What is Bitcoin and How does it Work?

This is one of the most common questions faced by financial intermediaries these days – be it mutual fund distributors, investment advisors, stock brokers, research analysts, trainers or educators. The question comes in different variations:

• Should I invest in Bitcoins?
• What is your view on …
• What do you think of …
• Can you tell me something about …
• Is it a good investment?
• What is the future …

Whatever may be the way of asking, the underlying question remains the same: Is Bitcoin a good investment?

In order to answer this question, we thought of digging a bit deeper to understand two related questions:

• What is Bitcoin? And
• What would qualify as an investment?

What is Bitcoin?

It is the most popular among all the cryptocurrencies. A cryptocurrency is a digital currency, available only in digital form, outside the control of any government or regulators, where additional coins can be mined only against “proof-of-work”. The biggest contributor to the “proof-of-work” is solving a cryptic puzzle. The word cryptocurrency is derived by combining “cryptic” from “cryptic puzzle” and “currency” from “digital currency”.

So, essentially Bitcoin is supposed to be a currency.

Hang on – is it an investment or a currency? People are going crazy over investing in Bitcoins and you are saying it is a currency. Is it a good idea to invest in a currency?

Let us start by understanding what makes a good currency.

What are the functions and characteristics of currency?

On a lighter note, in India, we have also seen the usage of Chlormint and Chocolate Eclairs as currency by certain provision stores in small towns.

The three functions of money are:

1. Medium of exchange
2. Store of value, and
3. A unit of account

Out of the above three, the most important is the first one – a medium of exchange.

In order to be able to perform these functions, the currency should possess at least the following characteristics:

• It should be generally acceptable,
• It should be portable,
• It should be durable,
• It should be divisible, and
• It should exhibit stability of value

The last characteristic especially ties in with the third function of currency – a unit of account.

Now, look at what has happened to Bitcoin prices in the last few years, including the recent few months. The price has exhibited extreme appreciation as well as a steep fall. How does one use a currency to keep track of the value of one’s possessions, if its own value is not stable?

Secondly, when the value of the currency zooms so fast, people start hoarding it and that reduces its circulation. Reduction in circulation goes against the very purpose of a currency.

In other words, the cryptocurrencies in general, and Bitcoins, in particular, fail to qualify as a good currency.

Someone may feel that the above argument is based only on the price movement. What if the price stabilizes? Will the Bitcoin be a good currency then? The answer to that is not simple: it depends on many other things that can move the price of Bitcoins as well as its general acceptance as a currency. The value may become stable if the governments of countries do not put restrictions, and people at large develop confidence in this. Some questions remain unanswered as of now.

On the other hand, if the price were to remain stable, buying and keeping currency serves the only purpose – store of value. In that case, it is not an investment, it is just storing the value.

Let us now focus on the second question:

If it is not a currency, can it be a good investment?

First of all, it has to be widely accepted that cryptocurrencies are not currencies and only then one can start the discussion on the above question.

As we have already mentioned earlier, a currency should have a stable value and hence there is no question of appreciation. While fixed deposits and bonds may have stable values there is a stream of income in form of interest from these avenues. Currencies do not pay interest or any other form of cash flow.

In the absence of a cash flow, one is expecting a price appreciation. There should be a logical reason behind such appreciation. While vacant land may not yield any current income, the same can be utilized for either agriculture, residential or commercial purposes. It is such a potential that can lead to an increase in market price in future. Gold and other metals also do not yield any current income, but the usage of these for various reasons may lead to price fluctuations – in both directions.

All the other investments, especially the financial ones, would offer some current income. Discounting such future income to a present value helps one arrive a fair price for the asset. This is how the world of investing works.

Cryptocurrencies do not offer any cash flow and there is no potential usage like in case of land or metals, except as a medium of exchange.

This means, cryptocurrencies do not qualify as an investment, too.

So why are so many people invest in Bitcoins and other such currencies? They do so only in anticipation that someone else may be willing to buy from them at a higher price later on. In financial markets, there is a theory that defines such a belief. It is called “greater fool theory” – need I say more?

The current rush for Bitcoins reminds one of the certain episodes in the history of financial markets, e.g. Tulipomania, Dot Com boom, etc. You may want to check up on these in my book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”.

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