Your guide to Bitcoin basics

David Joy, Chief Market Strategist, Ameriprise Financial

March 2018

Key Points

  • Bitcoin and other cryptocurrencies are generating buzz in the investment world
  • The value of cryptocurrencies has fluctuated wildly in the past year
  • Investors should understand the background and risks of cryptocurrencies before exploring financial opportunities

Over the past six months, digital money – commonly known as cryptocurrencies – has gained increasing media coverage. Bitcoin, in particular, has been the focus of much of this buzz due to its price surge and subsequent drop. Speculation on the future of this digital currency has piqued investor interest, causing many to wonder about its potential.

While Bitcoin is the most popular form of cryptocurrency, there are a number of other types of digital money, including Ethereum, Litecoin and Ripple. They exist only in digital form, unlike government-issued currencies (i.e., dollars and coins) we use more regularly. These virtual currencies facilitate electronic payments directly between parties without the intermediary of a banking institution and are designed to be secure and untraceable.

A bit of “crypto” history

While cryptocurrencies have attracted significant media attention in recent months, they first emerged in 2009 when Bitcoin was introduced. Its initial value was just $0.008.

Since then, the increase in value has been remarkable. Investors became particularly intrigued as Bitcoin skyrocketed in value last year. At the end of 2016, one Bitcoin was valued at $952. By December 2017, its value soared above $19,000, creating fears that it had reached bubble proportions.

How do cryptocurrencies work?

The growing popularity of Bitcoin has raised many questions among investors:

  • How do cryptocurrencies come into existence?
  • You can’t just decide one day to create your own money or else everyone would do it. Or can you?
  • How can it be trusted unless it’s guaranteed by a central bank with a controlled supply?

To help answer some of these questions, here’s more background on the topic.

Cryptocurrencies are created by private entities. They exist as encrypted mathematical formulas, or algorithms, with a pre-determined, limited supply. In the case of Bitcoin, that limit is approximately 21 million coins, of which an estimated 80% have already been put into use.

Speculation on the future of Bitcoin has piqued investor interest, causing many to wonder about its potential.

Bitcoin’s value is derived from the willingness of participants to accept them for payment. While the number of people or entities willing to accept payment in Bitcoins is limited, it is increasing. Their supply grows over time, up to that pre-determined limit, as a community of users “mine” Bitcoins by using powerful computers to confirm transaction payments. These “miners” are rewarded for their transaction work by receiving new Bitcoins. Transactions are processed on a public electronic ledger called the blockchain, a technology that maintains records of digital transactions in a verifiable and permanent way.

It is important to note that cryptocurrencies and the blockchain technology, although they work in unison, are separate and distinct. Cryptocurrencies certainly have their passionate supporters, but even those who are skeptical of the digital currencies’ long-term viability are far more positive on the future of blockchain and its potential, far-ranging business applications.

Marketplace uncertainty for investors

What makes the concept of cryptocurrencies more complex is determining the basis for their valuation. Why is one Bitcoin worth $19,000 and not $19 or zero? In essence, Bitcoin is worth whatever the marketplace says it is worth. In that respect, cryptocurrencies are similar to gold. Gold doesn’t have many practical uses, but it is limited in supply and has been accepted as a form of payment for millennia.

In December, both the Chicago Board Options Exchange and Chicago Mercantile Exchange initiated trading in Bitcoin futures, giving investors and speculators alike a vehicle for expressing their view on its value.

Regarding the investment merits, we consider cryptocurrencies to be highly speculative for a number of reasons.

  1. Cryptocurrency prices are extremely volatile. In 2017, the price of Bitcoin rose 1,400%, ending the year at $14,310. However, by the end of January, its price fell to $9,962, a drop of 30% in about 30 days.
  2. Security breaches have raised serious questions about the viability of cryptocurrencies. Toward the end of January, a hack of a cryptocurrency exchange in Japan resulted in the theft of $530 million.
  3. Cryptocurrencies are not regulated. However, that is changing as governments, including the U.S., are beginning to take a closer look amid concerns over money laundering and fraud.
Investors who consider adding exposure to cryptocurrencies to their portfolios should proceed with extreme caution.

The impact of growing government intervention

The specter of government regulation represents an existential threat to cryptocurrencies, with the ultimate concern being that they are regulated out of existence.

In January, the Chinese government shut down all Bitcoin mining operations in that country, which accounted for a large percentage of the cryptocurrency’s activity globally. South Korea is moving in a similar direction, and India has recently expressed its own reservations. In the U.S., the SEC has yet to approve any of the applications for Bitcoin exchange traded funds (ETFs), voicing concerns over transparency and market efficiency.

Other portfolio considerations

Nevertheless, in addition to futures markets, there are other investment vehicles that offer varying degrees of exposure to Bitcoin, including hedge funds.

Investors who consider adding portfolio exposure to cryptocurrencies should proceed with extreme caution. This is an investment that has a limited track record, is at risk of being exposed to price bubbles, and is susceptible to obstacles (such as increased regulation) that could have a negative impact on future valuations. You may want to talk to your financial advisor about the pros and cons of cryptocurrency investing.

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