When a pseudonymous person/group with the name “Satoshi Nakamoto” created Bitcoin back in 2008, no one would have imagined the advent of an asset class still incomprehensible to many. Like many at that time and even till 2 years ago, considered Bitcoin as fraud as we all have witnessed few altcoin ponzi schemes along the way. But BTC stood out from the rest and commands a 66% market share within crypto industry while Altcoins (name given to crypto currencies other than BTC) like Ethereum, Tether, XRP and more than 200 others control the rest.
Late 2000s have seen the rise of many Wall street (used as a protracted term for developed financial markets) activists. There was a lot of press against deregulation, demonizing capitalism (though there’s no such thing as true capitalism anywhere). Books against established order went onto became bestsellers overnight in the west. Movies and documentaries fed into the minds of “occupy” activists evicted from their homes. We then witnessed this new anonymous person / group launch BTC and more importantly blockchain as a technology. Large institutions at that time discounted this invention and called it a fraud until recently when they finally branded it an asset class.
If one observes the genesis of BTC and blockchain, the underlying asset becomes glaringly evident. The trust deficit in the so called fiat currency which is backed by nothing and gives central banks all the control. The concept of fiat currency issued by centralized institutions is a topic for another discussion, but blockchain as a revolutionary technology needs great attention. One may vilify BTC, but blockchain offers a fool-proof platform for transparency in monetary transactions. For one, it promises to solve the double spending problem by a fool-proof verification mechanism accorded to miners (or bankers — yes if you mine you are a self-appointed banker — explained below), two it avoids currency counterfeiting as once spent, the bitcoin with the same code can’t be duplicated, three the verified data can’t be altered or deleted. The issue of false verification can be fought off through its feature of maximum trust verification which is essentially consensus of all the millions of ledger participants (miners again) on what is to be recorded in the block. What’s more appealing is that each of these blocks (the set of transactions grouped chronologically) carry a time stamp. Unlike a typical monetary authority/central bank, blockchain allows decentralization of data that can be verified by any miner and is present on millions of computers, in essence securing against any loss/theft of data. This democratization of banking system attracted many across the ideological scale. The fight between the authority and masses as an old story has taken a drastic new turn in the last decade due to systemic inequalities in every society, owing to imperfect policy making ecosystem.
Coming back to BTC, its origin as a medium of exchange has been claimed by its founders as only an alternative but not a coup d’état on the world’s central banks. Having said that, BTC as storage of value and an asset class has taken off faster than BTC as a currency. Countries like Venezuela, Zimbabwe where the population has given up on their respective governments, began adopting BTC as a currency even ahead of the other developed countries. Few merchants in countries where BTC has been allowed, began seeing the value and are allowing BTC to replace currencies in order to safeguard businesses.
Back in 2008, when BTC was introduced one could mine (or create a ledger for a transaction) a bitcoin at the comfort of the house on a laptop. Fast forward, as the number of transactions shot up ever since, the computing power necessary to confirm / legitimize a transaction as a banker (miner) has shot up as well with electricity being the chief raw material apart from fixed costs on the equipment necessary to mine and make a profit. To explain more clearly, Bitcoin mining is the process of creating new Bitcoins by verifying the transactions in the Bitcoin network. Today, this is mostly done using purpose-built Bitcoin mining devices which are used to solve a mathematical problem (or hashing). The role of miners is to secure the network and to process every Bitcoin transaction. Miners achieve this by solving a computational problem which allows them to chain together blocks of transactions (hence Bitcoin’s famous “blockchain”). For this service, miners are rewarded with newly-created Bitcoins and transaction fees. The cost of verifying transactions is the capital cost to buy miners, the power consumption of running the hardware, plus operational expenses to keep the overall business running. The more computational power is employed to do the “hashing”, the bigger the share of the total reward that goes to the miner. This process of mining has grown into an industrial scale in the recent past with few governments directly engaging into mining business. Few mining farms in Russia and China use more than a 1GW power to profit out of the Bitcoin creation (taking advantage of their grey legal arena). All in all, today one could acquire a Bitcoin either via direct purchase into their digital wallets from specialized BTC exchanges (in countries where it is allowed) or via mining.
The fear of losing authority is pushing many countries even today to delegitimize BTC or for that matter all the other crypto currencies. Countries like India and many others are worried about the usage of this medium for funding extremism and money laundering. India is slated to introduce a bill around cryptocurrencies and most of them worry that it may ban existing cryptocurrencies and bring in a state sponsored digital alternative.
In the last 10 years alone, BTC gave an annualized return of ~324%. The average price of one bitcoin briefly reached approximately 40,000 U.S. dollars in January 2021. There are in total 21 million Bitcoins of which 18.5mn are already in circulation. It may take more than 100 years to reach 21 million at the current mining difficulty rate when compounded.
BTC despite statements from many market heavy weights like Warren Buffett has given net positive results till date for a long term investor though it has seen its fair share of wild swinging corrections in the shortest span. However, addition of few major institutional investors onto the bandwagon of BTC only adds more credibility. There are close to 63 mn active wallets today. The issue of volatility will be auto-addressed as new investors open wallets and buy bitcoins creating the much needed depth. Moving forward, only large institutions/investors can afford to mine BTC and the rest can participate in the growth story by buying from the open market.
Where does the Bitcoin derive its value from? It’s value lies in its scarcity and its underlying is the distrust on the conventional monetary system. Any comparison with gold at this stage will be ill-timed. Gold as a versatile commodity has much larger volumes and plays on multiple platforms, unlike Bitcoin which is still a starter in a new segment altogether. Any attempts at finding correlation between Bitcoin and Gold is a folly at this stage. BTC is the only asset that has a Sharpe ratio of greater than 1. The Sharpe ratio describes the increased rate of return received for the extra volatility sustained when holding a riskier type of asset relative to a risk free asset (say US T-Bills).
What could be Bitcoin’s role in one’s investment portfolio? As experts opine, anywhere between 5% to 10% of the asset can be a good hold. However, most experts caution regular trading in Bitcoin owing to its very high volatility and lack of sufficient history to time an entry and exit. Irrespective of what governments may or may not feel, BTC is here to stay and people will find ways to legally find access to this asset class.