Bitcoin has been around for more than a decade but most people only vaguely understand what it is. They’re exposed to headlines of meteoric price rises and devastating crashes but know very little of how it works and whether it is actually a good investment. It’s easy to find positive investment advice, and just as easy to find people who have lost substantial assets to its wild fluctuations. So what is bitcoin, and could gold be an effective hedge for it?
What is Bitcoin?
Bitcoin is a cryptocurrency. This means it exists entirely digitally and is not a fiat currency issued by a government like the dollar, sterling, euro or yen.
The key differentiating factor between bitcoin and fiat currencies is that bitcoin does not rely on a central bank or single administrator managing or overseeing the currency. Instead, it uses complex algorithms to create a decentralised digital ledger system that holds all the transactional information about the currency within it. This ‘democratisation’ of currency was bitcoin’s central ethos when it was developed by an anonymous person or group in 2008.
How does Bitcoin work?
Bitcoin transactions are recorded digitally in consecutive blocks of data which form a chain of information called a blockchain. It is this chain format that provides the cryptocurrency with its level of security. Because the chain is always visible to anyone who wants to scrutinise it, it is very difficult for someone to amend the chain illegally by stealing coins or spending them twice.
At any given time there are thousands of ‘nodes’ or computers that are working for bitcoin, managing the chain. Defrauding the blockchain would require over 51% of these nodes all working together, something that is very difficult.
Where do Bitcoins come from?
Bitcoins are created through a process called bitcoin mining. This involves an army of high-powered computers (nodes) working on a complex maths problem, the conclusion of which is an additional chain being added to the block and the transactions in that block of data being verified. Miners are paid in newly-created bitcoin which encourages more people to mine, more nodes to be created, and the security of the blockchain to strengthen.
A single person with a specialised computer would be able to mine for Bitcoin but the cost of electricity to run the computer can be prohibitive. It may take a year or more to actually receive any bitcoin reward. Its come a long way from the early days of mining when the nodes were widely distributed amongst home-grown miners with spare computer power capacity. These days most of the processing power is concentrated in the hands of industrial companies, especially in China.
According to Cambridge University analysts, bitcoin mining uses more electricity than the entire country of Argentina. There are a few Bitcoin miners listed on the stock market. Riot Blockchain in the US have seen their value rise substantially on the back of the current price surge.
Bitcoin volatility
The most visible accounts of Bitcoin are the headlines that recount the wild swings in value. If it isn’t rising 300% it’s falling 800%. In 2017, the value of Bitcoin flew up from less than $1,000 to almost $19,000 by December. It then fell precipitately in the first two months of 2018 to $8,000 and continued to slide to around $3,000 by the year-end.
Last year saw a similarly extreme performance. The cryptocurrency has been making steady progress since the start of the pandemic. In December, it went on another major surge, climbing from below $19,000 to a peak of $38,000 in January, before sliding 10% in just two days later that same month.
This exceptional volatility is both persuasive and dissuasive for investors. The highs are high but the lows are also low, and there seems very little rationale for either movement. Cryptocurrency has only been in circulation for a decade, and the value has been extremely volatile in that time. It is therefore difficult to know where the price of bitcoin will settle if it ever does.
What’s in your Bitcoin wallet?
The security of bitcoin has been a point of contention for many potential investors. The design of the blockchain technology itself is, by its very nature, extremely secure. The cryptographically secure data is distributed across many nodes, over half of which would need to be hacked to game the system. The concentration of mining capacity in the hands of a few major consortia impacts on the ‘distributed’ part of the blockchain. This could technically make it susceptible to a 51% attack (although this possibility remains very remote).
So, while in general the technology is not seen as easily susceptible to fraud or theft, there are several points in the bitcoin process that can be vulnerable. When coins are traded on an exchange the exchange itself can be hacked (the Mt Gox exchange hack of 2014 was the largest theft of bitcoin in its history). The other weak point in the bitcoin system is the digital wallet, which is itself only as secure as the key or password protecting it.
The value of bitcoin today will no doubt make it increasingly attractive to hackers, and inexperienced traders with low-security priorities are easy pickings.
Exchanges create another potential obstacle to getting rich quickly. To cash in or out of the cryptocurrency, you have to buy or sell on a bitcoin exchange. The frenzy when the currency is on its way up or down can create technical issues which can impact the ability to trade when it’s most important.
The best way to invest in cryptocurrencies?
Bitcoin’s meteoric rise in recent months was given a high-profile boost when Tesla owner Elon Musk bought $1.5 billion of the digital currency in January. Tesla has said it expects to start accepting bitcoin as payment in the future.
There’s no doubt the cryptocurrency is gaining mainstream supporters, which will go some way to underpinning its value, but it is definitely a case of buyer beware. The most important consideration when deciding whether to invest in bitcoin is the level of risk you’re willing to take because Bitcoin is a very high-risk type of investment.
Buying Gold vs Bitcoin
In order to balance out some of that risk, investing money in gold, which inspires far less volatility and has maintained its value for centuries could be a useful counterpoint in your portfolio. Physical Gold is everything bitcoin isn’t. It’s a physical gold coin or gold bar that cannot be lost in the digital ether.
Gold has retained its value throughout the centuries, fluctuating with the changes in global economic fortunes but ultimately providing its owners with a liquid asset of comparable value. In certain forms, it’s tax-free. And it is a safe haven in times of uncertainty, rising when the going gets tough and providing a useful hedge against other asset pitfalls. For investors interested in a risky cryptocurrency asset, consider a gold hedge around the digital garden.
