Understanding the Risks of Bitcoin & Cryptocurrencies

The media talks about Bitcoin every day, your friends are talking about it and large investment banks are looking at it. You may be wondering whether or not you should buy some Bitcoin if it is supposed to be the wave of the future. What is certain about Bitcoin is that it is incredibly volatile and speculative. Many experts have said that if you are an investor to stay away from it. No one should put any money into Bitcoin that they cannot afford to lose 100%. Next, we discuss some risks of Bitcoin to help you be better informed. 

Bitcoin's Value - Is it a Bubble:  

Probably the ultimate question is: what is the underlying value of Bitcoin Is there a sound foundation to justify how much it is worth?

Every currency in the world is a fiat currency it is legal tender whose only value is the backing by the government that issued it. There is no underlying asset to Bitcoin that backs its value, so it could also be considered similar to a fiat currency, except that it's not legal tender in any country. The increase and decrease in its value is solely based on what someone is willing to pay for it. 

We have seen bubbles many times throughout history, from Tulips in the early 1600s, to the dot com mania and now Bitcoin. The telltale signs of a bubble are asset prices that rise sharply and at a sustained rate without a change in the corresponding intrinsic value of the asset(s).

Some people may view Bitcoin as a new type of investment just like a stock, and this is definitely not true. Back in the late 90s, the internet was growing rapidly with masses of people coming online and a slew of new companies sprang up with pie in the sky dreams of taking a business concept online and making a fortune. Many say Bitcoin is the same, however, there is one big difference between Bitcoin and the companies of the tech bubble (1997-2000): There was actually a company behind the stock with a business plan (either good or bad) that was going to provide goods and/or services online Bitcoin produces nothing. 

Some experts, such as Kenneth Rogoff, a Harvard University professor and a former chief economist and director of research at the International Monetary Fund, have called Bitcoin the first true global bubble. Technology changes, but human nature does not and these kind of bubbles follow a very similar trajectory whether you're going back to fourteenth century Florence, or modern day China, Japan, and this really looks like a bubble; and the fact that it's a global bubble I don't really actually think is such a concern. It is not really that important yet. He goes on to say that while he believes people will lose money, it's not the same as a collapse in the banking system or a crash in the stock market.

Regulations:  

It is relatively easy to buy Bitcoin, but what is not so apparent is that it is actually quite a bit harder to sell; for example, you cannot transfer Bitcoins easily back to Canadian dollars and into your bank account when you sell it. 

Canadian financial institutions do not want to facilitate the movement of funds related to Bitcoin and other cryptocurrencies as they are not able to comply with anti-money laundering and anti-terrorist financing laws because of the anonymity of cryptocurrencies. Over the last number of months, banks and credit unions have been closing down accounts of businesses that have dealings with Bitcoin and other cryptocurrencies. 

Anonymity is touted as an advantage by Bitcoin proponents, however, you could easily be providing financing to terrorists, aiding organized crime to launder their proceeds of crime, or breaching UN sanctions against rogue nations by buying Bitcoins. 

If you look at the history of currency, initially we bartered, then China made bronze goods which were traded, followed by standardized coinage and paper currency.  It was rediscovered in many places that always the private sectors developed currency first, then government comes in and it regulates and appropriates.  

Some say they have a superior technology and we will defeat the government.  In the end, government always eventually wins.  The long run value of cryptocurrencies that are anonymous is minimal.  That doesn't mean the whole technology is worthless.  There are great ideas in the technology, but the anonymous part of it will not last in first world countries.  They will find a way to not allow transactions to be untraceable through regulation.  

Money Laundering, Terrorist Financing and the Illicit Trade:

I agree with the importance of anti-money laundering laws and controls.  Financial institutions do not know where the funds are coming from, as the whole idea of Bitcoin and these cryptocurrencies is that the money transfers are anonymous by design.  Someone could simply be selling their Bitcoin or it could potentially be a money laundering operation.  You are likely thinking that this is not a big deal.  How much money laundering is really going on?  Consider that we do know that transactions do exist for illegal activity globally.  Now , what would happen if the flood gates were open to make such transactions easier and untraceable? 

It is a known fact that Bitcoin and other cryptocurrencies have a strong attraction for those in the criminal underworld.  North Korea is heavily involved in hacking and cyberwarfare worldwide and has been aggressively targeting Bitcoin exchanges this past year. The most recent attack was a South Korean Bitcoin exchange called NiceHash in early December where roughly 4,700 Bitcoins were stolen, worth approximately $75 million at the time.  Bitcoin was used as the medium of exchange to buy and sell drugs and other illicit materials on a site called Silkroad, which was eventually closed by the FBI and Europol in 2014.

These examples are barely scratching the surface of the illegal and criminal aspect of cryptocurrencies. In North Korea's case, it is not inconceivable that western intelligence agencies are working around the clock to cut-off sources of financing, including cryptocurrencies. 

Competition: 

There are currently many competitors for Bitcoin and some are better versions in one way or another. You may recall MySpace, Altavista or Netscape from the early days of the internet. MySpace was the number one social media platform prior to 2005, until a better site came along called Facebook. 

Another disadvantage of Bitcoin is the immense amount of power it takes to run the global network of computers that verify transactions and mine Bitcoin. It is actually a very inefficient use of power. A competitor could easily come along with a new cryptocurrency that requires significantly less power to verify transactions and eventually overtake Bitcoin. 

Conclusion

Bitcoin has become a household name having the first mover advantage in the cryptocurrency world. The blockchain technology could ultimately be a more efficient method to process credit cards, debit cards and electronic payments, but Bitcoin is only a very specific application of it. Bitcoin's value is tenuous at best, and is fraught with risk of the current bubble bursting. Without the anonymity it really wouldn't be worth much. As long as Bitcoin and other cryptocurrencies exist, they will be used by criminals and rogue nations, which makes them a target for governments to shut down or to regulate. After wading through all of the hype and misinformation, is owning Bitcoin worth the risk?

Warren Buffet has recently warned "the cryptocurrency bonanza is certainly going to end in tears." Buffet is not willing to guess when the crash will happen, but stated it is "ultimately going to happen."

Written by:
Andrew Brydon, CPA, CA
Wealth Counsellor