How Does Bitcoin Work?

While bitcoin has dropped in price considerably from its peak, that does not necessarily make it a good investment. Learn more about the pros and cons of this cryptocurrency.
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While its critical to balance your money and investments among stable instruments, such as certificates of deposit (CDs), money market accounts and even savings accounts, there can be an understandable desire to allocate some investment funds in potentially higher-yield opportunities.

In the space of about a decade, bitcoin has transformed from a theoretical concept to a significant financial instrument. It has also been hailed as the wave of the future and derided as little more than a scam.

One thing is for sure: Bitcoin is much cheaper now than it was a year ago. Does that make it a good bargain? To assess that it’s important to acknowledge both bitcoin’s value and vulnerabilities.

Bitcoin’s roller coaster ride

Looking back at bitcoin’s roller coaster ride up to this point can help put its current price in perspective.

In the early months of its trading history, bitcoin sold for less than a dollar a unit. Its price rose fairly steadily over a period of several years, and then in 2017 the real volatility began. Bitcoin soared from under $1,000 a unit to over $19,000 in late 2017, but then came crashing down. It continued to decline for most of 2018, and so far this year has settled into a trading range of around $3,500 to $4,000 per unit.

Even at it’s current price, if you invested in bitcoin in its early days and held onto that investment you could see every dollar you put into bitcoin turn into thousands. However, that way of looking at it is a bit deceptive when you’re dealing with an investment fad whose popularity grew exponentially only once the price started to rise. The reality is that the trading volume of bitcoin was about 100,000 times heavier at its peak price above $19,000 than during its dollar-a-unit days.

This means that buyers are much more likely to have seen their investment in bitcoin lose over half its value than to have made a fortune in the currency.

Keys to Bitcoin’s value

Unlike the money in your checking account, Bitcoin is a cryptocurrency, which means it is a unit of financial exchange that exists entirely on the world’s network of computer systems. It is promoted as an alternative to government-backed currency systems, which while enjoying the backing of their national governments also carry the potential liabilities of debt and other vulnerabilities of the international banking system.

Two reasons why bitcoin has value are the following:

1. Limited supply. By design, bitcoin’s supply is limited because it requires intensive computer use (and specialized knowledge) to perform the problem-solving calculations required to generate new bitcoins. This process, known as bitcoin mining, requires so much computing power that it consumes a considerable amount of energy. According to The Economist, in high-cost electricity markets like California the price of Bitcoin would need to be at least $6,200 to justify the cost of mining new bitcoins. This means that when the price of bitcoin falls, the flow of new supply can be choked off, creating some support for the price.

2. Confidentiality. A big attraction to bitcoin is that it is free from the regulation of the banking system. That allows people to store and transfer wealth in relative anonymity, and there is a huge demand for that type of confidentiality. This goes beyond traditional money laundering by drug cartels and organized crime. The use of government positions to siphon public money into private accounts has become an international practice worth hundreds of billions worldwide. As much as that practice is to be condemned, the reality of it is that it creates a steady demand for bitcoin.

Bitcoin’s vulnerabilities

While limited supply and confidentiality help support bitcoin’s value, it does have some significant vulnerabilities:

1. Limited acceptance. To call bitcoin a “currency” is a bit of a stretch, because it can be exchanged only in a limited number of places and rarely used to purchase good and services.

2. Unpredictable value. One thing that holds bitcoin back from being widely used as a currency of exchange is its wild price swings. If you are running a business, it is simply too unpredictable to take in your day’s receipts in a currency that might rise or fall by 10 percent by the time you open for business tomorrow.

3. Cyber attacks. Naturally, a cyber currency is vulnerable to cyber attacks, and hackers have found ways to exploit bitcoin exchange systems to divert the currency into their own accounts. The problem with an unregulated system is that it leaves theft victims relatively little recourse.

4. Competition. Bitcoin has spawned a legion of competitors. Bitcoin has the first-mover advantage of being the most widely-accepted cryptocurrency, but there are now many alternatives. The relatively low barrier to entry for launching new cryptocurrencies somewhat undermines one of the keys to bitcoin’s value, which is the limited supply.

Bitcoin does not pay interest the way traditional savings would, so investing in it is purely a bet on its future price. Given how unsteady its price has been and bitcoin’s vulnerabilities, potential buyers should acknowledge that purchasing bitcoin is speculation rather than a value-based investment. You might choose to put money into it if you are feeling lucky, but don’t spend more on bitcoin than you can afford to lose.

Explore more traditional investments with the best online brokers and determine where you feel most comfortable investing.

Richard Barrington has been a Senior Financial Analyst for MoneyRates. He has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications. Richard has over 30 years of experience in financial services. He has earned the Chartered Financial Analyst (CFA) designation from the Association of Investment Management and Research (now the “CFA Institute”).