Earlier this month, Bitcoin prices topped $10,000. For many, it was a huge shock and sparked feelings of remorse for not having jumped on the Bitcoin train sooner. In fact, Google searches for Bitcoin, and Bitcoin-related topics, went up 1,000 percent over six months. Suddenly many previously dismissing the cryptocurrency as nothing more than a bubble about to burst were having second thoughts and doing the math on how much they would have made if only they’d gotten in sooner…
But should you be disappointed that you didn’t purchase any Bitcoin yet? That all depends on how well you understand it.
According to an article on The Hill written by University of Michigan Ross School of Business Assistant Professor Andrew Wu, people are too eager to purchase Bitcoin. Coinbase, the leading Bitcoin exchange in the United States, added 300,000 users in a single week. But unfortunately many of those individuals “have no clue what they are getting into, nor do they understand how Bitcoin works and its unique risks,” writes Wu. That’s a big problem.
Wu—who teaches such Ross courses as “FinTech Innovations,” “Big Data in Finance,” and “Machine Learning Methods in Business and Financial Research”—delved into a detailed description of what Bitcoin is and what it isn’t.
What Is Bitcoin?
Bitcoin is a technology that utilizes blockchain, “a family of decentralized record-keeping systems that allow different parties to share the knowledge of ownership and transfer of assets,” says Wu. Basically, this means that you can transfer physical goods and services for intangible capital like Bitcoin—similar to money. The difference with blockchain technology is that it’s tamper-proof and timely, which makes transactions more trustworthy without the requirement of a third party—such as a bank or notary—to oversee it.
There are three things that make blockchain work.
- Unique Data Storage: Blockchain uses a data storage structure that creates a record of each new transaction in a “chain” that prevents tampering and corruption of past data.
- Transaction Verification: According to Wu, blockchain utilizes “a versatile family of ‘consensus algorithms’ that allow peers to verify upcoming transactions and kick out inconsistent ones.”
- Robust Encryption: Blockchain incorporates robust encryption protocols for authentication and identity management.
Because of these three things, blockchain technology is being implemented into various industries to cut out middlemen and prevent fraud. “It has potential to significantly reduce intermediation costs in our society,” explains Wu. However, this doesn’t mean you should invest in Bitcoin immediately.
The Pitfalls of Bitcoin
While blockchain technology is exciting, Bitcoin is only one specific implementation of the technology and not necessarily the best. There are a few things to note about Bitcoin.
- Bitcoin is public and anonymous. When using Bitcoin, anyone can participate and view the history of all transactions, though the identities are masked with encrypted Bitcoin addresses.
- It can be difficult to verify Bitcoin transactions. Bitcoin is verified using a consensus mechanism called proof-of-work, or mining. Basically, peers come together to compete to verify the next group of transactions and the winner receives some Bitcoin. These peers are typically “huge mining pools, created by individual miners banded together or centralized ‘factories’ of thousands of computers located near a cheap power source,” writes Wu.
- Bitcoin isn’t as democratic and decentralized as people think. The power of Bitcoin is in the hands of a few large mining pools, exchanges, and developers. This is far different from equity investing, which places the power in shareholders hands to vote on the best course of action.
- Bitcoin is accepted at few online stores. According to a report by Morgan Stanley, only three online merchants out of 500 let customers pay with Bitcoin. This is down from five companies out of 500 that accepted it last year, making Bitcoin extremely volatile.
- Bitcoin has a lower capacity for transactions. Compared to Visa, which can process 56,000 transactions per second, Bitcoin can only process about seven transactions per second, making it very limited in terms of payment processing capacity.
Should You Invest in Bitcoin?
The question is, “Should you invest in Bitcoin?” According to Wu, right now, most investment in Bitcoin is speculative. People are investing on the hope that sometime—down the road—it will be worth something.
“Bitcoin, therefore, becomes the perfect speculative commodity, with a value that is based not on fundamentals or cash flows, but on future realizations of investment sentiment,” writes Wu. “Massive price spikes form because of investor hysteria that feeds upon itself, but spectacular crashes are also possible, and indeed happened many times, when some unexpected, even seemingly minute, shock hits the marketplace.”
For Wu, this means that caution is necessary. Too many people have invested in Bitcoin just to “beat the crowd,” but that’s not the best decision. Since investors are anonymous, there’s no way to know if institutional investors, retail investors, or bots are completing Bitcoin trading.
“Bitcoin exchanges are unregulated cash markets and have absolutely no disclosure requirements,” says Wu. “It is by nature a very different type of trading from most asset classes, and one should be cautious applying the market analysis—fundamental or technical—that is invented for other, more regulated markets.”
Wu recommends that potential investors look to past examples to determine if they want to take the risk on Bitcoin or not. He mentions the fact that in the 1630s, the price of tulips went up 1,000-fold in a year and created a futures market for tulip bulbs. And the same happened in the 1700s when people in France invested in Mississippi swampland. In both cases, the market crashed, and investors were left with nothing.
“I’m not saying a crash in Bitcoin is coming or how soon it will arrive—no one can predict that. I’m emphasizing that in an unregulated, sentiment-driven market, things can be extremely fickle,” says Wu. In the end, Wu recommends caution before investing and to not get too carried away by the dramatic return figures.