin chain? The exchanges where bitcoins are bought and sold? Disputes have arisen; the most recent, for example, as to how best to increase the size of each block to better compensate miners for the huge costs of electricity and computer power they must now necessarily incur.

Bitcoin, exchanges, and the electronic wallets used to hold bitcoins have been repeatedly subject to massive hacking and fraud, the most notorious being the attacks on Mt. Gox between 2011 and 2013. Mt Gox, in Japan, was then the largest exchange. Hackers transferred out 850,000 bitcoins, valued at around $450 million at the time, of which only some have been recovered. We learn of such big hacks nearly every week or month.

21 Million

It is contended by promoters that the main attraction of Bitcoin is that creation would stop at 21 million bitcoins. But, from what I have learned so far, there seems no fool-proof way how this will be enforced. There are also rumours of fake or secretly held bitcoins. And sometimes the single chain splits into two and forms a fork. This creates validation problems.

Although it might help it retain value, something enjoying only a limited quantity creates a rather faulty “currency”. The reason for this is that once supply dwindles or comes to a stop, people tend to hoard it rather than pay with it. This reduces its velocity of bitcoins through the economy, and eventually practically stops being used in commerce.

The price of each Bitcoin is also extremely volatile, sometimes moving up or down by 20% or more in one day. The Bitcoin price came close to $20,000 in mid-December 2017 but slumped to below $7,000 early in February 2018 before recovering to just below $11,000 as I write in mid-February. Speculating in Bitcoin may be profitable if you have the right information and technology due to the high volatility. Receiving payment in Bitcoin can be very risky unless you can immediately convert it to dollars.

Zero

In the long-run, I believe, the value of any cryptocurrency would be zero unless it offers something unique and its technology has an edge which can be protected by patents or trade secrets.

The reason why I state this is rather simple. While demand for any cryptocurrency is necessarily limited by the financial resources of current and potential buyers, the supply of “me too” cryptocurrencies is infinite.

Anyone with blockchain or similar technology and with sufficient resources can set up a new cryptocurrency system. And since the creators of new cryptocurrencies and the first buyers are the ones who eventually make the most money, and who often continue to control the new cryptocurrency, as we see in Bitcoin, the incentive to create new systems is huge. In fact, it seems that today Bitcoin is mostly controlled by a few huge miners who operate in areas where electricity is very cheap, in China, a few states in the US, and now in certain areas in Canada. This allows miners to operate warehouses full of dedicated computers and create blocks economically.

In the short-run, though, since a new cryptocurrency system might have some special attraction not immediately available to other cryptocurrencies, such as a temporary technological edge, it might attract more demand than there is supply.

Another attraction, other than technological, as we have seen, is the fame and popularity gained by being the first mover. The fact that Bitcoin is popular makes potential buyers feel safe. Also, popularity brings with it ancillary suppliers, such as Bitcoin ATMs, and companies willing to take payment in Bitcoin to enhance sales. These are called network effects.

A technological advantage of a new crytocurrency can only be retained via trade secrets or patents. (Bitcoin is based on an open system available to participants.) Trade secrets are difficult to protect when individuals change jobs or have friends or relatives in competing companies. Most patents depend on the enforcement of legal rights in a geographical region, such as the EU, or the United States, but are difficult, expensive, and sometimes impossible to protect in other regions, such as China.

Furthermore, once the details of a patent are published, it is quite often not too difficult for the technically savvy to find some alternative method to achieve the same objective, thus skirting around the patent. Often, these efforts to ‘cheat’ a patent result in an even better product. We see this often. In IT, the rule is evolution.

Regulation

As to popularity, this too needs protecting. Since Bitcoin and other cryptocurrencies do not have a central authority to lay down and enforce the rules, and since many national police forces are under-resourced and have more than enough serious crimes and pickles on their plate, fraudsters and other criminals tend to disappear into the ether with their ill-gotten gains. Often victims have very little or no recourse which scares existing and potential holders away.

Regulators and tax authorities are now taking a much closer look at cryptocurrencies than they did even until recently. In some countries, trading in cryptocurrencies is either banned or curtailed and in many others it is being closely regulated and monitored.

Technology

One of the major benefits of Bitcoin is the emergence and practical application of the blockchain and similar technologies. The blockchain, though still in its infancy, and not yet fully secure, is becoming increasingly available through the major software providers. Anyone can set up a blockchain to do something, at relatively little cost. Its applications are increasing: in freight handling, aircraft logistics, leasing, renting of apartments, transportation, money transfers, medical records, gaming, etc. Blockchain technology shows a lot of promise and is evolving very rapidly.

Investors must understand that Bitcoin is a non-productive asset but, unlike gold, does not have a millennial track record of popular demand. And, unlike the works of Rembrandt and Caravaggio, a Bitcoin does not glow in beauty.

As an investment, therefore, Bitcoin is very volatile, is susceptible to potentially serious technical and consensus-reaching problems, is quite open to massive fraud, and is competing with the numerous existing and new cryptocurrencies.

If you want to dip your toes in Bitcoin and ride the bandwagon, for a while, keep in mind these things, acquire the necessary knowledge, and make sure you sell as soon as you deem new believers are getting scarce.

Paul V. Azzopardi BA(Hons)Accy, FIA, MBA, CPA is a corporate director and has worked as a finan-cial and investment adviser and manager for many years. He is the author of “Behavioural Tech-nical Analysis” and other books. The views expressed here are entirely his own and not necessari-ly those of companies he is associated with.

email@paulvazzopardi.com