Should you invest in Bitcoin? Know its technology and investment risk
On February 8, Tesla, the 6th most valuable company in the world announced a purchase of $1.5 billion of Bitcoin. This piqued buying interest in the cryptocurrency. Looking at Elon Musk’s company’s purchase, you must be asking yourself – should I buy Bitcoin? But before spending your hard-earned money betting on “Bitcoin to the moon,” understand its risk.
We, at Interaxis, have been receiving questions like should I invest my savings in Bitcoin? In this post, we break down two of the most important risks associated with Bitcoin – the technology risk, and the investment risk.
Bitcoin’s technology risk
One of the most prominent risks with Bitcoin is technology risk. This involves the risk of understanding a new type of technology. Given Tesla is a technology company at its core, it understood the technology risks associated with Bitcoin.
It’s no surprise that Bitcoin’s underlying technology is vastly different than traditional financial investing. Be sure to acquaint yourself with this technology risk.
Bitcoin works on blockchain technology, which simply means a distributed ledger technology. This technology dictates the cryptocurrency’s creation, transfer, and settlement. Bitcoin works on the proof-of-work (PoW) consensus algorithm. This allows it to work without an external regulator, like a bank or government. PoW means a piece of data, which signifies ‘work’, generated by miners (or entities that create or mine the cryptocurrency). This data is created by solving complex mathematical equations to mine a block. Every 10 minutes a new block is mined. Each mined block has a hash function, which is an alphanumeric code used to identify the block. And each mined block contains confirmed transactions within it.
PoW is used to prevent the problem of double-spend. Since each block has a hash function, which is a result of the transactions, in order to reverse or duplicate transactions, every hash function after it will change. Bitcoin uses the SHA-256 hash function.
This is the most important technology underlying Bitcoin. But, from an investment perspective, there’s more.
Another defining principle of Bitcoin is ‘be your own bank.’ Wallets are the bank accounts that allow us to achieve this.
A wallet is software that allows you to custody, and transfer your Bitcoin. Think of this as a global bank account not tethered to a single bank. In the traditional financial world, banks charge different fees based on the location of customers (domestic, cross-border), banking systems (within the same bank, between domestic banks, between international banks), and types of transactions (single transfer, remittance payment). The only type of fees charged in the Bitcoin ecosystem is network fees. This is paid to the miners who execute the PoW algorithm to incentivize them to keep doing so. The fees change based on the data (or amount) being sent.
Wallets can be external – hardware wallets, that are disconnected from the internet. These are like hard drives that store cryptocurrencies. Examples of these are the Trezor and Ledger wallet. Wallets can also be internal – software wallets, that are housed on a website or application. Bitcoin.org and Blockchain.com provide wallets like these. There are also specialized wallet services like Metamask and Trust Wallet.
Every wallet is accessed using a private key, which is used to decrypt your wallet. This is a long alphanumeric number that is used at both ends of a transaction. In order for a transaction to be successful, the private key is used to “sign” transactions. In this way, if you have the private key, you have the unique ability to transact your Bitcoin. Hence the saying goes, “not your keys, not your coin.”
With all the enthusiasm around Bitcoin, the number of unique addresses created is steadily increasing.
Another entity that not only houses wallets but offers buying and selling of cryptocurrencies is a cryptocurrency exchange.
Cryptocurrency exchange also acts as indirect wallets for their customers. The exchange holds the private key to a wallet, and the customer has an account within the wallet. This wallet can be used to store and transfer cryptocurrencies.
A risk you should be on the lookout for is – the safety of your funds on the exchange. It comes as no surprise that several exchanges have been hacked. The most famous hack was the $450 million stolen in the Mt. Gox hack in 2014. Since then several exchanges have been hacked. Even one of the largest exchanges in the world, Binance, was hacked in May 2019. What you should look out for is – insurance. An exchange can insure their hot wallets (wallets connected to the internet) and cold wallets (wallets not connected to the internet). This is the credit risk when investing through cryptocurrency exchanges.
