In the last edition of Bullion University, analyst Greg Hudson gave a great introduction to what a Bitcoin is, how you can get your hands on Bitcoin, what they can be used for, some of the advantages of Bitcoin, and some of the commonly heard criticisms about Bitcoin.

For those of you who’d like a refresher, you can access the earlier piece here.

This week, I’d like to talk about a little about Bitcoin the ‘investment’; some of the unanswered questions and potential flaws (and I do mean potential), along with things I think ABC Bullion clients, as well as the wider community, need to think about in regards to Bitcoin.

By Jordan Eliseo, Chief Economist, ABC Bullion

I want to start by saying that I think Bitcoin is a fantastic and fascinating invention. Whether it lasts for 10,000 years or goes the way of the Dodo, Bitcoin will undoubtedly be remembered as the original torchbearer of the crypto-currency movement.

As a believer in sound money principles, as well as of free market enterprise (and the successes and failures that accompany such a market), I am a huge supporter of all attempts at innovation, particularly one that might stand as a competitor to the unsound monetary system under which the world is currently operating.

Created as a peer-to-peer payment system and digital currency by pseudonymous developer, Satoshi Nakamoto back in 2009, Bitcoin largely remained under the radar and well away from mainstream media attention for its first 4 years of existence.

In 2013, everything changed, with a nearly 6,000% increase in the price, gaining worldwide media attention. Bitcoin was arguably the ‘investment story’ of last year.

By the end of 2013, not only were asset managers talking about it, but so were central bankers and government officials, with some not sure whether it was (or is) an alternative to FIAT currencies, some kind of digital or “new gold”, the next Tulip or South Sea Bubble, or something in between.

As 2014 gets underway, we are in all likelihood no closer to answering those questions and only time will tell where the Bitcoin story ends (if it ever does). Here are my views covering Bitcoin as an investment, as money, as a digital payment network and some of the unanswered questions regarding Bitcoin.

Undeniably, early adopters of Bitcoin and those who either mined them directly or purchased them a couple of years ago would see Bitcoin as a great investment.

As you can see from the chart below, the price of Bitcoin has risen astronomically.

Across the course of 2012, the price of Bitcoin more or less tripled, rising from USD $5 on the 31st December 2011 to USD $14 per Bitcoin on the 31st December 2012. This was a tidy return indeed for anyone who was long.

What followed in 2013 however, dwarfed the experience of the previous year.  Bitcoin had an initial run up above USD $200 in early April 2013, which was followed by a sharp correction down to USD $69, which Bitcoin bottomed out at in July.

At that point, many who were paying attention thought that the Bitcoin rally and collapse marked the end of the mania. In fact, Bitcoin was just getting started.

Recovering back above USD $100 by late July, Bitcoin averaged USD $140 across the next three months before exploding upwards in November, when it ran from USD $208 to USD $1203 (the high so far).

Since then, prices pulled back all the way to $584 in mid December before closing the year out at USD $799. Currently, they are trading at USD $950 per Bitcoin.

Anyone who owned Bitcoin for the entirety of last year made a return of 5782%.

Expressed another way, $1,000 USD would have bought you 73.58 Bitcoins on the 31st December 2012.

1 year later those same 73.58 Bitcoins would have been worth $58,828, and today they’d be worth even more, fetching just over more than $69,900.

That’s some investment return so it’s no wonder many called Bitcoin the investment story of 2013…..take profits now and it will probably be the best ‘trade of the decade’, even if you do nothing for the next 6 years!

But as interesting and amazing as these statistics are, you can’t make money in the past.

Is Bitcoin likely to repeat this performance sustainably into the future? Almost certainly not and I don’t think even its strongest proponents would argue so. Indeed many of them seem to argue that this volatility and rapid ascension is all part and parcel of a new monetary system becoming established.

Perhaps this is true and ultimately, only time will tell.

However, investors should be aware that rapid and violent drawdowns in the price of Bitcoin are possible. A repeat of the slump seen between April and July 2013 could see Bitcoin head down toward USD $200, a rather large loss of capital for those investing now.

All the arguments in favor of Bitcoin were just as relevant several months ago as they are today. They didn’t prevent the volatility we saw in April and indeed December 2013.

