Have you had a chance to fully investigate what, exactly, Bitcoin is? No doubt you've seen it splashed across CNBC's front page at some point over the past year and if you haven't familiarized yourself with it, allow me to help: Bitcoin is insanity.
Well, actually, Bitcoin is a type of online digital currency (or cryptocurrency) based on the creation and transfer of an open source protocol that is independent of central banks or any other type of governance. Bitcoin's website describes it as "open source P2P digital currency." Put simply, it's an independent digital currency, catching popularity because it's the first of its kind; and conversely carrying what this author believes to be insane risk for the very same reasons.
Seeking Alpha contributor "Squeeky Wheel" does a superlative job of laying out the technical landscape behind exactly how Bitcoin works from the encryption and transfer. I strongly suggest that everyone looking for an extremely in depth explanation of how Bitcoin transfers take place read this article; it's one of the most thorough and easiest articles on Bitcoin I've had the pleasure of reading.
Put concisely, Squeeky explains the basics of how transactions work:
Bitcoin spenders announce all their transactions to the Bitcoin network. These are picked up by anyone which wishes to participate in verifying Bitcoin transactions - these are called 'miners'. Each miner takes each announced transaction and checks that it both, has right signature and data entries, and has not been seen before (ensuring this is a first-spend); if both pass the transaction is added into the newest 'block' of data. The miner then hashes the block. The one-way hash function is a mathematic function [y = hash(x)], with the special properties that 1) it is easy to compute y given x, but impossible to compute x from y and 2) small changes in x create big and random changes in y. So it is very easy to check that we agree on the outcome of the hash of a particular bloc! k, but it is very hard to get a particular hash value. In the Bitcoin protocol, the miners must get a hash for the block below a specified target value; if they don't, they add a random number - called a nonce - to the end of the block and try again. The miners will try billions of possible nonces before they successfully 'mine' the block. As a reward for the verification work, the winning miner gets to include a small transaction to himself - this is the source of the money supply. The new block is announced to all the other miners, who then verify the block and if it follows the rules, the miners all start on the next block. If the other miners think something is wrong, if they think someone is trying to cheat, they will reject the proposed block and continue to mine it for themselves.
There's a couple of major arguments that bulls are using to support Bitcoin that, in theory - not practice - make sense.
1. The Ideal of an Independent Currency
The first is that since Bitcoin is a community governed currency, nothing can be done in terms of hoarding it, issuing more, or manipulating it without the entire consensus of the group.
In other words, it takes advantage of some of the principles that make other open source items (like Linux and Wikipedia) awesome. There is a serious argument for doing anything open source - I'm still waiting on the day that we have open source style companies, run not just by shareholders - but by equals that do not carry position or governance. Bitcoin is on the right track here with the way that they've come up with a communal system for mutual accountability.
Furthermore, with the recent developments in Cyprus and other places economically, Bitcoin aficionados seem to ignore the fact that we already have two non-renewable gauges used to protect yourselves against disaster, gold (GLD, IAU) and silver (SLV). These two precious metals are still not getting the action they deserve as currency hedges, so what makes bulls think that Bitcoins are goin! g to?
!Not only that, but the major point that makes the precious metals much more of a better hedge and/or commodity is the fact that they are held in reserves by the major banks. Banks like Bank of America (BAC) and the Federal reserve hold gold in reserve. In other words, they are recognized globally as fall-backs to currency inflation.
2. Potential to Explode in Value Despite Deflation
Like with any other commodity that one would invest in, Bitcoin is getting a significant amount of play from investors due to the fact that the value could rise significantly in the future. It's an extremely speculative set of circumstances, but the fact that the Bitcoin is going to capped at 21mm units means that unlike currency, we cannot print or make more. Giving it a non-renewable feel (at least until some point when a government takes it over and figures out a way to make more) gives Bitcoin a lot of "buy and hold" appeal.
(click to enlarge)
As you can see from the chart above, the price of a Bitcoin has risen to well over $100 on buyers' panic that someday - although again beyond extremely speculative - if Bitcoin becomes the currency 2.0 on the world scale, it has the potential to be exponentially more valuable than it is now in 2013.
Bitcoin bears have tons of arguments against the currency:
1. Security
Yes, so far Bitcoin has been extremely secure, with the exception of one security incident in 2010 - when the currency was at its extreme nascent stages.
Monaterism reports on the August 2010 bug:
The August 2010 issue was caused by a vulnerability in Bitcoin's verification process, which did not account for transactions so large that they overflowed the permitted size.
On August 15th 2010, over 184 billion Bitcoins were generated in a transaction, and sent to two addresses on the network.
The usual checks fo! r this fa! iled because of the sheer size of the transaction, and because of a further vulnerability of the system that allows the input and output of a transaction to differ, in case a processing fee has been deducted.
Users spotted the unusual transaction within 1.5 hours, a patch was available within about four hours, and the 'correct' version of the network was making its way from peer to peer about five hours after the malicious transaction was first recorded.
