Bitcoin: The Original Cryptocurrency
August 29, 2022
If someone told you about an investment that has made some people millionaires overnight and has both a number of high-profile supporters and a global reach, would you be tempted to invest? If you were then told that the same investment also could lose most or all of its value almost overnight, and you might not have access to your money when you need it, how would it sound now?
You’ve just confronted the debate surrounding the digital phenomenon known as Bitcoin — an alternative currency that exists strictly as digital code. If you’re wondering what all the fuss is about, here’s a brief introduction to Bitcoin, how it works, and some of the potential pitfalls it presents.
Bitcoin as currency
Bitcoin is a digital currency supported by a peer-to-peer, computer-based electronic cash system first outlined in 2009 by an anonymous person or group using the name Satoshi Nakamoto. Bitcoin is created by “mining” — using complex software to solve complicated mathematical computations (or contracting with a mining company to do it for you). Solving a problem creates a so-called “block,” and the computer that solved it is rewarded with a set number of digital bitcoins, each of which is simply a set of one public and one private cryptographic key. (The units are generally “bitcoins,” while the general system is “Bitcoin.”) The number of solutions that can be discovered globally per hour (and thus the number of “blocks” created and bitcoins mined) is limited by the system’s software code. The total number of bitcoins available to be mined eventually is said to be limited to 21 million. However, most users acquire bitcoins either by buying them with physical currencies such as dollars or accepting them as payment for goods and services.
Advocates argue that the advantages of the system are: (1) it’s not controlled by any government’s central bank, (2) a global digital currency facilitates global commercial transactions, (3) every block and Bitcoin transaction is recorded in a public ledger known as “the blockchain,” and (4) the payer and payee are anonymous, much like a cash transaction, though recorded transactions are visible to anyone.
There are still plenty of Bitcoin skeptics, some of whom are concerned about the environmental impact. (Mining enough Bitcoin to maintain the blockchain consumes massive amounts of electricity.) And anonymity is the reason that Bitcoin has often been used for illegal activities such as money laundering and cyber scams.
How does a Bitcoin payment work?
Just as a physical wallet holds paper money and change, a digital wallet stores the private software keys that are bitcoins. It makes or receives payments by communicating with the network of other Bitcoin wallets. A growing number of well-known merchants and services now accept Bitcoin as payment.
Physical bitcoins, with embedded software keys, are also being minted. However, acceptance of bitcoins as payment is entirely at a seller’s discretion; there is no guarantee you’ll be able to spend them where you want to or get the value you expect.
Note: Bitcoin payments are irreversible. Once you complete a transaction, it cannot be reversed. Purchases can be refunded, but that depends solely on the willingness of the establishment to do so.
Speculating in Bitcoin
Bitcoin’s usage as a currency is a ripple compared to the tidal waves of investment speculation it has fueled. However, to say that Bitcoin as an investment is volatile is an understatement. Its value has fluctuated wildly as speculation and confidence in it have ebbed and surged. As recently as 2017, one bitcoin was worth about $1,000. Between March 2020 and November 2021, the price shot up more than 1,000% to a record high of $68,000 — driven, in part, by a stimulus-fueled surge of trading through brokerage accounts and investing apps. But by January 21, 2022, the price had dropped almost in half to about $35,000. (1)
Despite gut-wrenching volatility, there has been a noteworthy increase in interest and demand from mainstream U.S. corporations and financial institutions as they continue to incorporate cryptocurrencies or related crypto services into their business strategies. (2) And in 2021, the first U.S. exchange-traded funds (ETFs) tied to Bitcoin were launched. This was considered a significant milestone because ETFs provide a simpler way for retail and institutional investors to gain exposure to Bitcoin without holding it directly. (3)
The price of Bitcoin has been especially vulnerable to actions by individual governments, such as in 2013 and 2017, when Chinese regulatory crackdowns triggered drastic declines that cut Bitcoin’s value in dollars by more than half. (4)
Extreme volatility has led to problems for people trying to make payments in bitcoins. It’s hard to use a currency when you’re not sure from day to day whether the amount in your digital wallet is worth enough to buy a Tesla or a tank of gas. Complicating the issue is the fact that the value can vary on different Bitcoin exchanges.
Worse than not knowing how much your bitcoins will buy is not knowing whether they’re available to buy anything at all. Cryptocurrency has been subject to cyberattacks that have halted trading briefly on several exchanges. And at one point, one of the largest exchanges abruptly declared bankruptcy and announced that nearly half a billion dollars’ worth of bitcoins held there had vanished (though a portion of that amount was subsequently said to have been located). (5) In addition to problems at exchanges, law-enforcement scrutiny of digital transactions to combat money laundering could interfere with the ability of Bitcoin holders to access their funds.
The Wild West rides again
Bitcoin is not backed by either a government or any physical asset such as gold. Major exchanges are located around the world, and the decentralized nature of the system makes it more challenging for government regulators to get a handle on it. Unlike accounts at FDIC-insured banks, there is no protection for possible loss from a digital wallet. Moreover, a fraudster could pose as a crypto exchange, intermediary, or trader in an effort to lure victims to send money, which is then stolen.
In September 2021, China’s regulators issued a total ban of all crypto transactions and mining, citing systemic risks. (6) So far, regulatory oversight of Bitcoin by the U.S. government has been spotty, but change may be afoot. On March 9, 2022, President Biden signed an executive order directing financial regulators to study the risks and the potential benefits of digital assets and their underlying technologies, including the possible creation of a digital dollar by the Federal Reserve. Several different federal agencies will evaluate the potential impact of cryptocurrencies on consumers, investors, the stability of the financial system, and national security. (7) Regulators were given about six months to report their findings, which are expected to form the basis of a coordinated approach to regulating a rapidly growing cryptocurrency market worth about $1.75 trillion at the time the order was signed. (8)
The Internal Revenue Service has already said it will treat Bitcoin holdings as property rather than as a currency for tax purposes. This means the sale or exchange of bitcoins that have gained in value since they were acquired could potentially trigger a tax liability. Also, payments made in bitcoins are subject to the same information reporting requirements as any other payments made in property. And wages paid in bitcoins must be reported on a W-2 form and are taxable as income, like any other wages.
Speculation hasn’t been limited to the currency itself. Much as the Internet did in its early days, Bitcoin has spawned an entire ecosystem of startup companies and venture capitalists that are building out cryptocurrency technologies and products. As with early Internet companies, such ventures are likely to involve a high degree of uncertainty and risk.
Obviously, cryptocurrency still faces a lot of challenges. If you’re considering exploring Bitcoin, either for transactions or as a speculative investment, do plenty of research before you jump in. You should also be prepared for dramatic price swings and only use money that you aren’t relying on for something else.
Notes:
- Unanswered questions
- How will law enforcement and the IRS cope with the anonymity of Bitcoin transactions?
- How might regulatory changes such as the IRS tax decision affect Bitcoin values, both short term and long term?
- Will security and stability issues continue, and will they compromise confidence in the system?
- Will Bitcoin have to compete with other emerging digital currencies for dominance?
The return and principal value of ETFs fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. You may pay a brokerage commission whenever you buy or sell ETFs. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares. Investing in a fund is not investing in the price of a cryptocurrency. It is investing in what people think the price of cryptocurrency will be, and it can vary to a significant degree and could be more volatile than the cryptocurrency itself.
ETFs are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1) Yahoo! Finance, March 17, 2022
2) The Wall Street Journal, February 19, 2021
3) The Wall Street Journal, October 19, 2021
4) The Wall Street Journal, February 2, 2018
5) Yahoo! Finance, September 30, 2021
6) Reuters, September 24, 2021
7) White House Fact Sheet, March 9, 2022
8) The Wall Street Journal, March 9, 2022
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