HISTORY IS FULL of fringe investments that make headlines after rapid—and often inexplicable and indefensible—price increases. Bitcoin is one of the latest examples, leaving even casual observers asking, “What is it and should I buy some?”
First traded in 2009, bitcoin is the best-known cryptocurrency. Thousands of others have been introduced, but many have since died. That’s one problem with trying to pick the right digital currency to purchase: There are low barriers to entry. All it takes is a computer and the necessary skills to create a better digital currency. If their latest attempt doesn’t take off, entrepreneurs can always try again.
While economy-wide acceptance of bitcoin remains elusive, we may have seen a turning point with the recent announcements by PayPal that it would process bitcoin transactions, and by Tesla that it had stashed $1.5 billion of corporate cash in bitcoin and would start accepting them as payment for cars. Still, for now, using bitcoin as a digital currency—rather than just as a speculators’ plaything—faces three key challenges.
1. Unstable value. Bitcoin’s value routinely changes daily by 1% to 3%, and the change over a month or year can be staggering. By comparison, the exchange rate between the U.S. dollar and the euro has an average daily change of less than 1% and a monthly change of less than 3%.
Bitcoin also has a history of jaw-dropping declines. For instance, after hitting a high of $1,150 in November 2013, the price of one bitcoin dropped to $500 by mid-December and didn’t recover for four years. It touched $19,000 in late 2017, only to drop 83% to $3,200 a year later. As of yesterday, it stood at $48,000.
People don’t want investments or debts denominated in a currency where price swings are that dramatic, though speculators might. If I purchase one bitcoin for $20,000 and it doubles to $40,000, I may feel good for a moment. But if the value of my bitcoin drops to $5,000 instead, the items I hoped to purchase with that currency now cost a whole lot more.
2. Slow processing speed. To protect the security of the blockchain technology that makes digital currency so secure, processing is slow. As a result, there are practical limits on the number of daily transactions. That can cause even simple transactions to take days. The blockchain network processes about seven transactions per second. As users increase, so too will wait times. By comparison, one large credit card company processes close to 150 million transactions per day, or about 1,700 per second, with more capacity available. The slow processing speed of digital currency transactions is a significant roadblock to widespread use.
3. High transaction fees. These fees weren’t part of the original system. As bitcoin has grown over the past decade, users must wait longer for their transactions to be added to the blockchain. Transaction fees were introduced as an incentive mechanism to allow users to move to the head of the line. While this may benefit a lucky few, it does nothing to address the problem of processing speed and the massive amount of power required for blockchain transactions generally. Furthermore, while the fees may help prioritize some deals over others, the costs alone could make most transactions impractical.
Because of the above drawbacks, very few owners of bitcoin use it as currency. Rather, they’re using them to speculate that the price of a non-income producing asset will continue to rise. They may also hold them to shield transactions from others, notably government authorities.
There are fewer doubts about whether digital currencies will one day play a much larger role in economic activity. Rather, it’s a question of when. Even central banks are paying attention. According to a survey by the Bank for International Settlements, 10% of all central banks expect to issue their own digital currencies within the next three years. Even the Federal Reserve is studying the idea.
Bitcoin may eventually gain traction in ways that match its original vision, that of a global currency independent of interference by banks or government. For now, however, bitcoin is less a currency than simply an asset whose price has been bid up—one with an unstable value that produces no income. My advice: If you insist on buying bitcoin or any other digital currency, do so only with money you can afford to lose.
Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn.