A Few Things to Consider Before Investing in Bitcoin

Wednesday, Aug 18, 2021

Bitcoin and other forms of cryptocurrency used to be regarded as an investment for day traders only. Today, it is gaining interest, creating many questions for investors. Some investors look to Bitcoin as a way to protect their portfolio from inflation and currency debasement. The uniqueness of the investment provides an opportunity for growth and maintains a low correlation to other forms of investments.

How Bitcoin Works

Bitcoin isn’t the shiny photos of coins that represent it on the internet or in the image above. Bitcoin is a software, with a set of processes. It is a form of cryptography, or the science of making and breaking code. Bitcoin runs on a cryptography protocol known as blockchain. Blockchain is literally a chain of blocks of information, arranged in chronological order. This information can include contracts, emails, titles to property, bonds, marriage certificates, and more. Any type of written agreement can be established on a blockchain. When this happens, a third party no longer needs to be involved in the agreement. In the case of Bitcoin, the information stored in their blockchain is mainly from transactions.

It is best to think of Bitcoin as a list:

  • John sent a Bitcoin to Jane
  • Jane sent two Bitcoins to Susan
  • Susan sent ½ Bitcoin to Robert

By tallying up every transaction, you can track where each individual user of Bitcoin stands in the network. These transactions also don’t have to be between individuals. It can be used by AI, software, businesses, and various forms of technology.

Bitcoin has value because upon its creation, its creator set a cap on how many tokens can be in circulation. This creates scarcity, giving it value. Bitcoin is also divisible up to 8 decimal points, similar to the dollar which is divisible by 2. This means that someone does not have to own a complete Bitcoin in order to be a user in the Bitcoin network.

Bitcoin Value

To some investors, Bitcoin is seen as a hedge against inflation. That is because there is a finite amount of tokens. The government cannot create more as it can with currency. Bitcoin is not the only investment to provide some relief from rising inflation. Real estate and other physical assets may have the same effect, along with private equity and technology stocks. Gold also retains its worth as inflation rises, hence why Bitcoin has been granted the nickname “digital gold” as both assets can be divided, are not government regulated, are portable and transferable, and are able to be verified. There is also a finite amount of gold, just as there are Bitcoin tokens.

The recent crash in Bitcoin prices was not the first of its kind. The upward slope followed by a crash pattern has happened before. The Economic Times show that Bitcoin nearly reached $20,000 in 2017 before crashing to $3,300 just a year later. This time around, however, more solutions exist. Now, firms such as Fidelity offer cryptocurrency custody solutions, or independent security and storage systems meant to hold a large quantity of Bitcoin tokens. The interest of major investment companies such as this helps hold the value of Bitcoin steady, making it an appealing investment for even more companies. In July of 2020, the Office of the Comptroller of the Currency permitted national banks to process bitcoin transactions and provide cryptocurrency custody solutions.

Tax Implications

Currently, the IRS recognizes forms of cryptocurrency as property. This means that Bitcoin is taxed with typical capital gains. Crypto futures contracts are treated as futures and are taxed as ordinary income. The IRS has deemed it mandatory to report all Bitcoin transactions, even if only a small value. When investing in Bitcoin, it is required that the investor record all buying, selling, investing, and other usage of their Bitcoin assets. As with other tax reporting, incorrect reporting of Bitcoin usage can result in penalties and even prosecution. Investors considering Bitcoin should consult with a licensed tax professional before investing in Bitcoin.

The following types of Bitcoin transactions are taxable:

  • Personally mined Bitcoins sold to a third party
  • Previously purchased Bitcoins sold to a third party
  • Purchasing goods or services with personally mined Bitcoins
  • Purchasing goods or services with previously purchased Bitcoins

If you sell a Bitcoin for more than it was worth when you purchased it, you must pay taxes on the capital gains. If you buy goods or services for a value higher than the value of Bitcoin when you purchased the tokens, you must pay capital gains as well. It is a similar situation if you mined the Bitcoin yourself. The initial value is the fair market value when you mined the Bitcoin. If you sell it or purchase something of higher value, you must pay capital gains. If you are paid for your own goods and services with Bitcoin, it is taxed as ordinary income. Bitcoin donations are tax deductible, similar to cash donations.

