Bitcoin is hot again: What's different this time?

Disclaimer: Please do your own research! This opinion piece is solely for educational purposes and should not be taken as investment advice. I am not a financial advisor nor am I holding myself out to be. Bitcoin is a highly volatile asset and the price may drop drastically within a few minutes.

You might have seen the headline: Bitcoin has broken past the 20,000USD level. So, what is different this time compared to 2017 when the cryptocurrency was just shy of the level before it lost 80% of its value?

1. Differences in this year’s rally versus 2017’s

2. Some limitations of bitcoin / blockchain

3. Risks of owning bitcoin

4. An introduction to the technical aspect of blockchain and bitcoin

5. Conclusion

1. Differences in this year’s rally versus 2017’s

The inflow of institutional versus retail money.

This chart represents the number of Google searches for ‘bitcoin’ since 2004. Interest peaked in December 2017, which is close to the previous all time high. Compared to the interest peak in 2017, it is still relatively low now. Retail investors don’t seem to be as involved in this year’s rally, compared to the speculative frenzy of 2017.

Source: Google Trends

Square invests $50 million in bitcoin: Fintech leading company Square has purchased approximately 4709 bitcoins to constitute roughly 1% of Square’s assets at the end of the second quarter of 2020. Square’s Chief Financial Officer, Amrita Ahuja mentioned that: “We believe that bitcoin has the potential to be a more ubiquitous currency in the future”. Square also has a platform for bitcoin trading via the Cash App, which is a peer-to-peer payment service, and has an independent team working on cryptocurrency innovation. This is seen largely as a push by Jack Dorsey, CEO of Square and Twitter, and big-time believer of crypto.

Paypal to allow Bitcoin and crypto spending: Paypal, another fintech firm, a payment processor company, has recently announced that they will allow users to buy, sell and hold cryptocurrencies on their platform (it’s not available in Singapore yet). They have also announced plans to allow users to pay merchants in cryptocurrencies (a catch is that Paypal will still transfer the cryptocurrencies to fiat currencies like USD to pay the merchants). Paypal has roughly 360 million users as of 3Q 2020 and has approximately 28 million merchants, which is one of the largest merchant networks in the world. With such a wide user base, it will bring crypto to the masses. In fact, when this announcement was made, Bitcoin’s price jumped by 8% on that trading day. Paypal has said that they are aiming to “increase consumer understanding and adoption of cryptocurrency”

Visa to offer credit card that rewards purchases in Bitcoin: Visa, one of the largest providers of digital payment services has partnered with cryptocurrency start-up BlockFi to release a credit card that has rewards customers in bitcoin, compared to the traditional cash or airline miles.

Here at home: DBS, who once called Bitcoin a Ponzi scheme in 2017, has announced plans to set up a cryptocurrency exchange. SGX will have a 10% stake in the digital exchange. The exchange will enable trading between 4 fiat currencies: SGD, HKD, JPY, USD and 4 cryptocurrencies: Bitocin, Ether, Bitcoin Cash and XRP. DBS is the first traditional bank in the world to have a crypto exchange. DBS’ branding will give cryptocurrencies more legitimacy, as it is one of Asia’s biggest banks and institutional clients across Asia trust DBS with their money. The fact that MAS approved DBS’ digital exchange can be viewed as an indication that the Singapore government favours the adoption of cryptocurrencies. In fact, earlier this year, the Payment Services Act was introduced which stated that cryptocurrency businesses must comply with regulations. For retail investors, that means a maximum of SGD30k in cryptocurrency transfers annually (you can still use unregulated/overseas exchanges if you’re looking to invest in larger amounts). Unfortunately, the DBS digital exchange is only available to institutional and accredited (elite retail) investors.

Insurance companies in the US are buying bitcoin: MassMutual, a life insurance giant in the US, has invested $100 million in bitcoin. As an insurance company, they are traditionally seen as a conservative investor and only would make investments in tried-and-tested financial products, staying away from volatile investments, to ensure that they are able to pay out their claims. Like DBS, this foray can also be viewed as legitimising the cryptocurrency market. According to a report from JPMorgan, if other insurance companies were to follow suit and simply allocate just 1% of their funds to cryptocurrencies, it would create a $600 billion inflow into the market. To put it into reference, bitcoin has a market capitalisation of $442 billion at the time of writing.

