Swedroe: Bitcoin & Its Risks

December 04, 2017

Insurance Risk: Some investments are insured through the Securities Investor Protection Corp. Bank accounts are insured through the Federal Deposit Insurance Corp. (FDIC) up to a $250,000 per taxpayer ID. While some bitcoin exchanges have FDIC insurance for dollars deposited in an account with the exchange, bitcoins and other cryptocurrencies are not insured by any type of federal or government program.

Fraud Risk: While bitcoin uses private key encryption to verify owners and register transactions, fraudsters and scammers may attempt to sell false bitcoins. For instance, in July 2013, the SEC brought legal action against an operator of a bitcoin-related Ponzi scheme.

Market Risk: Like with any investment, bitcoin values can fluctuate. Indeed, the value of the currency has seen wild swings in price over its short existence. Subject to high-volume buying and selling on exchanges, it has a high sensitivity to “news." The price has fallen as much as 80% in a single day.

Liquidity Risk: While there are times when liquidity is good, and the spread between the bid and the offer can be narrow, with such large daily price swings, the spread between the bid and the offer can also be quite large. And if prices drop sharply, it may not be possible to find a bid even close to the last trade. Trading costs in such illiquid investments should not be ignored.

Taxes

In March 2014, the IRS stated that all virtual currencies, including bitcoins, would be taxed as property rather than currency. Gains or losses from bitcoins held as capital will be realized as capital gains or losses, while bitcoins held as inventory will incur ordinary gains or losses. Also note that bitcoin is ineligible for inclusion in any tax-advantaged retirement accounts.

Investment, Or Speculative Bubble?

I’ll admit I’m not an expert on bitcoin. That said, I do have almost 50 years of experience in the capital markets, which includes running a foreign exchange trading operation for one of the largest financial institutions in the world, Citicorp. And I’ve witnessed many bubbles over the years across various types of assets.

For example, silver bullion rose from $11 an ounce in September 1979 to $50 an ounce in January 1980. Two months later, the price collapsed to below $11 an ounce. I’ve also seen bubbles in real estate and stocks (e.g., the dot-com bust). Those examples have taught me to be highly skeptical of claims that the next time will be different. And none of the arguments I’ve heard in favor of bitcoin as an investment make sense to me. Let me explain why.

To start, let’s agree that the blockchain technology behind bitcoin is a game-changer, and the technology will play a big role in the future. However, that says nothing about bitcoin or any other cryptocurrency, for many reasons.

First, despite the claims I hear that one of the reasons for buying bitcoin is that there is a limited supply, this just isn’t true. The reality is that there is literally no limit to the amount of similar currencies that could be created. Thus, supply could swamp demand, like printing deutschmarks in 1920s Germany. We already have competitors in the form of Litecoin, Dash, Ethereum, Monero, Ripple and Zcash. And there is nothing to say that, in the future, some way couldn’t be uncovered to create not only more bitcoins than envisioned, but an unlimited supply of them.

Second, in the long run, currencies only have value if governments legitimize them (in the case of bitcoin, Japan has legalized the cryptocurrency). Clearly, regulatory agencies like the IRS could be concerned, as bitcoin likely is being used to engage in illegal activities, such as laundering money and avoiding taxes. The U.S. government could declare it illegal to transact in bitcoins, and the whole thing might collapse. Now, I’m not saying that will happen. But one of the most basic rules of prudent investing is to never treat even the unlikely as impossible, and this certainly is possible.

 

 

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