Is bitcoin the next investment bubble?

Unless prices stabilize, investing in the virtual currency is a gamble

Published: March 2014

It took a few years, but bitcoin, the virtual currency anonymously created in 2009, is becoming a disruptive force, at least to those who allow it to be. For online retailers, accepting bitcoin along with fuddy-duddy U.S. dollars has become a way to announce their virtual hipness. TigerDirect, Overstock.com, and Zynga are three of the larger firms now accepting the alternate currency for payment. And at least one service, SnapCard, will change bitcoin into dollars for you to use with any online goods and service provider.

But the real news is the value of bitcoin itself, which has grown more than 50-fold in its short life. Daredevil stock investors are used to their investments having double-digit price swings, but that’s during the course of a year. In 2013 the bitcoin daily price swing was greater than 10 percent on 42 occasions. And in the past three months, the price of one bitcoin doubled in value, and then lost half its value, not once but twice, in a matter of days. The first time, the market sold off simply on the news that China and India were going to regulate bitcoin. Then in February, what was the virtual currency's primary exchange, Mt. Gox, somehow "lost" about 5 percent of the world's bitcoin supply.

Nonetheless, bitcoin continues to polarize. Proponents claim that the virtual currency is revolutionary, because it bypasses financial intermediaries like banks and the banking system. Detractors consider it another mania, with at least one forecaster suggesting that one bitcoin might be worth no more than $10 when the bubble inevitably bursts. So is bitcoin the next Internet or this generation’s Internet stock?

Supply and demand

One of the attractions of bitcoin, according to its proponents, is that there will be a finite supply. About 12 million are in circulation, and no more than 21 million can ever be “mined” (in other words, produced). So fans claim that bitcoin investors are protected from the inflationary dangers that can affect traditional government-backed currencies.

But demand is much more of an unknown. The price increase in 2013—from $20 in January to more than $1,000 by December—indicates that the demand for bitcoin skyrocketed last year (see chart below), but tells us nothing about whether that rate of demand will persist.

One thing we do know for sure: Where there’s new money, Wall Street will inevitably find a way to capitalize on it. Two prominent examples are a private-equity trust completely comprised of bitcoin currency, open to anyone with $25,000 or more to invest and a willingness to tolerate front-end, back-end, and administrative fees of 1.5 percent and 2 percent (and that’s not total fees, but each fee). There might even be a bitcoin exchange-traded fund to invest in soon if the Securities and Exchange Commission approves its registration.

Which brings us back to the question: Why are people increasingly holding and valuing bitcoin? Is it for the frictionless instant transactions they can provide or simply because they believe they will make a killing?

It’s true that traditional banking systems have their shortcomings, particularly in the U.S., where it can still, frustratingly, take days for some types of transactions to clear. But it seems likely that the attraction of bitcoin is still largely speculative in nature.

Where no tax man has gone

Perhaps the most compelling reason to be wary of bitcoin as an investment is the basic uncertainty. For example, British tax authorities currently consider it to be a voucher, not a currency, which is a difference between a 20 percent tax and none at all. And the Internal Revenue Service has yet to clarify much of anything about how bitcoin holdings will be taxed. For example, will they be treated like a currency, a collectible, or something else altogether?

Maybe the best outcome from the bitcoin experiment isn’t that it will make some people rich, but rather that it might persuade our traditional banking systems to undertake a much-needed overhaul to make financial transactions better, faster, and cheaper.

More than a bit

The price of one bitcoin climbed from $20 in January 2013 to more than $1,200 last November, before climbing, and falling again, to about $600 in February. The 2013 climb in price was fueled by wider acceptance of the virtual currency as well as a healthy amount of speculation.

 


Editor's Note:

This article also appeared in the April 2014 issue of Consumer Reports Money Adviser.



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