10 things investors need to know about bitcoin

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If you have a gambler’s taste for risk and reward, here are ten things you need to know about Bitcoin before taking the plunge.

Bitcoin might better be called the antigravity currency because lately it’s been moving in one direction only – up, up and way up. Year to date its value has increased 1,600 per cent to around US$16,000. Nearly US$3,000 of that on a single surge just last week.

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Everyone agrees that Bitcoin’s soaring valuations are being fuelled by a speculative frenzy. Stories abound of people emptying their bank accounts and putting all of their available cash into the cryptocurrency in the hopes of getting rich quick.

On the flip side, the Bitcoin bubble could burst anytime, rendering the digital money worthless overnight. History has many examples of currencies that have failed and been relegated to the dustbin, usually because of run on their value in the other direction: down, with a devastating inflationary effect. The Weimar Republic’s disastrous monetary policy and resulting hyperinflation following The Great War reached a crescendo in 1923 when a single U.S. dollar traded for 4.2 trillion German marks. You would need a wheelbarrow of mark notes to pay for a single pint of Hacker-Pschorr at a Hamburg beer hall. Never mind purchasing a Mercedes-Benz or Porsche 911 Turbo. The situation was remedied by the issuance of a new currency, the Rentenmark, backed by bonds indexed to the price of gold.

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A similar situation in Zimbabwe just a decade ago meant that a can of Coke that cost ZIM$50 billion in the morning cost ZIM$150 billion that same night. That situation was finally stabilized when Zimbabwe adopted the U.S. dollar as its official currency, then switched to mobile wallets stored on a cellular phone.

From an investment and personal finance point of view, Bitcoin is risky. There are however ways to mitigate that risk by investing in companies such as Shopify (SHOP.TSE), PayPal (PYPL.NASDAQ) and Intuit (INTU.NASDAQ), who have exposure to Bitcoin but won’t be ruined if the cryptocurrency fails. To be clear, MoneySense did that piece not so much to encourage investors to grab some indirect exposure to Bitcoin, but to make them aware of how their stock investments may already be being affected by the mania.

We don’t advise playing this mania. But we also know that readers want to understand why it’s happening and how that market is evolving, if only to sound authoritative at your next dinner party. To that end, here are 10 things you need to know.

1. How do I buy it?

Go to a high volume Bitcoin exchange like Coinbase or Vancouver’s QuadrigaCX and sign up for a free account. (U.S.-based Coinbase, the world’s biggest Bitcoin exchange, is presently overwhelmed with demand with as many as 100,000 people per day signing up.) An account will give you a reasonably secure place to store your purchase and tools for converting your local currency in and out of Bitcoin. After you signed up, connect your Bitcoin and bank accounts. This will involve a few verification steps. Once that’s done you’re ready to go. Most exchanges charge a transaction fee of about one per cent. If you’re not comfortable linking your Bitcoin and bank accounts, you can also use a bank wire or credit/debit card to make a purchase. Bitcoin ATMs, often found on university campuses, accept only cash money. The advantage of ATMs is that there’s no waiting for the transaction to clear, compared to three to five business days online.

2. What if I want to mine bitcoins?

As gold can be mined out of the ground, so too bitcoins can be mined by digital means. Anybody can become a Bitcoin miner by running specialized computing tools that help process and confirm transactions on Bitcoin’s peer-to-peer network. Cyber miners can earn transaction fees paid by users or newly created bitcoins issued according to a fixed formula. The more miners there are, the lower the rewards. This is not an interesting option for speculative investors; leave this to the millennials still living with their parents. Meanwhile, as miners proliferate and entire server farms are setting up to run the currency, the power suck is causing energy blackouts and total power consumption is exceeding that of more than 100 nations.

3. Why is the supply of bitcoins limited to 21 million units?

Theories abound based on fancy mathematical equations, but as with most things Bitcoin, no one really knows for sure. A common sense explanation is that an arbitrary cap was set to attract people who don’t like currencies whose supply has no limit. The reason being that this can lead to an inflationary spiral like the one in Germany or Zimbabwe. To date about 16 million bitcoins have been mined. But consider this: if Bitcoin triples in value from its current level – it has increased sixteenfold so far this year – and reaches a unit valuation of US$50,000, with a 21 million unit float, total market cap would be US$1 trillion. That’s comparable to the $1.2 trillion worth of physical U.S. dollars in circulation around the globe from Venice Beach, California to markets in Africa and Kabul.

