Bitcoin buyers: Proceed with extreme caution

Bitcoin buyers: Proceed with extreme caution
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"Oh man, I wish I had bought some Bitcoins last year. I would be a millionaire now!"

I've heard this many times this year from friends, business contacts and students, especially last week when Bitcoin prices topped $10,000.

Google searches on Bitcoin-related terms went up 1000 percent in the last six months, and Coinbase, the leading Bitcoin exchange in the U.S., added 300,000 new users in the last week alone and now have more accounts than Charles Schwab.

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What's scary is that many of these eager, prospective Bitcoin traders have no clue what they are getting into, nor do they understand how Bitcoin works and its unique risks. So I think it would be helpful to provide some information on what the technology is, what the investors are and aren't betting on and where we might go from here.

 

The technology behind Bitcoin is called blockchain. It's fairly innovative and versatile, with many applications in and out of finance.

Essentially, blockchain is a family of decentralized record-keeping systems that allow different parties to share the knowledge of ownership and transfer of assets — from physical goods and services to intangible capital to digital tokens such as Bitcoin — in a timely and tamper-proof fashion, thereby facilitating trust in transactions without the need for expensive third-party intermediaries such as banks and notaries.

Three features help make this happen: First, a unique data storage structure that "chain" each new group of transactions to the previous group, thereby preventing tampering and corruption of past data; second, a versatile family of "consensus algorithms" that allow peers to verify upcoming transactions and kick out inconsistent ones and finally, robust encryption protocols that provide authentication and flexible identity management.

Consequently, many industries from logistics to compliance to health care are adopting the technology as a solution to cut out the middlemen, automate contract execution and prevent fraud. It has potential to significantly reduce intermediation costs in our society.

However, investors are not rushing into Bitcoin because they are banking on the bright future of blockchain technology. Although many people equate one with the other, blockchain is not just Bitcoin. Rather, Bitcoin is one specific implementation of the blockchain. Think of blockchain as a programming language, and Bitcoin as one specific app built from that language.

First, Bitcoin is a public and anonymous version of blockchain. Anyone can participate and see the history of all transactions, but all identities are masked in the form of encrypted Bitcoin addresses, which are often used once then discarded.

Second, how do you incentivize peers in a public system to verify others' transactions? Bitcoin utilizes a consensus mechanism called proof-of-work, also known as mining. Peers compete to verify the next group of transactions by solving an increasingly difficult cryptographic puzzle, and the winner receives some Bitcoin on a sliding scale over time to compensate for its effort.

This is how new Bitcoins are "created." Most of this is now done by huge mining pools, created by individual miners banded together or centralized "factories" of thousands of computers located near a cheap power source.

This suggests that Bitcoin is not as decentralized and "democratic" as most people think, and investors are not obviously betting on these features. The recent failed Segwit2x drama in Bitcoin (think of it as a software update) should really remind people of the power concentration in the "community."

Despite the promise of decentralization, a few developers who write the Bitcoin protocormous power in shaping its future. Compared to equity investing, where shareholders get to vote on corporate matters, Bitcoin investors really have no say on how it's "run": All the power is concentrated among a few large mining pools and exchanges.

On the business side, investors are not betting on Bitcoin becoming a fiat money replacement or even a mainstream medium of exchange either. There are few places where you can actually buy stuff with Bitcoins, and that number is going down.

A recent report by Morgan Stanley showed that only three out of 500 top online merchants let customers pay with Bitcoins, down from five last year. In fact, why would any Bitcoin owner want to pay it out when its prices are skyrocketing by the minute?

From the merchants' perspective, the extreme volatility of Bitcoin makes it a poor working capital solution and an accounting nightmare. This seems to defeat Bitcoin's original promise as a means of cashless transaction.

In addition, the design of the Bitcoin blockchain — transactions are grouped into 10-minute "blocks" of a fixed storage size — limits its payment processing capacity.

At its theoretical peak level, the current Bitcoin can process about seven transactions per second, compared to the 56,000 per-second capacity of Visa.

So what are investors betting on, then? Speculative psychology. The main reason to buy Bitcoin seems to be the hope that, somewhere down the road exists some poor schmuck willing to buy it for more money.

Bitcoin therefore becomes the perfect speculative commodity, with a value that is based not on fundamentals or cash flows, but on future realizations of investor sentiment.

Massive price spikes form because of investor hysteria that feeds upon itself, but spectacular crashes are also possible, and indeed happened many times, when some unexpected, even seemingly minute, shock hits the marketplace.

One should recognize the dangers of trying to "beat the crowd" by forecasting the sentiment of Bitcoin investors. Because of the anonymous nature of Bitcoin, we don't even know who is trading them to begin with. How much of the trading is done by institutional investors, retail investors or bots?

Bitcoin exchanges are unregulated cash markets and have absolutely no disclosure requirements. It is by nature a very different type of trading from most asset classes, and one should be cautious applying the market analysis —fundamental or technical — that is invented for other, more regulated markets.

Nevertheless, there are a couple of episodes in history that we can draw parallel to. Investors are psychologically drawn to things that they don't understand but that "have potential."

The "tulip mania" in the Netherlands in the 1630s had seen prices of tulips — which, just like Bitcoin, were difficult to find a fair value for — going up 1,000-fold in a year. In 1636, futures markets were created for tulip bulbs, while just last week, Bitcoin futures trading will be launched by CME, CBOE and Cantor Fitzgerald.

In France in the 1700s, shares of the Mississippi Company, which oversaw the swamps of Mississippi, went up 10-fold in a year due to the promise of untold far-flung riches (in Mississippi swamps!) and even poor peasants were jumping on the bandwagon by selling their livestock.

Presently, according to a new survey, the average Bitcoin investor won't sell until prices are near $200,000. Both the previous examples ended in crashes, destroying the newly-minted millionaires as quickly as they made them.

I'm not saying a crash in Bitcoin is coming or how soon it will arrive — no one can predict that. I'm emphasizing that in an unregulated, sentiment-driven market, things can be extremely fickle. Also, regular exchanges have market makers providing liquidity, as well as volatility-curbing safeguards such as circuit breakers.

Bitcoin exchanges have little of that. So, if something triggers a crash, it's easier for everyone to run for the door at the same time, amplifying the effect the initial shock.

Thus, regardless of what you plan to do with Bitcoin-related investments, proceed with caution, have a solid risk management plan in place and do not bet all your portfolio on one investment.

It's easy to be so carried away with the dramatic return figures that one forgets all about the risks, and Bitcoin has so many unique risks that it warrants special vigilance and discipline from the investor.

Andrew Wu is an assistant professor of technology and operations and an assistant professor of finance at the Stephen M. Ross School of Business at the University of Michigan.