Q. Can you please explain what Bitcoin is and how it works? What are the risks of investing?

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Q. Can you please explain what Bitcoin is and how it works? What are the risks of investing?

A. Bitcoin is a form of digital currency. Created in 2009, it is the first example of a category of money or store of value referred to as Cryptocurrency.

Software developer Satoshi Nakamoto devised Bitcoin as an electronic payment system. The idea was to create a currency independent of any central authority. Unlike conventional currencies, Bitcoin is unique in that it is decentralised. No Government or Central Banks controls the Bitcoin network.

There are only 21 million Bitcoins in existence. However, these coins can be divided into smaller units. The smallest unit is one hundred millionth of a Bitcoin and this is referred to as a “Satoshi”.

You buy Bitcoins either through Cryptocurrency exchanges or directly from others via Bitcoin marketplaces. Bitcoins can be traded by exchanging cash or other currencies, services or goods.

The Bitcoin system is peer-to-peer. Transactions can take place between users directly, without an intermediary. These transactions are verified by computer network nodes and recorded in a public distributed ledger called a ‘Blockchain’. The Blockchain transactions are verified and recorded by a network of nodes (or databases) on the internet. Because each node stores its own copy, there is no need for a trusted central authority (bank). Designed to work as a currency, bitcoin is touted as a low-cost medium of exchange with international currency transfers costing a fraction of what, say, a bank may charge.

To buy Bitcoins, you must first establish a Bitcoin “wallet”. As there is no physical currency, the value is stored electronically. The process of establishing a wallet in Australia is akin to opening a bank account and subject to conventional banking requirements verifying identity and the source of funds.

There is a range of exchanges that you can trade Bitcoins through but be aware they do not offer the same capital protection as banks.

The ATO has stated that profits derived from Bitcoin transactions are taxable.

Whilst a large market, it is still early days and the market has been volatile and subject to intense speculation. “Cryptomania” has seen investors pile in with rapid price gains and increasing media attention reinforcing perceptions that it’s a way to instant riches and those who don’t “believe” just “don’t get it”. Over the last five years, the price of Bitcoin has soared from $US12 to over $US14000. Since I last wrote on this subject in July 2017, valuations have surged six times. Bitcoin enthusiasts see it as the currency of the future. An alternative view is that it is just another example of a bubble in an investment market.

The recent volatility in the value of cryptocurrencies is a warning. Here are a few reasons you should be very wary of Bitcoin and Cryptocurrencies.

The primary function of any currency, crypto or otherwise, is to be a reliable store of value to execute trade. ‘Cryptocurrencies’ are far from being a reliable store of value. The market has had numerous large 20% plus setbacks in value (five this year alone) meaning huge losses if someone transfers funds into Bitcoin for a transaction – say to trade an asset but it collapses in value before the transaction completes.

Bitcoin produces no income or yield, it’s impossible to value and unlike gold it’s intangible. The price could go to $100,000 but could fall to $10.

While the supply of bitcoins is limited there is competition in the form of other crypto currencies that provide a similar currency transaction function. In fact, there is now more than 1000 of them. A rising supply of such currencies create competition and could push the Bitcoin price down.

Given the increasing acceptance and popularity of Crypto currencies, I would imagine it is only a matter of time until Governments or Central Banks establish their own Crypto currencies to avert the risk of monetary and financial instability that alternative currencies pose. This may legitimize Crypto currencies for the broader public who may not embrace crypto currencies unless they have government backing.

Bitcoin is anonymous with funds only tied to bitcoin addresses. Regulators are likely to crack down on Crypto currencies over time given its use for money laundering and unregulated money raising. China has already moved quickly on this front.

I admit I personally struggle to fully understand how it works and one important lesson from the “dot com” era and the Global Financial Crisis was if you don’t understand what you are investing in, you shouldn’t invest.

Even if you do understand how Bitcoin works, the Crypto-currency market exhibits all the hallmarks of a classic speculative bubble. I seriously doubt most investors are buying Bitcoin for it’s primary function being currency exchange, but rather to speculate. “Cryptomania” looks eerily similar to the Tulip Crisis of 1630’s or the South Sea bubble of 1720’s. “Those Who Cannot Learn From History Are Doomed to Repeat it”-George Santayana.

Click here to see Bitcoin Price trend over the years 

By | 2017-12-15T18:07:30+00:00 December 15th, 2017|Blog, Media Articles, Q&A Andrew Heaven|Comments Off on Q. Can you please explain what Bitcoin is and how it works? What are the risks of investing?

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