Therefore, as an investment, I don’t believe Bitcoin will be as profitable in the next few years as it has been in the past, but I could be wrong and it might go much higher.

Either way, it will definitely provide profitable trading opportunities over time. Having said that, I have no idea what signals one would use as a way of deciding when to go long or short Bitcoin.

It’s critical to separate the arguments in favor of Bitcoin as a monetary transmission mechanism, and ensure this is not confused with an argument for or against Bitcoin as money itself.

Whilst there has been clear technological development with Bitcoin and it does have significant advantages vs. more traditional means of moving money or facilitating transactions (all subjects Greg’s article touched on for which I agree with wholeheartedly), this does not make Bitcoin itself a good form of money over the longer term.

Consider this; It was only a decade or so ago that internet banking really took off and it became the norm to transfer money via your PC or smart-phone. In the old days you went into a bank, or you wrote a checque.

Undoubtedly, the transmission mechanisms for moving FIAT money are infinitely more efficient today, but they in no way make the money itself more valuable.

This is important to keep in mind. Whilst some Bitcoin fans, although not all, see the adoption of Bitcoin as a payment mechanism by retailers (for example Overstock) as ‘proof’ of Bitcoins monetary value, in my opinion this is not so.

That’s not to diminish the Bitcoin protocol, but for retailers, accepting Bitcoin is also another way for businesses to drum up sales. It is also worth noting that, at least in the case of Overstock, whilst it accepts Bitcoin as payment, it doesn’t keep them, converting them to USD. Many businesses that “accept Bitcoin” are also doing this, using a payment processor called BitPay.

In this sense it’s no different really than from when credit cards went mainstream in supermarkets and department stores, meaning you no longer needed to write a cheque, bring physical cash, or put things on lay-by.

On a side note, and please don’t take this as specific tax advice, Jim Rickards helpfully pointed out in a debate on Bitcoin and Gold (video link available at the bottom) that users of Bitcoin must declare gains on Bitcoin as part of their tax return.

This is important. Lets say you buy a Bitcoin for $500, the price doubles and you then use your Bitcoin to buy a $1,000 worth of clothes. This is something you’re meant to declare to your relevant friendly tax authorities.

Just because the fact Bitcoin has fantastic advantages as a peer-to-peer payment and as a monetary transmission mechanism doesn’t prove that Bitcoin is money, it also doesn’t prove that Bitcoin isn’t money.

In fact, the short answer to this question (at least in my opinion) is that YES Bitcoin is money. People are using it like money, are valuing it as money today and believe it is money today.

If it looks like a dog, and barks like a dog, then it’s a dog!

A more complete answer is of course more complicated, due to the fact that just because Bitcoin is seen as money today, it doesn’t mean it is ‘good money’ or that it will be money in the future.

Inside a prison, cigarettes function as money (so I’ve heard and read).

In Zimbabwe, their dollars were used and valued as money until such time that the sheer over-issuance of the currency led people to abandon it.

Today, the US Dollar is money, but it’s lost nearly all its value since its link to gold was broken. Of course anyone with a keen interest in precious metals reading this article would no doubt agree that the USD, as well as many of its FIAT cousins, are moribund.

That’s exactly why people are buying physical gold and silver, to preserve their wealth.

Ultimately, the future that has befallen other FIAT currencies and other types of money in the past could well be the future that awaits Bitcoin, though no one can be certain of that.

Greg actually touched on this in our first article on Bitcoin last week. He stated that; “bitcoins total number has been limited to 21 million. In this way they can be likened to gold in that there are a fixed amount of bitcoins”.

Likened to gold is not the same as gold. Indeed I actually see this as a major flaw in Bitcoin, at least if it were to ever to become a sustainable and widely accepted form of money.

And the reason for this is that the supply of gold is not fixed at a certain tonnage. This is different to Bitcoin, which is fixed at only 21 million coins. Although it must be stated that each coin is divisible down to 8 decimal places, so theoretically there just over 2 quadrillion ‘units’ of bitcoin in the system. 

Furthermore, gold has not been money for 5,000 years because it’s supply is fixed. It’s been money because the overall supply of gold is stable, and there is an important difference between stable and fixed.

