Since beginning of 2017, the price of bitcoin has increased by 1300% as more and more consumers flock to it hoping to profit off its increasing popularity
With the price of a bitcoin reaching record highs of more than $10,000, more and more ordinary people consider investing in the cryptocurrency. The recent price surge, however, comes with tremendous risks. Investors should be prepared for the possibility that they could lose their entire investment. Bitcoin was launched in 2008 by an anonymous author under the name of Satoshi Nakamoto as a means of transacting without the need for intermediaries. Since the beginning of this year, the price of bitcoin has increased by 1300% as more and more consumers flock to it hoping to profit off its increasing popularity and the associated increase in value.
Cryptocurrencies are not currencies at all. As the Financial Times explains, bitcoin is a string of computer codes which means that new bitcons can be created – up to an agreed limit – by computers that gain the right to do so by solving complex puzzles. Transactions are recorded in a database called a blockchain. Bitcoin, like other assets like gold, doesn’t yield income. You have to sell it to realise any value. And, like gold and other currencies, it can be transferred peer-to-peer.
Part of the nervousness about bitcoin is that, along with other cyptocurrencies, it challenges the traditional role of banks and central banks. In the classical world, banks act as intermediaries by providing loans out of the deposits they took and from funding from the central bank. The central bank uses the rate at which it provides this funding as a lever to ensure price stability. The introduction of cryptocurrencies threatens this model because banks are no longer necessary to intermediate funds and there is no central bank to ensure that prices are stable.
The more immediate fears about bitcoin centre on the recent dramatic rise in its value. There’s nervousness in the market that a flash crash might be imminent after the cryptocurrency tumble by more than $1,300 in minutes on the bitcoin exchange Bitfinex. It did recover to levels above $10,800. The flash crash echoes long standing warnings that the bitcoin party is set to end in tears. Most recently Jamie Dimon, CEO of JPMorgan, one of the world’s largest investment banks declared that he would fire any employee trading bitcoin for being stupid.
In a highly unusual alliance, his words were echoed by economics Nobel Laureate Joseph Stiglitz, who has gone even further arguing that bitcoin: ought to be outlawed.
All of these are clear warning signs that the professionals do not trust the lofty promises of crypto enthusiasts.
There is no doubt that Bitcoin – and in particular blockchain, the technology behind it – has the potential to revolutionise the financial services industry.
A blockchain functions as a transparent and incorruptible digital ledger of economic transactions, recorded in chronological order, that operates on a peer-to-peer network.
Fundamentally, the technology allows exchange of value to occur in an environment of peers with conflicting interests without the need for trusted intermediaries. That, in effect, wipes out the need for banks or financial companies which fulfil this role.
The use of the technology is not limited to financial transactions. Virtually anything of value can be traded on a blockchain. But no matter how useful the underlying blockchain technology is, or how widely it can be applied, there are real and substantial risks involved in bitcoin.
The first, and most significant risk is that compared to any currency, share, or gold, bitcoin is extremely volatile. The volatility of bitcoin to US dollar is almost six times the volatility of the Rand to US dollar. While this is great in good times, it is potentially devastating for investors in bad times.
The third, and possibly biggest risk is regulatory. In September 2017, the Chinese government outlawed bitcoin exchanges in mainland China, sending the price of bitcoin tumbling. Despite the claim that bitcoin is a “global currency”, the reality is that 58% of all bitcoin mining happens in China. If at any point the Chinese government should decide to make Bitcoin mining illegal the price is likely to plunge into oblivion.
Other countries have also voiced concern. The Russian Central Bank recently issued a warning to investors on the risks of investing in cryptocurrencies, citing concerns about a bubble. This suggests that there might be a concerted crackdown.
Cryptocurrencies are banned in India as their use is a violation of foreign exchange rules. The Australian Reserve Bank has taken a different approach. It monitors the cryptocurrency market in a bid understand the underlying technology.
The South African Reserve Bank has expressed its openness to blockchain technologies. But it has also highlighted potential risks to consumers.
There are real risks that many consumers investing in cryptocurrency don’t fully understand. Advertisements promise that bitcoin can make you rich fast. And social media is alive with stories about friends of neighbours or distant cousins who have made a lot of money through bitcoin.
Without a doubt, these cases are real, and those who invested early can reap large benefits. But this is true in every bubble – from the dotcom bubble to the tulip mania. It’s also true in every pyramid scheme.
As always, investors should be extremely wary with any scheme that promises quick returns.
