INVESTMENT UPDATE

Bitcoin Update

  • 10 March 2021
  • 10 mins reading time
  • Bitcoin, along with other cryptocurrencies, has garnered many headlines.

  • Its rise in value against the dollar has been meteoric, but the lows have been as sudden and as sweeping as the highs.

  • With very little inherent value, we do not regard cryptocurrencies as an investment opportunity.

This is an update on an article we wrote more than three years ago. In that time, the price of Bitcoin has slumped and rocketed and fallen again.

Despite its greater popularity at the time of writing in March 2021, we have not changed the three bullet points at the top of this article.

Those points still represent our view that cryptocurrencies carry too much risk and uncertainty for the long-term, stable growth in investments that we seek.

Bitcoin price has rocketed again

Investment house, BlackRock, and electric car manufacturer, Tesla, have both joined the Bitcoin bandwagon. BlackRock has an investment arm looking to benefit from prices moves – both up and down. While Tesla’s boss, the somewhat controversial Elon Musk, has said that he would accept Bitcoin payments for his products.

Unsurprisingly, the value of the cryptocurrency rose to over $50,000 per Bitcoin in early 2021. As a result, many an investor is frustrated at having missed out on what they might see as a big win.

We don’t see it that way.

Conventional currency

To understand what a cryptocurrency is, we first need to look at more conventional currencies, and then consider the differences.

If you look at a £5 note, words, “I promise to pay the bearer on demand the sum of five pounds” appear written on the side that bears the Queen’s head. This harks back to how cash as we understand it today, evolved.

A brief history of money

Throughout history individuals have traded with each other. Over time exchanging goods in kind was replaced by the use of gold as a widely accepted method of payment.

Simplifying history somewhat, rather than carrying gold around all of the time, people would place it with someone who had sufficient means to keep it safe, in return for a receipt confirming how much gold had been deposited. This was an early form of banking.

These receipts had to be fairly durable, and difficult to forge. This enabled traders to pay for goods with receipts rather than bits of gold. The gold stayed in safe storage and people exchanged the bits of paper instead.

If anyone needed access to gold, they simply handed one of these receipts to a ‘banker’ who would redeem the note for the amount of gold specified.

It was a relatively short step from this to an official form of money governed by the monarch and eventually by a central bank. The central bank would hold huge amounts of gold to act as collateral for the receipts/ cash that was flowing around in trade.

Over time, the “gold standard” as it was called, became obsolete and central banks were given the freedom to print new money should it be needed. This became possible because everyone (in most countries) had sufficient trust in the currency for it to remain widely accepted as a form of payment.

This sort of money is known as fiat money, taken from the Latin fieri meaning “arbitrarily decided or chosen by decree”.

Jump forward in time a little further and the vast majority of money is no longer in the form of physical paper and coins. Instead it is in the form of numbers held on computers. Salaries transferred, bills paid, and savings maintained are all held on electronic registers with the understanding that the currency is backed by the central bank.

Central Power Bank

This puts central banks in a position of both great responsibility and great power. As well as controlling how much cash is printed, they act as the lender of last resort, i.e. the bank that lends to all the commercial banks.

As well as increasing or reducing the interest it charges commercial banks to discourage or encourage borrowing and spending, the Bank of England (BoE) also controls the amount of money in the economy. It does this by “printing” new electronic money, which it has been doing since the start of the 2008-09 financial crisis. The BoE can also reduce the amount of money in the economy by withdrawing it from circulation.

The key point for an investor is that, as well as an economic guardian, the Bank of England also oversees the value of the pound.

To understand what a cryptocurrency is, we first need to look at more conventional currencies.

Cryptocurrencies: outside central bank control

Cryptocurrencies don’t have a central bank, neither are the supported by a physical asset such as gold. They are, in effect, just numbers on a computer screen that, in theory, anyone can buy with dollars, pounds, euros or whatever.

Like shares in a company, if enough people want to buy them, then their value will rise; if not, they will fall. There is no central bank to step in and try to maintain the cryptocurrency’s value.

This is seen as one of the major advantages of a cryptocurrency: its value cannot be influenced or interfered with (depending on your perspective) by a national authority such as a central bank or government.