For anyone who read or watched Bullion University lesson 1 (available as a video link at the bottom for those who want a refresher), you’ll remember gold is money, and different to other commodities not just because it’s scarce, but because the overall supply is stable, growing at just over 1.50% per annum based on 2,800 tonnes of newly mined gold per annum and 170,000 tonnes in pre existing supply (mostly in coins, bars and jewelry form).

That’s a point worth repeating. The total supply of gold is not fixed. It is stable.

Human beings will, in all likelihood, always be able to mine gold, particularly as new mining technologies make even lower ore grades economically viable.

Therefore, the overall gold supply will continue to grow in a stable fashion over time, as will economic activity, despite the hiccups along the way.

Bitcoin is different. Over the long run, as the supply is supposedly fixed, hoarding will be incentivized. This may help make Bitcoin a good investment or speculation (as we touched on before), but I doubt it will help it remain a useful form of money over the long run.

The technological advancements of Bitcoin and its use as a payment system and a way to transfer (wealth) are theoretically just as effective whether its $1 per coin, $100 per coin or $1,000,000 per coin.

People’s willingness to use Bitcoin however, may well be affected depending what’s happened to the price.

On this point I think even Bitcoin’s most ardent supporters would be honest and admit it is the 2013 ‘investment return’ on Bitcoin and the incredible price spike that has generated the media headlines.

Undoubtedly, more and more people have become more attracted to using Bitcoin precisely because of the price rise. I fear that were the price to collapse to under $100 or even lower, they might not be so enamored with the fact their local coffee shop has started accepting Bitcoin as payment, even though the network would still perform the same functions.

Remember also that money itself is not meant to be inflationary or deflationary per-se, it’s meant to be stable. It’s the free market process, which drives competition and innovation that ensures we get better value for our money over time.

Opposed to this are governments and central banks. As we all know they issue FIAT currency over and above actual economic output with the stated aim of reducing the purchasing power of our money via inflation.

Therefore, whilst I can certainly appreciate why someone might prefer deflationary Bitcoin to inflationary FIAT, in my opinion neither are a substitute for, or superior to stable physical gold and silver.

There are two final question marks or potential problems that I see with Bitcoin. The first of those is whether or not the number of Bitcoins really is limited to 21 million coins?

On this note, in the video debate which I’ve linked in from YouTube below, Jim Rickards and Roman Skaskin argue the merits of gold and bitcoin. Roman Skaskin whom, whilst admitting that gold was great and that he owned some, was arguing that Bitcoin is ‘better than gold’.

What I found fascinating though was in the QnA session (approximately 34 minutes in), discussion turned to whether or not there might one day be more than 21 million Bitcoin.

Skaskin stated; “would the community support the changing of the protocol to expand to 40 million or 80 million? They would not if it would cheapen the Bitcoins they currently own, but if it was a problem and people were abandoning Bitcoin altogether, they would choose that, to save the value of their Bitcoins”.

Now granted, this is one gentleman talking in a QnA format but that really got my attention. From the research I’ve done, the answer is yes; the number of Bitcoins is only limited to 21 million because so far that’s what ‘the community’ has promised to itself.

Obviously, any attempts to play around with the number of Bitcoins able to be mined would cause ‘confidence’ issues with the Bitcoin network itself and ultimately, dilution of the value of existing Bitcoins.

Bitcoin is also better ‘regulated’ through its open source architecture, in my opinion, compared to say the USD. Unlike the USD, where it’s just a few economists sitting around a central bank boardroom who get to decide how many USD to create, anything done on the block chain to alter the number of Bitcoins on issue would be able to be seen by everyone.

Nevertheless, the bottom line is that the 21 million coin limit is just part of the code for now, and it can be changed.

Therefore, theoretically, just like FIAT currency; the number of Bitcoins is infinite. Whilst I hope the number of coins isn’t increased arbitrarily and the network maintains the integrity it appears to have at present, this is a risk people need to be aware of.

If Bitcoin does gain critical mass, most users won’t know cryptography, understand ‘open source’ or what the block chain is. They could be totally sideswiped by any shenanigans in the system.

This is exactly the fear that many precious metal analysts and bulls like myself, have for large percentages of the population whose wealth and standard of living are exposed to what central banks are up too, through their interventions in the bond markets and their issuance of trillions of dollars of FIAT money.

