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On the Edge of Bitcoin

The price of a bitcoin broke $1,000 a token on January 1, 2017, edging towards its former summit of $1,216.70 set back in 2013. Fast forward to the beginning of December 2017: bitcoin has ascended from a cult following to become a mainstream star as the token passed $19,000 on December 16th. The result is a year-to-date return of approximately 1,700%, with the coin having a market capitalization greater than that of Nike, McDonalds, and other global companies ubiquitous within their respective industries. To put its rocket-like ascent in perspective, the return of the broader U.S. stock market, as measured by the S&P 500, yielded a relatively modest return of roughly 20% over the same period.

As the price and mainstream attention of bitcoin continue to increase, so does the base of investors that are willing to sign up and stake their claim in the future. While it is easy to get caught up in the excitement, the first step, like for all investments, is to understand what you’re investing in.

Starting with the basics, bitcoin is credited as the first cryptocurrency ever created. To the un-indoctrinated, the common assumption is the “crypto” in cryptocurrency stands for cryptic, adding to the shroud of mystery surrounding the technology. However, it stands for cryptography, “the practice and study of techniques for secure communication.” While this may seem like a trivial point, it is an important distinction tied to the original thesis of the purpose of bitcoin. You may be surprised to hear, but one of the most hotly contested issues of bitcoin and cryptocurrencies is agreeing on what they are exactly.

Bitcoin was first introduced to the world in November 2008 by a creator, or possibly creators, using the pen name Satoshi Nakamoto. Nakamoto released the paper “Bitcoin: A Peer-to-Peer Electronic Cash System.” Or simply put, it’s a digital payment system that doesn’t rely on banks or financial intermediaries and is largely outside of regulatory and fiscal oversight. This humble role quickly dovetails into grander concepts of a currency of the people (not tied to a government or external entity), escaping the fiddling power of central banks, and the future of what money will look like, however it is unclear the level of disruptive impact it will ultimately achieve.

At the heart of cryptocurrencies exchange is a technology called “blockchain”, which is essentially a decentralized ledger. For example, when you use an electronic cash transfer to pay your credit card with a linked bank account, the bank will reflect the debit and credit to the respective accounts in their internal ledger. The purpose of the bank is to serve as a trusted third party that both sides believe will complete the transaction as it was entered. Blockchain removes the need for a third party (the bank) to create an orderly transaction by outsourcing the ledger to a series of nodes, or “miners,” that all maintain a copy. When a transaction occurs, the miners are all given the same information, “x pays y” and the amount exchanged. Once verified, all miners add the transaction to the current “block” of the blockchain where it is permanently recorded. The miners are rewarded for their work by receiving a payment in bitcoin. As the value of bitcoin continues to rise it has created the cottage industry of bitcoin mining, also commonly referred to as “bitcoin farming.” Anecdotally, as of December, bitcoin mining has an estimated annual power consumption of 30.1 terrawatt hours, approximately the same energy usage as the country of Morocco.

It is easy to see the potential of the technology. With mass adoption it could pull market share from the incumbent online money transfer systems like Paypal and possibly extend to tackle the banking industry. However, it would nearly be impossible to predict or justify the value based on the original concept alone. Which may have led to the historic proclamation by the CEO of JP Morgan, Jamie Dimon, that he called bitcoin both a “fraud” and “stupid” and that he would fire any trader caught trading it. In that context, I think Mr. Dimon is correct, as the market capitalization of bitcoin now exceeds that of Visa. Yet it is questionable if JP Morgan shares his views as they have recently announced their intent to trade bitcoin futures.

To further complicate matters, bitcoin by no means is the only player in the cryptocurrency space. The same beautiful concept and blockchain technology pioneered by bitcoin is also found in hundreds of other coins. Yes, there are hundreds of coins currently available for purchase. Some have also experienced rocket-trajectory price appreciation, while others have been neglected by the marketplace. The advantage bitcoin possesses to this extent is that it is the largest and most known of all cryptocurrencies.

However, it seems the purpose of bitcoin itself has evolved as the price continues to go up. Ironically, it is harder to justify bitcoin as a method of payment now that the price has become so volatile. The best way to describe this effect is by looking at the first purchase ever made by bitcoin, two pizzas for 10,000 bitcoins back in 2010. At today’s prices that is roughly a cost of $185,000,000. In hindsight, it would have been cheaper to put that purchase on a credit card. Yet, as its effectiveness as a method of exchange decreases, the use as a store of value, or commodity value, continues to increase. Could this be a new gold for the digital age?

Bitcoin’s use as a commodity is elegant and terrifying. The value (beyond that of a digital payment system) is based solely on what the market places on it without any underlying financial fundamentals to justify the price tag. It could be argued that this concept is already broadly accepted with other commodities like diamonds. They are less scarce than we would like to believe and can be manmade to a level that is acceptable for industrial use. Perhaps this is a continuation on a concept that started when De Beers told us that “Diamonds are forever.” To this extent bitcoin does offers an improvement to physical commodities as the total amount of bitcoins is known and finite. By design there will never be more than 21 million coins. As of today, only approximately 12 million of those coins have been mined.

The surge into bitcoin through the first half of 2017 fits into the thesis in our last investment newsletter that public financial markets are reaching full valuations. Cryptocurrencies present an opportunity to pull out of those markets and invest in new technology. Additionally, for wealthy investors residing in emerging market countries, it provides an opportunity to invest in an asset untied to their country and respective currency. Those flows led to price appreciation and increased headline attention. The question now is, are the rapid increase and flows over the last several months a reflection of investors adopting this new technology or grounded in the fear of missing out of the potential fortune to be made?

With this backdrop, the wild ride of bitcoin starts to make more sense. What is more difficult to understand is the future of bitcoin. Will the start of 2018 find bitcoin at $30,000? Will it be at $10,000? It is difficult to tell, yet both are possible. For any investor serious about investing in cryptocurrencies it is important to consider the extreme volatility seen in the cryptocurrency space and equally important to understand why you are investing in it. If the answer to the latter is because of the returns seen over the past year, I would like to remind you of the disclaimer you will find on any investment offering: “past performance is no guarantee of future results.”

We hope you find this helpful in understanding bitcoin and the unchartered waters of cryptocurrency and value your feedback. Please feel free to contact us if you have any questions, would like to discuss further, or better understand how this relates to investing in traditional asset classes.

All the best,

Ryan De Silva, CFA, CFP ®

President, CIO

Arrowroot Family Office