In the last year, no investment asset has performed nearly as well as cryptocurrency. Leading the pack, Bitcoin has nearly tripled in just the last three months.
Do these price movements represent a massive bubble, or sober recognition of the innovation and opportunity provided by cryptocurrencies? There’s probably a little bit of both baked in to the current price.
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What is cryptocurrency?
Put simply, cryptocurrency is a type of money that is produced digitally. Cryptocurrencies differ from traditional currencies in several ways:
- They are not issued by a government
- There is no physical form (like a dollar bill)
- The creation of new currency units is set by an algorithm (as opposed to fiscal or monetary policy)
- There is a significant amount of privacy and secrecy around who, exactly, owns how many of each coin
Otherwise, bitcoin and other cryptocurrency coins to behave like currency. They can be collected, traded for goods and services, or converted in to other forms of currency. A big part of the sales pitch is that bitcoin should face limited inflationary pressure compared to government-issued currencies from countries with large budget deficits.
How does crypto work?
At the heart of cryptocurrency technology is the blockchain. In short: blockchain refers to a distributed open ledger. That means every person who participates has a full record of every bitcoin transaction. The individuals making the transactions are relatively anonymous behind their Wallet IDs, but the entire archive of their currency movements is very public.
Individuals can also “mine” bitcoins by dedicating CPU and GPU power toward maintaining the block chain and demonstrating proof of work. When new blocks are solved, the individual or team that solves it will be rewarded with some fraction of a bitcoin. Mining pools allow people to work together to increase their odds of a return and share the rewards.
New coins are distributed directly to the user’s digital wallet, and that wallet can then be connected to various exchanges where the coins can be traded or cashed out. Some stores even accept direct bitcoin payments, so you may even be able to make purchases directly from your digital wallet without needing a middle man.
How much is it really worth?
This is the part that no one can really know for sure. Prices are generally set by supply and demand, but bitcoin has had a difficult time with price discovery due to the fact that there’s still a strong expectation of rapid price increases.
In simple terms, we can’t tell how much of the demand is based on pure speculation. The lack of regulation and transparency further inhibits price discovery and hurts bitcoin’s ability to be a serious asset.
Did Tesla buy $1.5 billion in BTC because they need the bitcoin or because they expect it to go up in price? Since it’s unlikely that they’re paying employees or suppliers in crypto, it seems to follow that most of these large purchases are just speculation on the hope that prices will only continue to go up.
What’s the catch?
While blockchain provides an innovative and new way to distribute public records, there are still some big problems with the early implementations as currency.
For one thing, bitcoin is fairly illiquid. It can take days for an exchange trade to fully resolve. It’s also extremely volatile, so the price may have changed significantly while you’re waiting for a transaction to go through.
There’s also a classic economics problem with deflating currencies: Why would you spend it today if the expectation is that the price will only increase? Ironically, these upward price pressure makes for a bad currency because no one wants to spend it:
The biggest problem, perhaps, is the sheer amount of resources crypto consumes. Proof of work scripts require massive amounts of electricity and contributes directly to global warming. Bitcoin alone recently surpassed the entire country of Argentina’s carbon footprint.
The future of cryptocurrency
Bitcoin will probably be around for a while. Simply being the first major cryptocurrency will give it a lot of momentum going forward. Ethereum, and a few other large coins, will probably also stick around for a while.
Will prices continue to surge? No one can say for sure. There is certainly a lot of investment excitement, but how much is for the innovation and how much is just hype?
There are some other alternative coins to keep an eye on. As time goes on, new developers will create new cryptocurrency systems that fix or address the problems introduced by Bitcoin.
Blockchain and digital currency is likely to be with us for a long time to come, but that doesn’t mean Bitcoin prices will continue to double every month or two! Don’t get carried away with the hype, and remember that the best long term investment strategy is diversification.
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