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Cryptocurrency, bitcoin and block chain

It seems that you cannot pick up a paper, or watch the daily news these days without hearing something about cryptocurrencies, particularly bitcoin.

Much of the interest has come from the eye-watering returns to date from bitcoin. In 2010 one bitcoin was worth $0.057 and that same bitcoin closed on 30 December 2017 at $17,570.  Mind-boggling returns if you were an early adopter.

Financial markets throughout history are littered with such events, call it speculation.  In 1634 in Holland, Tulip Bulbs became the item of speculation as a result of demand from the French for rare Tulips.   Up until very recently, the Tulip bulb mania was the largest and most famous bubble of all time. At the height of the market, the rarest tulip bulbs traded for as much as six times the average person’s annual salary.

In December 2017, the rising price of Bitcoin surpassed that of the Tulip speculation.

so what is this all about?

When you think about currency, the first things that may come to mind are Australian coins and bank notes.  Currencies can largely be classified into two monetary systems, namely, fiat money and commodity money (i.e. objects that have intrinsic value as well as value in their use as money e.g. gold).

Without going into too much detail, in economic terms, our coins and bank notes are commonly referred to as fiat money – basically this means money, without intrinsic value, that is issued and controlled by our Government and deemed as legal tender, namely, recognised as an appropriate medium of exchange for the purchase of goods and services.

In addition to coins and bank notes, data such as bank balances and records of credit or debit card purchases can also fall under the umbrella of fiat money.  As such, the way that you complete a payment for a purchase with fiat money may be with physical money (e.g. coins and bank notes) or via electronic means (e.g. a debit card that draws from the money held in your bank account).

An important point regarding electronic payments is the process that is undertaken to complete a transaction.   Here is a simplistic example:

  1. On your way to work, you stop at your local café, and decide to purchase a morning coffee by using your debit card and the vendor’s EFTPOS machine.
  2. This payment request is received and then actioned by your financial institution (unless there is insufficient funds in your bank account).
  3. Your financial institution then sends a payment file to the receiving financial institution who then processes the payment file and transfers funds to the vendor’s bank account.
  4. The end result is your purchase is approved and both your bank account and the vendor’s bank account are adjusted to reflect the transfer of funds e.g. a debit in your account and a credit in theirs.  However, unbeknownst to you and the vendor, there is one final step that takes place.
  5. The sending and receiving financial institutions settle the differences in the amounts of debits and credits via the Reserve Bank of Australia at the end of the day.

The definition of fiat money and the process involved in transactions are important to understand when considering the remainder of this article.  With this in mind, over the last few years, there has been increased discussion around cryptocurrency, Bitcoin and blockchain.
what are they?

Cryptocurrency

A cryptocurrency is an alternative type of currency, considered by some to be a hybrid between fiat money (such as coins and bank notes) and commodity money (such as gold or silver). It’s a virtual or digital currency, which is not considered legal tender; however, it can be used as a medium of exchange if a vendor chooses to accept it as payment for their goods or services.

Cryptocurrencies do not require government issuing or control, nor assistance from financial institutions to process payments.  Instead, they use special encryption techniques (e.g. cryptography) to keep data secure, store and create ‘monetary units’ as well as verify transactions within a decentralised (e.g. peer-to-peer network), digital public ledger (e.g. a blockchain).

As it stands, there are over 1,000 different types of cryptocurrencies, with a combined market capitalisation (market cap) of over AUD $710 billion.  Market cap refers to the total market value of a company’s outstanding shares (or, in the case of cryptocurrencies, their monetary units) and is calculated by multiplying the current market price of one share/monetary unit by the number of outstanding shares/monetary units.

Market cap is commonly used to understand the relative size of one company versus another.

Bitcoin

The cryptocurrency that is probably most well-known, and the first of its kind, is Bitcoin.  An unknown individual or group called ‘Satoshi Nakamoto’ created it in 2009 along with the technology that underpins it, namely, blockchain.  As at 31 December, Bitcoin had a market cap of over AUD $292 billion and a trading value of AUD $19,025 per monetary unit (i.e. bitcoin).  Despite the high trading value, you do not need to purchase a full bitcoin; each bitcoin is able to be divisible to a certain amount of decimal places. Bitcoin, as with other cryptocurrencies, can be purchased and sold via special cryptocurrency exchanges.

Blockchain

Blockchain is the technology that enables the existence of cryptocurrency.  Blockchain is a decentralised, digital public ledger of all cryptocurrency transactions linked together as ‘blocks’ in a linear sequence.  Here is a simplistic example of the blockchain process involved in transactions:

  1. You request a transaction involving the transfer of bitcoins from your account to another’s as payment for the purchase of goods or services. This request is initiated via instructions utilising what are called public keys (comparable to a bank account number) and private keys (comparable to an ATM PIN).  As these keys are long strings of numbers and letters, the underlying identity of the sender remains anonymous.
  2. The requested transaction is broadcast as a block to a peer-to-peer network consisting of computers, known as nodes.  Individuals or groups called miners operate these nodes.  The network of nodes then approve the transaction and validate it by solving mathematical algorithms.
  3. Once verified, the transaction block is time stamped and added to the existing blockchain in a way that is permanent and unalterable.  A reward for the miners in approving and validating a transaction is payment via transaction fees and/or the release/creation of new bitcoins.
  4. The transaction is complete.

