Co-written with Sr. Portfolio Manager Susie Stanley-Jones
Put simply, Bitcoin is a peer-to-peer electronic payment system that allows online payments to be sent anywhere without going through a financial institution. Bitcoin has been making the headlines lately because of its meteoric rise in price. However, it is not the only cryptocurrency available. Others include Tether, Ethereum, and Ripple. The goal of any cryptocurrency is to enable transactions that cut out the middlemen, making dealings cheaper and more efficient.
Some think that these benefits could spell the end for currencies as we know them, but cryptocurrencies currently have some significant problems. First, there is no par price, so value can change dramatically. The rise of Bitcoin is a perfect example. While history is replete with cases of unstable currencies, for the most part people have faith that the value of the dollar is pretty constant. Cryptocurrencies also make it easier to evade taxes, endangering any government’s ability to provide services. Another problem is theft, as illustrated recently by the hacking of NiceHash and Mt. Gox before that. Theft is a problem for hard currencies, as well, but we have a well-developed system to deal with the challenge. Bitcoin has its own problems. Since Bitcoin has no governance, changes in the software (called forks) do not have to be recognized by all. As a result, offshoots like “Bitcoin Cash and “Bitcoin Gold” have developed.
Cryptocurrencies work on a technology called blockchain (not to be confused with Blockchain which is Bitcoin’s digital wallet). Basically, it is a distributed ledger that traces the use of a decentralized application. Ultimately, blockchain is a digital spreadsheet that is reconciled on a continual basis and available in a global shared space. The fact that this information is available openly on multiple computers at all times means a failure of one system will not disrupt the information flow. There is complete transparency. Multiple administrators work independently to create one network.
Blockchain has the potential to disrupt any transaction that requires sharing documents or contracts. Financial institutions would feel this disruption. More importantly blockchain’s shared-ledger could affect the time, cost and complexity around how transactions are recorded. Blockchain’s one shared, encrypted ledger has the capacity to render our trade process clean and transparent, making record keeping more efficient. Blockchain applications have some very real applications beyond the simple means of currency exchange. Stock trading could be done peer to peer without a clearing house. Companies could be brought public without investment banks. Intellectual property could be better protected and identity management could be enhanced. Ultimately, the value of block chain platforms is that they can provide a way to authenticate digital information.
But back to Bitcoin — is it a speculative bubble? Adding to its legitimacy, last week the Chicago Board of Options Exchanges began trading futures contracts on Bitcoin and this week the Chicago Mercantile Exchange began trading contracts, as well. A similar situation from history, however, illustrates the risk in such a move. In Holland, a futures and options market quickly developed in the 1630s around tulip bulbs. The Dutch had just begun importing the flower from the Ottoman Empire, demand soared and prices rose astronomically. Despite the development of a futures market, by the winter of 1637, the bubble burst and prices fell 99%.
To be sure no one knows where Bitcoin prices will go or where the currency will end up. It is safe to say that this is speculation and not an investment. It is hard to fathom Bitcoin, or any other cryptocurrency, totally replacing hard currencies at this point. However, cryptocurrency is here to stay, in one form or another. It is likely that a stable cryptocurrency will develop that works alongside hard currencies rather than completely replacing them.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 20 years of portfolio management and investment experience. Rick designs and implements investment and risk management strategies for the bank’s clients. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in the Journal of Investment Management and Financial Innovations, as well as, the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.