4. Where can I spend bitcoins?

About 100,000 merchants and vendors accept Bitcoin payments worldwide and their numbers are growing every day. The list includes e-commerce sites such as Overstock.com (OSTK.NASDAQ) and technology companies like Microsoft (MSFT.NASDAQ). Payments are made from a wallet application, either on your computer or smartphone by entering the recipient’s address and payment amount. Many wallets can obtain a payment address by scanning a QR code or touching two phones together with NFC technology.

5. Can I lose my bitcoins if someone hacks into my account?

Yes, hacking into Bitcoin exchanges is a full-time job for some people. Every Bitcoin wallet is linked to a private key, or secret string of numbers like the serial number on a dollar bill. Exchanges generally keep this private key because it makes transacting in bitcoins easier. However, if the exchange gets hacked or decides to shut down and walk away with your money, there is little you can do about it. The bottom line is that if your bitcoin is stored on an exchange, you do not technically own it because you do not have the private key for your exchange account. The same rule applies for storing bitcoin in most other types of online wallets. The only way to truly own your bitcoin is to hold the private key in a hardware wallet, which is a secure USB device that can only be accessed by a PIN. A hardware wallet also protects you in case your PC is hacked or infected with malware. Popular hardware wallets are Ledger Nano S and Trezor.

6. Can Bitcoin be used instead of gold as a hedge against financial markets?

Bitcoin is best used as a small speculative play in any portfolio. As a general rule Bitcoin goes up in step with economic volatility, so a small exposure will allow you to participate in its gains if financial markets start to fall. Chinese investors have bought bitcoins as the yuan has dropped in value and new rules have made it more difficult to legally move funds out of the country. However there is no replacing gold as a physical store of value that can be stashed under your bed.

7. What are bitcoin futures?

Bitcoin hit an important milestone this month when CME Group and CBOE Global Markets, two of the world’s largest futures exchanges, were given regulatory approval to list the currency. Futures contracts are a type of derivative in which two parties agree to transact at a specified price on a specified day. This gives speculators a chance to make money by betting on Bitcoin’s downfall. Analysts says a futures listing has the potential to turn cryptocurrencies into a legitimate asset class, but it could also result in even greater volatility. Trading started this weekend and so far, it sounds like the mania is intact as the price soared more than 20 per cent earlier this week.

8. Is bitcoin a Ponzi scheme?

A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from money paid by new investors. Ponzi schemes are designed to collapse at the expense of the last people to be lured to the party. New York fraudster Bernie Madoff was the biggest Ponzi scheme operator, cheating investors out of an estimated US$64.8 billion. Bitcoin is a free peer-to-peer software with no central authority, which means no one can make fraudulent promises about its investment returns. But as with other major currencies subject to floating exchange rates, Bitcoin’s price can spike up or down dramatically depending on supply and demand.

9. What’s the difference between Bitcoin and Ethereum?

Not much. Ethereum is also cryptocurrency based on blockchain technology, connected by a public database that keeps a permanent ledger of digital transactions. As with all other blockchain currencies, this database doesn’t require a central authority to maintain and secure it. Like Bitcoin it allows individuals to make peer-to-peer transactions without needing to trust a third party or one another. Ethereum is not as widely known or accepted as Bitcoin, but its value is also bubbling up as the fortunes of Bitcoin rise.

10. Can I keep Bitcoin secret from the government and hide from taxes using it?

Bitcoin is the currency of choice in the dark economy of tax evaders, smugglers, drug merchants and hackers-for-hire for the simple reason that it provides near-perfect anonymity. For the average Bitcoin investor, the ethics of the cryptocurrency boils down to capital gains. Yes, you should report these gains on your tax return, but strictly speaking the government might not have a way of ever knowing about them, unless the bank account you used to purchase bitcoins gets audited. That’s because Bitcoin exchanges are not currently required to report the trading activities of their users to anyone. Nor could they ever be likely compelled to do so. Of course, as this investment moves into traditional markets such as futures exchanges, the banks and the government will have full transparency into your activities. Bottomline, not reporting income and investments on your tax returns is a very serious offence.