A Bitcoin Bull Market

Bitcoin continues to follow a boom-and-bust cycle. Each cycle has reached a different peak. According to The Ascent, before this year, Bitcoin hit peaks in 2010, 2013, and 2017. During each of these peaks, the value of Bitcoin would rise dramatically, then fall by almost 66% in the next year. This pattern follows the Bitcoin halving events, in which the value of mining Bitcoin is cut in half. Starting at 50, the value of Bitcoin has halved in 2012, 2016, and again in 2020, where the value was left at 6.25 according to Investopedia. With typical investments, this would pose a concern, but Bitcoin investors look to the predictability of the halving events as a positive rather than a negative. The predicted supply growth results in more transparency for Bitcoin investors, which with the number of Bitcoin investors, means the demand for Bitcoin will continue to drive up the value.

The reason more people are buying into Bitcoin is mostly based on how useful Bitcoin has become as a payment method. Due to the global nature of Bitcoin, it can be seen as a more efficient method of payment for foreign purchases as the currency does not have to be converted. The belief is that the more widely Bitcoin is accepted as a payment method, the more participation in Bitcoin will grow.

While Bitcoin is growing as a network of payment, it is also growing as an investment. Its returns have been promising compared to other investments, making it a good portfolio diversifier for the long term. Bitcoin is typically not highly correlated with other forms of investments. As the network of Bitcoin investors continues to grow, so will the security around Bitcoin.

A Bitcoin Bear Market

The biggest risk that Bitcoin brings as an investment is its incredibly high volatility patterns. It is five times as volatile as gold, four times that of the S&P 500, and nearly 9 times that of the S&P Real Assets index over six years, according to Bloomberg.

To say whether or not Bitcoin is a good investment depends on the situation of the investor. While the widespread adoption of Bitcoin could reduce volatility to some degree, there is a possibility that end-of-period rebalancing could force investors to sell and actually increase Bitcoin’s volatility.

Another issue Bitcoin is facing is its leadership as a cryptocurrency. While it is the most popular of the cryptocurrency options, its market share has dropped from 70% of the cryptocurrency pie to 46% according to Bloomberg. Other forms of crypto have surpassed Bitcoin in the area of growth including Ethereum, Dogecoin, and Ripple. These other forms of cryptocurrency have a higher usage rate compared to Bitcoin, and not as many limitations. Bitcoin may no longer see itself as the leader of the cryptocurrency options if this continues.

Bitcoin faces another form of competitive risk with the new promise of Central Bank Digital Currencies (CBDCs). While cryptocurrency is rising as a challenger against traditional forms of currency, regulatory risks are still a threat. CBDCs have a similar technology to Bitcoin and other forms of cryptocurrency, however, they are backed by governments and other forms of regulatory agencies, which is forcing adoption. The fact that Bitcoin is not government regulated does offer it a leg up, as well as the fact that it is a global currency while the CBDCs are currently only spread across individual nations. As Bitcoin becomes more widely accepted, this risk will decrease.

There are other risks for Bitcoin as well. Some countries have threatened to ban cryptocurrencies completely. There is also the risk of hacking, although this is generally targeted at individuals or service providers with weakened security. Hacking the entire Bitcoin network would mean taking control of over half of the Bitcoin mining power. Bitcoin’s network is fairly decentralized, although it is estimated that over half of their mining takes place in China. This does create risk as it is highly concentrated in one area.

Bitcoin has also been criticized for wrongful use. All of Bitcoin’s transactions are recorded and held permanently, meaning that all Bitcoin transactions can be tracked. The FBI has tracked Bitcoin users making illicit purchases. There is no assurance that Bitcoin will not be used for illicit and illegal reasons.

Lastly, Bitcoin mining requires a significant amount of energy. In fact, it is estimated that the amount of energy used to mine Bitcoin thus far is more than the total consumption of energy in all of Argentina! As the value of Bitcoin goes up, more miners are incentivized to enter the Bitcoin network. As more miners enter, the complexity of mining grows as well, due to Bitcoin’s algorithm. Every time the complexity increases, so does the energy it takes to mine. This could have a massive environmental impact. That being said, it is difficult to say whether the majority of Bitcoin mining is using clean, renewable energy or not.

Bitcoin has certainly held the attention of investors in the past few years. Its high returns and low correlation with other investments make it a good portfolio diversifier. However, it does also present a series of risks, which means buying into Bitcoin needs to be an educated decision.

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