Given the characteristics of blockchain, mostly around the permanent and unalterable nature of time stamped blocks within a chain, it has been proposed that this technology has other applications not just limited to cryptocurrency, for example, property settlements, voting and health care record keeping.

Important considerations

Volatility

To date, speculative investing and short-term trading has taken precedence over the intended use of cryptocurrencies, namely, to act as an alternative medium of exchange for the purchase of goods and services.  Part of the reason may be attributed to the fact that the value of cryptocurrencies can be quite volatile.  Reasons for the volatility may be due to government reactions to the alternative currencies (e.g. taxation measures and proposed regulation), varying perceptions of its intrinsic value (and, how to calculate it) and news relating to potential security vulnerabilities*.  An example of volatility can be seen in Bitcoin’s trading value per monetary unit (bitcoin) for the month of December 2017:

  • Highest recorded trading value: AUD $25,767.29
  • Lowest recorded trading value: AUD $14,203.24

*For example, the hacking of cryptocurrency exchanges, which has occurred in the past and resulted in investors losing funds relating to the purchasing and selling of cryptocurrencies.

Tax Treatment

Below is not a complete list, but serves to highlight several considerations for investors and consumers regarding the tax treatment of cryptocurrencies, such as Bitcoin:

  1. Cryptocurrencies held for investment purposes may be subject to capital gains tax upon disposal, however if cryptocurrency costing $10,000 or less is used to acquire goods or services for personal use, capital gains tax does not apply.
  2. In May 2017, the Government announced it would end GST on the purchase of cryptocurrency from 1 July 2017.  Legislation amending the GST Act has recently passed through parliament, however for this proposal to take full effect further amendments are still required regarding the GST Regulations.

Investment Considerations

Whilst we have tried to simplify cryptocurrency, Bitcoin and blockchain into something intelligible, as you can see it can be quite complex.
is bitcoin a good investment?

Obviously the answer to this question will be revealed in the fullness of time.

One thing we can say is that there are certainly parallels between what is happening today with bitcoin (and other cryptocurrencies) and financial market speculation in times gone by.  The most recent was the dot-com boom of the late 1990s and early 2000’s. This ended with a lot of people losing a lot of money.  Along the way however there were obviously some winners.

Importantly the dot-com mania left us with the infrastructure of e-commerce, so that today online transacting is an important part of our daily lives.

No fool like a greater fool

There may be good reasons for buying bitcoin, but at the moment the dominant reason is that its price keeps rising.  Basically people are buying today with expectation of selling it to someone else for a great price. In investment terms this is called the “Greater Fool Theory”.

The Greater Fool Theory simply means that someone purchases an investment, (whether overvalued or not) in the expectation of selling at to someone (a bigger or greater fool) at a higher price.  Thus the justification for purchasing the investment is that there is always someone more foolish to sell the investment to.

Just like in the most recent dot-com boom, we are seeing companies change their name, to include a reference to bitcoin, blockchain or some other cryptocurrency for no other reason than to boost the share price.  For example, just the other day the Australian Financial Review reported a US company previously called “Long Island Iced Tea”, who were an unprofitable Iced Tea company watched their stock triple in one day after changing the name of the company to “Long Blockchain”!!

And this is just one isolated example, of which there are many.  Crazy stuff.

One thing you can be sure in all this craziness is that sound investment principles will be ignored, and many people will lose many millions (if not billions) of dollars.  Sure, along the way there will be some who will make vast profits, but as in past financial market speculation events, these will number in the few.

I (and many others) believe there will be a significant price crash in the cryptocurrency world.  Have no doubt this has all the hallmarks of the dot-com boom, and other financial market speculation events throughout history, and every one of them ended badly.  However, when the dust settles on of this we will be left with the technology that preceded (and caused) the boom.  From that point there is no doubt that the technology that underpins cryptocurrencies will become part of our daily lives.  One example of this is that the Australian Stock Exchange (ASX) is currently investigating how they can use the blockchain in the settlement of share transactions.

A word of caution.

For anyone considering investing in cryptocurrency, it’s important to keep in mind investment fundamentals (e.g. diversification, risk versus return and liquidity).  There is significant scope to lose money here, so any potential investor should keep that at the forefront of their mind.

Aside from the potential of the price collapse, there is also the potential to lose funds via security vulnerabilities and the associated tax treatment.  With this current mania, as there was with others there is also significant scope for illegal and criminal activity.   A sad fact of life in the financial world is when there appears on the surface to be an environment of easy cash, hype and speculation you can be well assured there will be a lot of people using a variety of means and claims to separate people from their hard earned.

Further to this anyone seeking advice in regard to this, or any other financial matter should only do so from someone who holds the appropriate licensing, such as an Australian financial services licence holder (or their representative), or a suitably qualified accountant.

If you would like investment, or financial planning advice, we would love to hear from you..