Source: Chainalysis Markets
Every US bank account is insured by the Federal Deposit Insurance Corporation (FDIC), but there is no centralized entity insuring exchanges. However, several exchanges have an internal fund to make customers whole if it gets hacked.
So, in summary, exchanges offer custody services, but at a cost. The functionality of using a custody and transfer service of exchanges comes at the cost of a potential hack.
Bitcoin’s technology risk
Bitcoin has tremendous investment risk. While the headline numbers read – Bitcoin is up by 7x in one year a lot of the risks are left out. For instance, within a 12-hour window, on March 12, 2020, Bitcoin went from $7,500 to under $4,000. This triggered over half a billion in liquidations on the biggest derivatives exchange – BitMEX. Not to mention the millions lost across spot exchanges throughout the world.
Bitcoin is by no means a stable investment. This does not mean you shouldn’t invest in Bitcoin. If you would like to invest in Bitcoin, you can do one of two things – you can hold it (or hodl it, short for ‘hold on for dear life’) or trade it.
Hodling simply means holding on to Bitcoin for a long period of time. Especially during times of high volatility, either when the price rises or falls. This involves taking self custody of the cryptocurrency either through software or hardware wallets.
The creator of Bitcoin – Satoshi Nakamoto has held on to 1.1 million BTC mined in the early days of the network. This is worth over $50 billion today. However, these Bitcoin are classified as ‘unspent,’ meaning they have not been converted to cash. This is by far the most hodled amount of Bitcoins.
Trading Bitcoin simply means buying and selling the cryptocurrency to make profits. This can be on a spot exchange, where actual Bitcoin is bought and sold, or on a derivatives exchange, through futures and options. Derivatives can either be physically delivered, meaning the actual Bitcoin will be delivered on expiry. This involves the exchange to have custody of the Bitcoin traded. Or it can be cash-settled, meaning the dollar-difference is settled during the expiry.
Bitcoin and other cryptocurrency derivatives come with high leverage. Always be cautious when using these products to trade.
It’s no surprise that the Bitcoin markets are very volatile. But why is this? Why is it that Bitcoin moves by 4-7% each day, which amounts to $1,800-$3,200 per day at the current price level.
Here are a few reasons why Bitcoin is so volatile.
- No centralized regulation: There is no one centralized regulator for Bitcoin exchanges. Several exchanges operate throughout the world, trading the same cryptocurrencies, but under no one authority. Compare this to the traditional stock markets, where exchanges are under the scrutiny of the financial regulators. For instance, the NYSE (New York Stock Exchange) is supervised by the SEC (Securities and Exchange Commission) and the FINRA (Financial Industry Regulatory Authority).
- Everyone’s market: The Bitcoin markets are open to everyone. It is not limited to a particular geography or type of income-group. This increases the demand for the cryptocurrency. Since there is only one global price and many markets of demand, the price fluctuates.
- No single exchange: There are several exchanges where the same Bitcoin is listed. This makes price discovery even more difficult. Coinmarketcap lists over 300 exchanges by trading volume. It should be noted that several exchanges fake their volume and hence are not trustworthy. So, always do your due diligence before investing via an exchange.
- No timing: There are no fixed market timings. The Bitcoin markets are open every hour of the day, every day of the week. Since there is no specific time for making orders and settlement every trade happens in real-time and makes the markets more volatile
What works for you
Whichever path you take, please remember that Bitcoin is rife with technology and price risks. The technology risk comes with having to understand how the underlying blockchain technology works and how supporting technology like a wallet and exchange works. Price risk comes with dealing with volatility.
Once you understand these risks, you should formulate your investment thesis. If Bitcoin and other cryptocurrencies fit this thesis, feel free to invest in them – either through hodling or trading.
But always remember that being educated on Bitcoin and cryptocurrencies will better your investment thesis. In that education endeavor, we at Interaxis can help.