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BLOG: Beware the Bitcoin bubble

Written by: Adrian Lowcock
Bitcoin is in the headlines again as this week Elon Musk, the founder of Tesla, announced his company had bought $1.5bn. The news sent the price of Bitcoin soaring.

Whenever interest in a particular area seems to start gaining pace, there is a tendency towards herd mentality which means that we’re either chasing to catch up, fuelled by ‘FOMO’ (fear of missing out), or we’re all over the latest fad, feeling rather smug that we caught whichever particular wave was the topic of the day and hoping we ride it for long enough.

Bitcoin, along with other cryptocurrencies, is having its time in the spotlight.

What is Bitcoin?

Bitcoin uses a technology called blockchain. This is a decentralised system, which records all transactions and activity on Bitcoin. As such it means that no one institution, such as a central bank, is responsible for buying, selling or valuing bitcoin. It is decentralised, but it is also thought to be tamper-proof as each block in the chain is linked to its processor.

Bitcoin is the largest and most popular cryptocurrency and tends to get most of the limelight. Others include Ripple or Ethereum but literally thousands exist, and they won’t all necessarily behave in the same manner.

Is Bitcoin a currency?

Supporters of Bitcoin believe it can replace ‘fiat’ currencies, such as the pound or the US dollar, as a currency, hence the term cryptocurrencies. However, Bitcoin faces some major obstacles which, in my view, mean it is some way off being a legitimate currency.

Firstly, the price of Bitcoin is volatile and currencies need to be stable, to accept a currency you need to believe that what it is worth today will be the same tomorrow. That stability is based on the fact that fiat currencies are backed by central banks and governments.

Currencies do fluctuate in price, but they are small changes compared to what we see in cryptocurrencies. Transactions rates and volumes are not fast enough for Bitcoin to work in a wider population and the energy Bitcoin system uses to validate each transaction is huge and growing every transaction.

Is Bitcoin an investment?

Traditional investments are valued based on what income they provide or the growth potential of a business and its future profits. Bitcoin neither yields an income nor does it produce anything. In this sense, it is similar to gold, which also neither produces nor yields anything.

Gold, however, is used in (a little) industry. Whilst its physical existence means it can be admired and appreciated, and is used to make jewellery. It, therefore, has some utility. Gold also has several thousand years of history to back it up, Bitcoin a little more than 10 years. However, gold also splits opinions amongst investors.

What’s Bitcoin worth?

The honest answer to this is no-one knows. Similar to gold, Bitcoin has a fixed supply and as such it has a rarity to it which makes it valuable. However, because it doesn’t have an income nor produce anything the value of it is only what other people are willing to pay for it.

Lack of Liquidity

Not only does Bitcoin have a limited supply, but there is also the issue of liquidity. A lot Bitcoin is either locked up by large investors, yet to be created (mined) or simply lost trapped in a digital wallet or hard drive, because someone has lost their password, never to be recovered.

With so little Bitcoin changing hands each day it doesn’t take much demand to move the price up and when the price rises it attracts more interest which helps drive the price further. These speculative bubbles have appeared several times in Bitcoin and in my view, this is what we are seeing this year.

Bitcoin is high-risk and is currently unregulated. The Financial Conduct Authority put it well when recently it said people investing cryptocurrencies should be prepared to lose everything.

Adrian Lowcock is head of personal investing at Willis Owen

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