They are currencies of the people, by the people and were predicted in a 1997 book written by William Rees-Mogg and James Dale Davidson called “The Sovereign Individual”.

From this point on, the article will address its points as they apply to Bitcoin as it is the best-known of the numerous cryptocurrencies.

Who created Bitcoin?

The person accredited with creating Bitcoin is referred to as Satoshi Nakamoto, though the veracity of that name and the person’s true identity are clouded in mystery.

According to Bitcoin.org, Nakamoto came up with a Bitcoin specification and proof of concept in 2009, before “leaving the project in 2010 without revealing much about himself”.

Since then, countless developers have descended on Bitcoin to bring it to where it is today.

A parallel of this can be seen in Sir Tim Berners-Lee’s invention, the World Wide Web.

So who controls Bitcoin?

The short answer to this question is: no-one.

Bitcoin is run as a network that anyone can contribute to, but no one owns (a system often referred to as peer to peer). Like the Internet, anyone can use it, but no one owns it out-right.

Also like the Internet, Bitcoin uses software that does not require a licence to operate and which can be freely used and adapted by anyone. This type of software is frequently called ‘open source’.

The key is, whatever software is used none of them change the basic structure or existence of the Internet. And so it is with Bitcoin.

Software programmers can download the coding that supports the exchange of Bitcoins and offer improvements to the way it works with thousands of contributors supporting the network.

It sounds like a free-for all: how secure is Bitcoin?

This is a common question. But it is the nature of how they work that give cryptocurrencies such a relatively high level of security.

Imagine you have a shopping list held online. On its own, it’s vulnerable to hackers who might break through your security barriers and mess around with your shopping list.

To prevent this, you could have everyone in your family keep a separate online copy of your shopping list in completely different locations on the Internet.

Each version of the shopping list can be compared to every other version so that if a lorry-load of marzipan suddenly appears on one of the lists, this is obviously a result of unwelcome interference. It is removed and the shopping lists all tally once more.

While it’s simple for a hacker to corrupt one or two versions of the shopping list, the more copies of the shopping list in existence, the harder it is to corrupt all of them consistently.

With Bitcoin, every transaction that takes place is recorded on a ledger, and that ledger is duplicated thousands of times across Bitcoin users the world over. This makes it far more trouble than it’s worth for a hacker to try to corrupt.

This ledger history and the system that monitors the consistency of the records across its numerous versions, is referred to as “Blockchain”.

How do you buy or sell Bitcoins?

You get hold of Bitcoins by installing a programme (an application or ‘app’) on your phone or computer, or by creating an account online. This application is called a “Wallet” for obvious reasons.

Wallets are free to download and access and typically take a couple of minutes to install. Each wallet requires an email address, a password (measured for how difficult it would be for someone to guess) and a PIN code (i.e. a four-digit identification number).

Once that’s done, you can upload traditional fiat money (pounds, dollars, euros etc.) to the wallet and use that to buy Bitcoins through an exchange or directly from other holders.

It takes an average of 10 minutes for each purchase or sale of Bitcoins to be confirmed. This allows time for other copies of the Blockchain to confirm that the transaction is valid (the seller really does own the Bitcoins), and to record the transaction in all versions of the ledger

What’s in it for the software providers?

To begin with, Bitcoins, after that, fees.

The system is set up so that the people who provide software services either in the form of wallets, exchanges or online storage, can earn Bitcoins (or bits of Bitcoins) once they’ve delivered a prescribed level of service.

In an analogy to acquiring gold, this process is called mining. It was great while the system was still nascent as it encouraged more and more developers to contribute to the group effort.

Now the system is more mature, it is harder to mine new Bitcoins. Instead, developers earn fees by charging for their services. However, competition is steep and this has helped to keep fees down to date.

In theory fees could be avoided altogether by users writing the software to create your own wallet, or by finding someone to trade with directly to avoid most of the online services the contributors provide.

But that would mean being a computer software engineer and taking part in a private trade at a less favourable price than you might have achieved if you’d used an exchange – even taking the fees into account.

How many Bitcoins will be produced?

