Speculating About Bitcoin

Speculating About Bitcoin

Highlights:

  • Bitcoin has swiftly risen in popularity, but faces significant challenges headed into 2018.
  • The benefits of Bitcoin stem from its decentralized nature, cryptology, blockchain technology and growing acceptance as an exchange of value.
  • The challenges of Bitcoin revolve around determining its value, its price volatility, securing access to the coins from loss, and susceptibility to outside regulation.

The buzz around Bitcoin is hard to miss. The digital currency dominated headlines late last year with its meteoric rise from $985 per coin in January, to $19,784.93 at its peak in December—then falling over $1,000 in less than an hour shortly thereafter. Paralleling the rise in media interest, we saw internal searches for “Bitcoin” on AmericanCentury.com increase over 1,000% from Q3 to Q4 2017.

Bitcoin has had a rocky start to 2018, experiencing a rollercoaster ride of volatility on the news that the governments of China and South Korea may put regulations in place to significantly curb, or even shut down, bitcoin operations in their countries. The tumult has some investors wondering if Bitcoin will live up to its hype, or if it’s just another craze. Below is American Century Investment’s current stance, plus some facts on the currency, to help you cut through the noise.

Where We Stand on Bitcoin

Currently, Bitcoin is not an approved security, so American Century does not invest in it. As I’ll cover below, the digital “currency” presents several challenges from an investment management standpoint—particularly in calculating its value. We’ll keep closely monitoring Bitcoin and other digital currencies as they develop and evolve. In the event we think a currency has investment potential, it will first be fully vetted by our derivatives/new securities committee before we invest.

Benefits of Bitcoin

The benefits of Bitcoin stem from its decentralized nature, cryptology, blockchain technology and growing acceptance as an exchange of value.

Decentralized Currency and Inflation

Because there is no central control of the digital currency, there is no central bank policy affecting its circulation. Bitcoin’s founders created a protocol that limits the total number of Bitcoin to a maximum of 21 million. Because of this limit, there is no possibility of inflation in the traditional sense—one cannot simply create more of the currency, affecting its overall value, unless the protocol is changed to allow a larger supply.

Cryptology

Bitcoin and other “cryptocurrencies” use cryptology algorithms to both create and exchange coins. Coins are first “mined” when someone uses a computer to solve one of the complex algorithms. While difficult to solve, the answer to the algorithm is easily verifiable by others in the Bitcoin network, much like verifying a jigsaw puzzle was completed correctly. As more coins are mined and exchanged, solving the algorithm gets progressively harder. This helps prevent “double spending” fraud where the same coin is used twice by the same person to buy something.

Blockchain and Transaction Fees

Bitcoin transactions occur directly between two individuals, with a peer-to-peer network of people who solve the exchange algorithms verifying the validity of the coins through an online ledger called blockchain. Blockchain technology records all the coin transactions and allows for nearly instant transactions to occur as users transfer coins from one digital “wallet” directly to another using a private “key” or signature. Since there are no intermediaries—like physical banks—involved, there are virtually no transaction fees and transfers are instant.

Growing Acceptance

Global acceptance and usage of cryptocurrencies has spiked in recent years. Japanese banks have even started exploring the creation of their own cryptocurrency with the aim to have it in place by the 2020 Tokyo Olympics.

In addition, the Chicago Board Options Exchange (CBOE)1 launched Bitcoin futures trading on December 11, 2017 which put into place mechanisms, such as trading halts, designed to curb some of Bitcoin’s notorious volatility. While the price of the Bitcoin futures contract surged wildly, hitting two trading halts within the first couple of hours on the exchange, we think putting the mechanisms in place in an attempt to control volatility was a step in the right direction.

Criticisms of Bitcoin

The predominate criticisms of Bitcoin revolve around its value, volatility, security and regulation.

Value

With no central bank regulating the currency, the value of Bitcoin is not backed by anything but the belief in the algorithm. Valuing Bitcoins and other cryptocurrencies as traditional currencies isn’t possible; there isn’t an underlying economy to assess supply/demand for its goods and services, or fundamentally drive inflation. Bitcoin cannot be a store of value, and thus is not yet generally accepted as a form of payment at grocery stores, gas stations, restaurants, etc. Therefore, demand for digital currency appears to be driven more by speculation than by actual use as a mode of commerce. Because of this, many have argued we are experiencing a classic bubble trajectory.

Volatility

It’s not unusual to experience extreme volatility in Bitcoin prices. Since 2013, Bitcoin has experienced at least six major price drops ranging from -22% to -71% of the peak value. 2 3 These swings were associated with some of Bitcoin’s major vulnerabilities, including hackers attacking popular exchanges, government regulation, and speculation.

Security

Bitcoin is not considered hackable, but the places where they are stored—such as computers and phones—are vulnerable to hacks. Bitcoins can also be simply lost; if the wallet containing the code and keys to use the bitcoins are located on a drive that crashes or is thrown away, the owner will no longer be able to access them. It’s equivalent to leaving cash in a burning house, but without the chance of insurance or the ability for a central bank to print more for circulation.

Regulation

As we’ve seen in the first weeks of 2018, Bitcoin and other cryptocurrencies are also very sensitive to external impacts like government regulation. China is home to the world’s largest Bitcoin mining operation, and South Korea is home to one of the largest markets for cryptocurrencies. But both countries have announced intentions to potentially ban trading of the currencies in their countries.4 The U.S. Senate’s financial services panel will also consider the effect digital currencies may have on the economy in a hearing next month.3 Each announcement has only added to the volatility of cryptocurrency prices.

Have a Plan

Before investing in anything, we believe investors should understand the fundamental, bottom-up value of an asset, regardless of media hype. An investment should work to help you achieve your goals given your comfort level with risk. As with any speculative investment, please remember there are no guarantees of performance. Having a plan in place to reach your financial goals—and sticking to it—is the best defense against getting caught up in the hype of a “hot stock” that may or may not help get to where you want to go.

Have questions about Bitcoin? Give us a call at 1-800-345-2021

1 The Chicago Board Options Exchange (CBOE) is an exchange for trading securities, indexes, and financial products.

2 http://fortune.com/2017/09/18/bitcoin-crash-history/

3 https://www.reuters.com/article/usa-senate-bitcoin/u-s-senate-panel-to-discuss-bitcoin-with-markets-regulators-source-idUSKBN1F001H

4 https://www.reuters.com/article/uk-markets-bitcoin/bitcoin-skids-on-news-south-korea-prepares-to-ban-cryptocurrency-trade-idUSKBN1F00CM

The opinions expressed are those of Matt Oldroyd and are no guarantee of the future performance of any American Century Investments fund.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.