Hedge fund managers including bitcoin in their portfolios: Paul Tudor Jones has 2% of his assets in bitcoin and believes that bitcoin is just getting started as a store of value. Stanley Druckenmiller has called bitcoin better than gold.

Wall Street wants in: S&P Dow Jones, a financial data provider, has announced that it will be launching a cryptocurrency indexing service in 2021. This means that there will be something like the S&P500, but for cryptocurrencies. The index will include more than 550 of the top traded coins, to make it easier for investors to access the new asset class and to reduce the risks of the highly volatile market.

The list can go on, but the gist is most institutional investors are viewing cryptocurrencies as a hedge against fiat currencies, from which they are increasingly losing trust due to record levels of “money printing”. An inflow of institutional money might bring more stability to the price.

Fun fact: There are insufficient bitcoins for every millionaire to own one. Bitcoin’s maximum supply will cap at 21 million, whereas there are roughly 46.8 millionaires.

2. Some limitations of bitcoin / blockchain

Transaction speed: The processing speed for bitcoin transactions is still slow. The blockchain can only 4 transactions per second due to the nature of the blockchain (which I will explain in section 4). On the other hand, Visa can process up to a maximum of 65000 transactions per second. If bitcoin were to be widely used as a currency, it would not be able to handle the amount of transactions that happen on a global scale. As a result of this, when there are large volumes of transacrions occurring, for example during a sell-off, a queue is often formed. To cut this queue, some may choose to pay a higher transaction fees to miners (I've explained the mining porcess in section 4, but miners are essentialy those who verify a series of bitcoin transactions)

Energy requirements: To maintain the bitcoin network, a hefty 64-terawatt hours of energy is required per year. That’s more than the energy requirements of Switzerland. If bitcoin is still in its early stages of adoption, this poses a challenge, as the energy requirements will only increase.

Source: LongHash

Again, the list can go on. Due to these limitations, I believe that bitcoin is currently more a store of value rather than a ‘currency’,

3. Risks of owning bitcoin

No central authority: Most people view this as an advantage, but there are some disadvantages associated with it. The fact that there is no government or bank to rely on, means that if you lose your coins due to a hacking incident, or simply because you forgot your password, they’re gone for good. There is no way to retrieve the coins due to the nature of the blockchain. This is unlike fiat currency, whereby if you lose money, you can still report it to the police, or call your bank to reverse an accidental transaction etc. Another problem with the lack of central authority is that whenever there is a disagreement within the community on how to deal with problems related to the blockchain, there will be a new version of the currency created. This is called forking. It led to the creation of bitcoin cash, another popular cryptocurrency. The details of it are rather technical, so I will not delve into it.

Potential regulations: With greater adoption, governments will step in. Some will say that governments are stepping in to save fiat currencies from losing their value, or to create greater financial surveillance as cryptocurrencies provide anonymity, but I believe it is more to prevent “underground” transactions. XRP’s (another popular cryptocurrency) price just dropped by 25% after the Securities and Exchange commission filed a lawsuit against Ripple (major owner of XRP). The allegations were that the firm brought in $1.3 billion in an “unregistered securities sale”. Regulators want the currency to be flagged as a “security” which will bring along much scrutiny with it, just like how public companies must comply with many regulations.

4. An introduction to the technical aspect of blockchain and bitcoin

This section is rather technical and not finance related (it may be a long read), but it is important to have some basic understanding of how the technology behind bitcoin works, like how it is important to have knowledge about the stock market in general when investing in stocks.

TLDR: The blockchain is a distributed (i.e. across many computers across the world) ledger (database of transactions) which possesses characteristics that make it extremely difficult to hack. Bitcoin was the first cryptocurrency to blockchain as the undergirding technology. A simple analogy would be Google documents, whereby everybody has access to the exact same document and can edit it. Obviously, this is an oversimplification, and there are many more steps involved in assuring that there is no fraud. There is no central authority in charge of the currency, and no third parties like banks to verify transactions, and instead, verifications are done via various algorithms.

If you’re interested to find out more details, read on, else you can skip straight to the conclusion. For those who are a little more technically inclined, I must apologise if I have not done justice to the technical concepts and complexity that goes into the blockchain, and for those who are not as technically inclined: I also apologise if I have not simplified these concepts enough.

