By Gary Brooks, CFP®
Over three days during the week of Thanksgiving, Coinbase, a digital currency exchange opened 300,000 new accounts. Chasing the eye-bulging rise in the price of bitcoin, Coinbase accounts now outnumber Charles Schwab brokerage accounts according to Bespoke Investment Group.
Even more than strong global stock markets, bitcoin has turned into the story of 2017 as its price has broken through several milestones with a gain of more than 1000 percent this year.
While bitcoin has been around since 2009 – and is just one of over 1000 forms of digital currency or “cryptocurrency” – this marketplace is still in its infancy, and it has some lawless characteristics. Bitcoin is not regulated by government agencies. It is a decentralized currency not under the control of any central agency or bank. Even calling it a currency is questionable. It can be used as a form of payment. Microsoft, Dell, Expedia and others accept payment in bitcoin just the same as cash and credit. But, the U.S. IRS does not consider it a currency, partly because few people are using it that way. The IRS treats bitcoin as property subject to capital gains taxes on the growth in price over purchase cost.
Creating bitcoin is difficult. It requires specialized computers, skilled programmers, exceptional math and advanced encryption techniques. Bitcoin “miners” use software to solve sophisticated math puzzles, adding blocks to an existing blockchain which is the public ledger of bitcoin creation and transactions. Based on rules of how blockchains are created and managed, there is limited supply of bitcoin that can be added to the blockchain.
I’ve spent several hours learning about bitcoin, and I’m still not certain I understand the technical complexities. At this point, I don’t consider it a necessary addition to a diversified investment portfolio. That may come with time – and perhaps with a lot of opportunity cost for not having been in earlier – but at this point this marketplace is still too small and speculative for serious money needed to fund major life goals. As a play account on the side, go for it.
Later this month, futures contracts based on bitcoin prices are expected to be available to trade on U.S. exchanges. This way, investors (traders really) can participate in the bitcoin market without owning the underlying currency/investment.
Investors have made tremendous gains just in the past few months. The price per bitcoin took three and a half years to go from $1,000 to $2,000. It took seven weeks to go from $6,000 to $11,000 on November 29. This is a remarkable trajectory for an investment that doesn’t have any earnings, or pay any dividends or interest. It’s like gold in that the price is simply whatever the next person is willing to pay and has no relationship to company profits, interest rates or other measures of value. Assets like this are also prone to spectacular collapse.
The extraordinary liftoff of bitcoin prices year-to-date has not been without momentary declines, but you have to step back deeper into bitcoin’s short history to see how extremely fragile it can be. In June 2011, the bitcoin price declined 50 percent in just three days then had a 90 percent bottoming in November 2011. In April 2013, it dropped 70 percent in a week. When investment bubbles expand and collapse, they often go farther in both directions than seems possible as investor psychology drives extremes.
As user-base grows more diverse and price history builds, bitcoin’s pricing should become more stable, but there is no certainty in that.
Many very bright people are now working exclusively in this marketplace to not only capture investment potential but to expand use and functionality of the underlying platform that digital currencies are built on – the blockchain.
Blockchain acts as a sort of DNA marker for every creation and transaction of cryptocurrencies. While the future has a wide range of potential outcomes for currency management, blockchain could become valuable to other industries as well. Fields such as medical records, identity management and other industries that require precise, secure communications and records retention could utilize blockchain.
It is a rapidly-advancing innovation that could change the way we transact and share information on a much broader scale than today.
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