I recently had an enquiry from a long-standing client about the merits of investing in Bitcoin. If you’ve been following the meteoric rise in value of this fascinating new phenomenon you might be interested to read my response.
Matt, your Bitcoin question is an interesting one. At the time of writing the value of one ‘bitcoin’ is over $11,000, up from only $5 in 2012, and making some people very rich in the process – at least on paper (or should that be ‘on screen’?). Are there any parallels?
In the 1630’s the price of tulip bulbs in Holland started to rise dramatically as it became fashionable to own unusual and rare plants. At its peak the price of one bulb reached the equivalent of 10 years salary for a skilled craftsman. People made huge fortunes buying and selling bulbs to each other, and it became an obsession of the whole population. One person sold 12 acres of land in exchange for a single tulip bulb.
In 1637 the whole thing came crashing down and just as fortunes had been made, fortunes were lost and some people faced financial ruin. The price of tulip bulbs came back down to ‘normal’ and the mania was over.
What is the difference between a tulip bulb and a bitcoin? It is that if the price fell to zero you would at least be left with a tulip bulb. Very nice on your windowsill.
The whole area of cryptocurrencies is fascinating and complex, and the first thing you should ask is what are their purpose?
Bitcoin was invented as a means of exchange. In that sense it is no different from pounds, dollars, euros or yen. In some countries (Japan, China and Africa among others) traders will accept bitcoin as payment for goods and services. If bitcoin were to become established it is feasible that you might one day pay for your groceries using it.
Where it is different, though, is that bitcoins exist on people’s computers, outside of the current financial system. It isn’t a recognised currency and it is a long way from becoming one.
I strongly believe that ‘digital currencies’ will gain traction over the period to come, and have the potential to change the way we operate and trade with each other in profound ways.
The reason they will do this is because a digital currency can offer certainty of transaction in a way that traditional currencies cannot, as well as potentially very low transaction costs. If you begrudge paying a 10% fee to convert your holiday money back into sterling you’ll be attracted by the idea behind bitcoin.
To become mainstream, though, digital currencies need to achieve a number of things. Firstly they must be capable of being trusted, and that is what the blockchain technology behind bitcoin offers. Each transaction can be verified and its audit trail exposed to confirm the veracity of the ‘money’.
Secondly, to be widely used a currency has to be stable. If I am going to pay for things in bitcoin I want to know that it is going to be worth about the same in the future so I can have confidence in its value. At the moment I can’t imagine many people using bitcoin to actually pay for things because they would rather hang on to them and watch the value increase.
And herein lies the problem, because people are investing in bitcoin purely because they expect the price to rise, not because of any intrinsic value it may have. That link was lost long ago. And the more it rises, the more people will want to invest. If everyone else is making money on bitcoin (or tulip bulbs, or property, or chocolate smarties) then it’s natural to want a piece of the action.
A ’bubble’ – whether it is in tulips or electronic money – is built on the human loathing of sitting by and watching whilst everyone else is making a fortune. History shows that the higher the price goes, the more will be the number of people pronouncing valid and plausible reasons why it will go far higher yet. This bubble is no different.
Along the way many people will make much money, as they already have done. But at some point bitcoin has to either fulfil some useful function (which requires price stability – the very opposite of its current behaviour), or investors will ask “Why am I paying all of this money for this tulip bulb? What does it actually do?”
If technology hasn’t yet provided the answer it will collapse in price quicker than a falling firework. Some commentators are calling bitcoin ‘the new gold’, a store of value that will still be there when the rest of the financial world is going to hell in a handcart. But at least gold actually exists, with a 5,000 year price history to measure it against. Bitcoin has no history, and no measure of its ‘fair’ value.
If you buy now, how will you know when to sell? Neither is bitcoin unique. Its success has already spawned numerous spin offs and alternative new technologies, some arguably overcoming many of bitcoin’s operational flaws. There is only one gold.
These are exciting times for emerging technologies and there’s fun to be had for people who know what they are doing. There may be big money to be made. But you’re playing with fire and should treat any investment accordingly.
For me, bitcoin fulfils none of the criteria of serious investing and I won’t be sticking my fingers in the flames. I’m off down to the garden centre for some spring tulip bulbs (£1.99 from Marshalls). But if you’d like to make me a serious offer for them I’m open for business. All payments in cash please.