And whilst Bitcoin users may say “that will never happen here”, anyone with an interest in precious metals and monetary history will know that across the passage of time, people have constantly tried to play games with money in order to gain an advantage over others, and put themselves ahead of “the community”.

A final risk I see with Bitcoin is competitor risk. It would seem that, particularly as the technology is open source, it would appear relatively easy to adopt and dare I say ‘improve on’.

According to Wikilist (a link to which is provided at the bottom of the article) there are 5 major crypto currencies, four ‘new’ crypto currencies, 16 minor ones and 11 dead or dying ones (seems they have a shorter shelf life than FIAT currencies).

Wikipedia suggests that by December 2013 there were more than 60 crypto currencies and I have even heard that there are now more than 100 of these things floating around.

To my knowledge, the second most popular one appears to be Litecoin, which is apparently very similar to Bitcoin. Created in October 2011, Litecoin will end up issuing 81 million coins.

As I write this article (23rd January 2014), the price of Bitcoin is $970, and the price of Litecoin is only $28.90. Now even allowing for the fact Litecoin will end up with nearly 4 times as many coins on issue, one could be forgiven for thinking the ratio between these two should be closer to 4:1 rather than the present ratio which is over 30:1.

Is Bitcoin too expensive, is Litecoin too cheap; both, or neither?

The truth is we don’t know regarding the pricing, but what we do know is that Bitcoin faces plenty of competition.

Indeed, according to an article that appeared in yahoo finance on the 16th January 2014, yet another crypto currency, NoFiatCoin (XNF) has been launched. This crypto currency can be traded on the Ripple network, and, according to the news article and the original press release, it’s actually backed by physical precious metals.

Now granted Bitcoin has ‘first-mover’ advantage, is much better known than all the others combined and isn’t likely to disappear anytime soon, but how can anyone be certain that something better than Bitcoin won’t come along in the crypto space.

When it comes to physical gold and silver, 5,000 years of history teaches us there are no superior forms of money. Can we say that with certainty about Bitcoin? I do not believe so.

Indeed a final question for Bitcoin enthusiasts is; what monetary role (I’m sure it could still be a useful as a payment system) do they think Bitcoin will play in a world returned to some form of hard money standard?

No matter how hard social democracies and their central banks try to fight that outcome, history is also pretty clear that’s where we are going to end up.

In that kind of environment, I’d see Bitcoin as a cheap and efficient way of transferring gold-backed money, but I wouldn’t see it as money itself. Just like I think my credit card is more efficient than my old chequebook, I don’t think the credit card itself should or will ‘go up in value’.

I want to finish with a quote from Thomas Edison that I think may end up being very relevant for Bitcoin.  Whilst I am unsure of it as an investment going forward, and I’m skeptical it will last as a form of money itself, I am blown away at the thought that has been put into it, how the block chain works and the efficiencies it can generate as a payment system.

Edison, one of the more famous and brilliant inventors in history, who held over 1,000 patents at one point, tested plenty of ideas and hypothesis that didn’t end up working out.

Not to be discouraged in his efforts to create the phonograph, nickel-iron batteries, electricity and the incandescent light bulb, amongst other things, he was once quoted as saying “I have not failed. I’ve just found 10,000 ways that won’t work”.

Edison was a genius, and anyone reading this today lives in a world where our standards of living are better for his efforts.

Irrespective of the future price movements of Bitcoin and whether it does or doesn’t last as a payment or monetary system, it is a terrific invention and advancement in technology and it deserves to be respected as such.

For anyone who wants to know how to buy it (I might buy one just as a pure speculation and am not advising this to anyone) then this link will take you to a website with some useful information on how to buy Bitcoin in Australia.

Jim Rickards on gold
http://www.youtube.com/watch?v=OramhrxZMF4

Bitcoin myths exposed
http://www.youtube.com/watch?v=XBF7Sev2dZM&feature=youtu.be

Bullion University Lesson 1
http://www.abcbullion.com.au/education/bullion-university-stock-to-flow-ratio

List of Crypto currencies
https://en.bitcoin.it/wiki/List_of_alternative_cryptocurrencies

NoFiatCoin – new digital currency
http://au.finance.yahoo.com/news/first-bitcoin-alternative-backed-gold-005843591.html

Bitcoin price downloads
https://blockchain.info/charts/market-price

Disclaimer: this publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance.