Swedroe: Bitcoin & Its Risks

December 04, 2017

As the director of research at Buckingham Strategic Wealth and The BAM Alliance, it’s not surprising that I’ve been getting lots of calls lately about investing in bitcoin. Just seven years ago, bitcoins were trading at about 10 cents. Four years ago, their value had jumped to about $125. About a year ago, their value had reached about $600.

On Wednesday, Nov. 29, 2017, their price had risen to more than $11,150. Then, by the following morning, it had fallen to about $9,100, a drop of almost 20% in less than 24 hours. By that evening, they were again trading at about $10,000.

Prices continued to climb, north of $10,500, early Friday, possibly on news that a new bitcoin futures contract received regulatory approval. Nothing attracts the attention of the public like the possibility of missing out on the latest craze. Regret aversion is a powerful emotion.

What Are Bitcoins?

Bitcoin is a worldwide cryptocurrency and digital payment system called the first decentralized digital currency — there is no central repository or single administrator.

It was invented by an unknown person or group of people under the name Satoshi Nakamoto, and released as open-source software in 2009. Bitcoins are created as a reward for a process known as mining.

There are no physical bitcoins, only balances kept on a publicly distributed ledger. The system is peer-to-peer, and transactions take place between users directly, without an intermediary. These transactions are verified by network nodes and, like balances, are recorded in a publicly distributed ledger called a blockchain.

It’s important to understand they are not issued or backed by any banks or governments. However, while they are not “legal tender” (they don’t have the approval of the U.S. government), there is currently a limited ability for bitcoins to be exchanged for other currencies, products and services. Bitcoins can also be traded, and the pending introduction of a futures contract in bitcoins has helped attract even more attention.

Risks Of Investing In Bitcoin

Because their value is not guaranteed by a government, their digital nature means the purchase and use of bitcoins carries severe inherent risks. That is why many investor alerts have been issued by the Securities and Exchange Commission, the Financial Industry Regulatory Authority, the Consumer Financial Protection Bureau and other agencies.

Regulatory Risk: Bitcoins are a rival to government currency, and may be used for black market transactions, money laundering, illegal activities or tax evasion. As a result, it also seems likely that governments may seek to regulate, restrict or even ban the use and sale of bitcoins, and some already have. Others are coming up with various rules.

For example, in 2015, the New York State Department of Financial Services finalized regulations that would require companies dealing with the purchase, sale, transfer or storage of bitcoins to record the identity of customers, have a compliance officer and maintain capital reserves. Transactions worth $10,000 or more will have to be recorded and reported. Such concerns should raise questions over bitcoin’s future in terms of liquidity and longevity.

Security Risk: Many enthusiasts celebrate the decentralized properties of bitcoin; however, this feature also brings with it a great challenge for novice purchasers. The challenge is in securing or protecting your “coins.” When you exchange dollars for bitcoins, you are leaving behind many financial protections and taking responsibility for the security of your bitcoins into your own hands. While there are steps you can take to help secure your coins, should you misstep and get your coins stolen or lost, there is nobody to call to get them back.

After buying bitcoins on an exchange, such as Coinbase, purchasers have several choices regarding where to store them. Many choose to leave them in a bitcoin wallet offered by the exchange. However, by doing so, purchasers assume a large degree of security risk, because exchanges generally retain control over the private keys associated with bitcoins. Given that exchanges store and have control over thousands of bitcoins, they are prime targets for hackers. One especially notorious hacking incident took place in 2014, when Mt. Gox, a bitcoin exchange in Japan, was forced to close down after millions of dollars of bitcoins were stolen.

If a hacker gains access and steals a bitcoin owner’s private encryption keys, the hacker could transfer the bitcoins to another wallet and take control of them. It is generally wise for purchasers to immediately move bitcoins away from the exchange on which they were purchased to some other type of wallet, where you can actually control the private keys associated with the bitcoins purchased. This can be done through a web-based wallet, a hardware wallet (which is similar to a thumb drive) or even by choosing to use a paper wallet (printing out the bitcoin private keys and addresses, and not keeping them on a computer or hardware at all). However, all of these options have their own associated benefits and risks to be weighed.

 

 

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