Bitcoin is a phenomena. It tends to raise strong emotions, but it actually raises more interest and questions than any trading asset at the moment so finally I’m plucking up the courage to put down in words my thoughts around it.

A brief caveat before I start.

This is not financial advice. Like most regulators, the FCA is very sceptical of bitcoin and all crypto because it doesn’t really understand it and it is also very hard to regulate.

Their view is:

“Cryptoassets are considered very high risk, speculative purchases. If you buy cryptoassets, you should be prepared to lose all your money.”

So from an official, regulated stance, that is their view. And as a regulated financial adviser that is my starting point.

But…

I think there is a lot more there that we can try to understand. I’m not a crypto expert at all, but I tend to view this with my trader/ markets hat on. Bitcoin and other crypto assets are tradeable entities and markets tend to have similar attributes over time so I will use this as my lens to explore further.

Let’s dive in.

There is a lot here so I’m going to split this over two posts. In this post, I will cover the basics of crypto and Bitcoin, whilst in Part 2 I will cover more around my views and historical analogies we can use.

Bitcoin and crypto 101

I’ll keep this brief. As I said, I’m not an expert and there are plenty of books/ articles you can read if you want to understand at a greater level.

I’ll leave it up to Investopedia to define a cryptocurrency:

“A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology — a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.”

The word ‘cryptocurrency’ is a little out-dated these days as it has moved more to cryptoasset or cryptocommodity (which I prefer – more on that later).

A currency implies using it to pay for things, which perhaps was what it was designed to do, but a feature that all currencies need is stability – so you can be sure what you buy is worth similar the next day. Bitcoin and other cryptoassets don’t have that (yet) but do tend to be viewed more by professional investors and regulators as commodities.

The commodity comparison I think is better because that implies that the asset has a defined value specified only by what people are willing to pay for it – just like oil or gold – which may move around depending on supply and demand characteristics and tend to be valued and traded in US$.

There is no true value of one ounce of gold, apart from the market price and the same can be said for Bitcoin. Even though the general term that tends to be used more often these days is cryptoasset.

For the rest of this discussion I am going to concentrate just on Bitcoin which is the biggest and most well-known of all the cryptoassets. There are many others, but I don’t have the space and you probably don’t have the patience!

So why is Bitcoin popular?

Bitcoin was launched in 2009 by an anonymous person (or persons) who goes by the name Satoshi Nakamoto. The real Satoshi has never come forward and the original account of Bitcoin he used remains completely untouched – with a current market value of $54 billion! We know this because transparency is a key feature of Bitcoin which I describe more below.

Another fascinating key feature is the way Bitcoin is designed – there can only ever be 21 million ever produced. The reason behind this is very technical and has to do with how Bitcoins are “mined” – where computers using vast amounts of electricity compete to solve puzzles to unlock a Bitcoin – and I won’t go any further than to say the mathematics has been proven and is clear.

So far there have been around 18.5 million Bitcoins mined already, so there are less than 3 million new Bitcoins left, and currently a new Bitcoin is mined about every 10 minutes.

The limited supply feature of Bitcoin makes it different from a normal commodity. If the price of oil or gold or diamonds rises sharply because of demand, that gives producers and miners extra incentive (and profit) to increase their production and/ or supply. In Bitcoin that simply isn’t possible.

So as a commodity, it has limited supply which is highly unusual and potentially very valuable.

Another feature as to why it’s popular is the final sentence of the Investopedia definition.

“A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.”

Crypto and Bitcoins are on what is called a decentralised network (like the internet), so there is no one controlling authority like central banks or governments which makes it very different from fiat (normal) money. Investors like this because it means nobody can supposedly meddle with it.

The other feature that reinforces that concept is the blockchain technology backing it, which basically lists every single transaction a particular Bitcoin has ever made, thereby giving you proof of its authenticity. Blockchain itself is a fascinating technology which potentially has many uses outside of cryptoasset space – for legal contracts and other areas where verification and transparency are important. Put both features together and you have a powerful argument for people who don’t trust authorities or governments – especially in times of huge debts and money printing potentially devaluing the value of fiat (normal) money.

An aside

The fear around government manipulation of money is not so silly. Currency debasement has been happening forever – from Roman emperors shaving the sides off their silver coins to Henry VIII debasing the amount of gold and silver for cheaper metals to the German government of the Weimer Republic printing almost unlimited bank notes.

Modern day comparisons are Modern Monetary Theory (where the government issues debt to the central bank which buys it and then immediately cancels it) and even Jeremy Corbyn’s planned magic money tree. Historically, if you rapidly increased the supply of money the end result is always the same: inflation. Prices go up to compensate this lower value of money.

So this brings me to the end of Part 1. I’ve described some of the features that can explain the popularity – limited supply, supposed protection against government interference and inflation. In Part 2, I will look at Bitcoin through a trading lens and see how it follows investment theory and compares to some other bubbles.

Adam Walkom