The maximum number will be 21 million, but with the current number in circulation close to 17 million, and the rate at which they are being added having slowed (as was intended from the original design), it is likely to be years before the maximum is reached.

Until then, Bitcoins can be divided down to 0.00000001 of a Bitcoin. At the time of writing, that equates to around one millionth of a US cent, in theory affording this cryptocurrency plenty of scope to deal with rising value.

But cryptocurrencies are not invulnerable

There is potential weakness in the exchanges where people deposit money and trade Bitcoins. Hackers have managed to break through the security systems of at least two of these exchanges and steal either Bitcoins or fiat money.

The most notorious instance was that of “Mt. Gox” from which $460m disappeared in 2014, sending the company into bankruptcy. While there was clearly some nefarious activity involved, it was discovered that the company was badly managed and an easy target.

The exchanges have the equivalent assets and responsibilities of banks, so their security systems need to be just as robust. Mt. Gox was something of a wake-up call for cryptocurrency exchanges, and has led to improved security.

Down the back of the sofa

However, the most common form of loss, according to bitcoin.org, is that of people losing or forgetting their wallet details. Once that happens, there is no way that anyone can spend or sell the Bitcoins that are in that wallet, so they effectively drop out of circulation permanently.

Why is Bitcoin so highly valued?

Bitcoin’s original value was based on its inherent quality of being international and out of the reach of central banks.

This initial attraction was overtaken by momentum in 2017 as more and more people saw the stratospheric rise of Bitcoin’s equivalent value in dollars. This led to speculators buying Bitcoins in the hope of multiplying their assets.

To say that this was a high risk strategy is a colossal understatement. Previous sharp rises along similar lines have included the housing bubble of 2007, internet bubble of 2001, the stock market bubble of 1929, the Mississippi property bubble of 1721, and the Tulip bubble of 1637.

But there is at least one difference between most of those rises and that of Bitcoin: the cryptocurrency’s rise has been far quicker and steeper.

While it might be tempting to regret having missed out on the value created out of thin air for holding such an asset, a similar thought could be applied to not betting on the winner of the 4.30pm at Catterick.

Sure enough, the risks of buying such a stratospherically rising asset proved to be a high-risk strategy to say the least. The dollar value of Bitcoin plummeted by more than 50% in the early part of 2018.

It’s since shot up to $57,000 a coin before slumping back to $45,000 then jumping up to $50,000, all in the space of a few weeks.

These rapid changes in price make it very difficult for an investor to know when to buy or sell. And that makes for a very high-risk “investment”.

What are the risks?

Putting aside the sharp movements in price, cryptocurrencies have a number of vulnerabilities.

Firstly, they are fairly embryonic at the moment, so sharp movements in value are bound to occur, both down as well as up.

What’s more, as China demonstrated in September 2017, a country could ban the use of cryptocurrencies. At the moment this is easier for autocracies to implement, but that could change if cryptocurrencies lead to tax avoidance or evasion.

Should this happen, then it would not take a great stretch of the imagination to conceive of leading economic nations getting together to restrict the use of cryptocurrencies.

One organic restriction that has already begun is that of competition. The other cryptocurrencies being developed include Ethereum, Ripple, Litecoin, Dash, NEM, Monero and Zcash. As with all developing offerings, some will blossom or specialise, others will merge or fail. With the might of Facebook behind Libra and central banks looking to join the fray, this could prove to be the largest threat to all the competition.

Conclusion

So cryptocurrencies are just forms of money that only exist on computers. In this way, they are like most of the money that everyone deals with on a daily basis.

They are not subject to government interference, but are not immune to it, and that poses a huge potential risk to valuations and integrity.

Some people will have done very well out of Bitcoin if they bought and sold at the right time. But without intrinsic value or the ability to project future price moves, and with legislative risks and competitive cryptocurrencies being introduced, Bitcoin and its counterparts have a long way to go before they feature in our investment considerations.

Important information

Any views expressed are our in-house views as at the time of publishing.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

Fees and charges apply at Schroders Personal Wealth.

In preparing this article we may have used third party sources which we believe to be true and accurate as at the date of writing. However, we can give no assurances or warranty regarding the accuracy, currency or applicability of any of the content in relation to specific situations and particular circumstances.

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