As the name suggests, blockchain is simply a chain of blocks (something like a linked list for the technical personnel). The blocks are basically data that contain information about transactions (the block contains more than just transaction data, I will elaborate in the mining section), i.e. the exchange of ownership of coins between various parties. So how are transactions verified?

Hash function:

Source: Wikipedia

As seen in the picture, the yellow box is like a ‘transformer’. With an input, it will output a fixed length message “digest”. With a small change in the message, the output is extremely different. This makes the hash function seemingly random. It is also impossible to reverse the function, i.e. with the digest only, you will not be able to get the input message.

Imagine this: You and your friends have agreed to set up a distributed ledger for paying each other. Anyone can go in and add a transaction, e.g. Friend1 pays Friend2 $100. To ensure that nobody can create a false transaction to benefit themselves, e.g. Friend2 adding the transaction “Friend1 pays Friend2 $100” without Friend1 verifying, transactions must be verified with digital signatures. Here’s how it works: Imagine All of you have a public/private key combination. As the name suggests, your private key is only available to you and your public key is visible to everyone else. Friend1 will hash their transaction data (pass it into the yellow box), then encrypt the hash with their private key, which will form the signature. The transaction data along with the signature is sent to everybody else. Everybody else will hash the transaction data again and decrypt the signature with Friend 1’s public key which will return the original digest (pink box) created by Friend 1. If the two digests are equal, it proves that Friend 1 indeed did verify the transaction. Here’s a picture to explain it:

Source: Docusign

In fact, there is no “cash” or “currency” stored. It is simply the history of transactions which is the “currency” of bitcoin.

Earlier I mentioned that the blockchain is distributed, i.e. everybody has a copy of it. Now, how do we verify that everybody is indeed recording the transactions that an individual is broadcasting to everyone else? Bitcoin uses something called the proof-of-work. When people broadcast their transactions to the network, there are a bunch of people called bitcoin miners listening for these transactions. The proof-of-work means that the miner that has put in the most CPU power will be adhered to. Then, with a list of transactions, the miners will have to guess a number (called a nonce) that solves a cryptographic puzzle. The puzzle is; the hash of the block must begin with a certain number of zeros. The hash contains 256 bits, and a bit is either 0 or 1. So for a hash to begin with x zeros, the miners must guess 2^x hashes. The nonce is incrementally increased until the hash is correct (begins with x zeros). Below is a GIF to illustrate for the x = 4 case:

When the nonce is changed from 1 to 2, the first 4 digits of the hash change from 0100 to 0000, which means the number is 2 for the puzzle to be solved. Once a miner solves the nonce, everybody will have to add the block to their personal ledgers, ensuring that everybody has the same copy of the history of transactions. As a reward for solving the puzzle, the miner is rewarded 6.25 BTC (roughly 194k SGD at the time of writing)

Just like when transactions are valid only with a digital signature, blocks are only valid with a valid proof of work. This proof-of-work mechanism makes the blockchain extremely difficult to hack.

Remember I mentioned that the blockchain is a chain of blocks, what this means is that every block has a reference to the previous block’s hash. So, for a hacker to manipulate any data, they would have to redo the proof of work for the block he has modified and all subsequent blocks, which is computationally infeasible. It also means the more the blockchain is used, the more secure it is as more blocks are added. To illustrate, it takes roughly 10 mins to guess the correct nonce for just one block. So if you're hoping to mine some bitcoins, chances are you won't be successful as miners have dedicated facilities and hardware to get the job done.

Source: Towards data science

5. Conclusion

Thank you if you’ve read thus far; obviously, there are many more finer details to the blockchain, but this is the essence of bitcoin or any other cryptocurrency. If you’re interested in having a further conversation, do reach out to me in the comments, as I’m already way above my recommended word limit.

Conclusion: Bitcoin and cryptocurrencies in general are still not widely accepted and investing in them carries an inherent risk. If you do invest in them, I would recommend against allocating a large percentage of your portfolio towards it. If you already have invested in it, I might sound paranoid, but I would reccomend withdrawing your coins from your exchange and holding them elsewhere (unless you're actively trading), as I mentioned earlier, if you lose your coins due to any reason, there is no way to retreive them, so it's better to ensure a certain level of security. There's a saying in the crypto community, not your keys, not your coins. An analogy would be having stocks in your CDP versus a custodian holding them for you. You can get started with a hot wallet (mobile will be safer then desktop), and if you have large amounts, you should get a cold (offline) wallet.

Cover image: CNBC