2. Bitcoins are the Preferred Currency of Criminals Online
With anonymity and aversion from the laws that govern the world's currencies, Bitcoin has become a commonly used currency for criminals online.
Because there is little to zero regulation behind Bitcoin usage, it's easily the favorite for people that participate in potentially illegal activities, like online drug dealing and online gambling in areas where it isn't legal. If this continues, it becomes very easy for the government to step in, label Bitcoin a ponzi scheme or money laundering operation, and shut it down.
3. Not Backed By Major Banks/Governments/Anybody
The fact that Bitcoins aren't backed or regulated by any major government or institution means a couple of things:
They're likely to agitate and draw bad attention from major banks and governments who are likely to not accept them. You don't need to be a finance major to know that going against "the institution" is usually a great way to get your project canned very quickly.They have no real protection against fraud or security breaches - unlike things we have now like fraud protection on our credit cards and bank accounts.4. Public Approval and Trust/Paypal
If you're like me and you're convinced that the governments of the world are not going to take kindly to someone trying to usurp their respective currencies, you understand why bears argue that public trust is going to be a hard thing to come by. Bitcoin, to have a market, is going to have to win over the trust of hundreds o! f thousan! ds (if not millions) of people to become a currency that's taken seriously - and it's going to have to do this before being taken out by governments, hackers, and other people that would have an interest in Bitcoin failing.
Furthermore, the conveniences that Bitcoin offers us in terms of not having to have a physical exchange of money are already cornered by Paypal and direct links to bank accounts. Ideally, the concept works. But with banks having direct deposit, bills drawing from your bank account, and Paypal to take care of the rest, we hardly ever touch our money nowadays anyway. Conversely, if we wanted to carry physical money, we wouldn't be able to do so.
What's New and My Analysis
In the news again, it was reported by CNBC.com on Saturday morning that the US had seized $28 million in Bitcoin from a man linked to running an online drug market:
U.S. authorities have seized an estimated $28 million in the digital currency bitcoins from the alleged owner of "Silk Road," the online marketplace for drugs and criminal activity that law enforcement shut down three weeks ago.
Federal prosecutors in New York said Friday that the 144,336 bitcoins, a digital currency widely used on the defunct site, were discovered on computer hardware belonging to Ross William Ulbricht, known online as "Dread Pirate Roberts," who was arrested Oct. 1 in San Francisco and charged with various conspiracy counts. They said it represented the largest ever bitcoin seizure.
This is one of many stories that are linking the online currency to illegal activity. It's not going to be long before the government declares that Bitcoin itself is illegal because it is part and parcel to illegal activity online.
To me, the Bitcoin craze is complete insanity. In addition, there's been talk of a Bitcoin ETF - which is simply lunacy.
Investing in Bitcoin is an extremely risky proposition - investing in a Bitcoin ETF, should it come to fruition, is even worse. Yes, there is a ! chance th! at they could continue to appreciate in the coming years - just as they've done in the past two years - but investors need to know that the mere fact of Bitcoin even existing in years to come is nothing near a guarantee.
The facts are that you need to be all right with taking a 100% loss in whatever money you invest in the upcoming Bitcoin empire.
From a macro view, this makes the point for me that we're heading down a risky path as investors - one where there's eventually going to be ETFs that are derivatives of each other and carry insane amounts of risk.
Forbes recently reported about the bad direction we're heading in:
Many obscure ETFs like Direxion's leveraged semiconductor fund can be hazardous to investors who aren't careful. These leveraged funds are designed for day-traders and backed by derivatives. Though providers warn that these funds are not meant to be held as long-term assets, many investors miss the fine print.
The SEC launched a review of all funds last March, deferring applications for "actively managed and leveraged ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives" in the meantime.
"There has been a lot of concern generally about derivatives in the last few years, and specifically in our division about the use of derivatives by investment companies, including ETFs," says Elizabeth Osterman, head of the exemptive applications office of SEC's Division of Investment Management. "Our decision to defer the review of exemptive applications for derivatives-based ETFs reflects concerns about whether granting exemptive relief for those funds would be consistent with required regulatory standards in light of those concerns."
In 2012, there were a record number of ETF closures, citing competition, super saturation of the market, and competition for managers fees:
A record number of exchange traded fund closures in 2012 and Russell Investments shutting down i! ts passiv! e ETF business illustrate the tough competition in the industry.
A total of 71 exchange traded products have announced closures in the U.S. this year, breaking the previous record from 2008, the Financial Times reports.
Although ETF assets continue to rise, profitability is falling as managers slash fees to compete and gain market share, according to the article.
From a macro perspective, this is things moving in the wrong direction again for us. As we saw with the housing bubble, so many of the signs that things were going wrong were based on the derivative trading that these ETFs can also be the vehicle for. I'd advise all investors to take caution when dealing with speculative ETFs and non-government regulated/approved currency, as they sometimes crash or disappear as quickly as they appear, and to keep themselves in check and with the basics when they trade.
As always, I wish all investors the best of luck.
Source: Bitcoin Remains Not Viable And Borderline IllegalDisclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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