The US Commodity Futures Trading Commission (CFTC) last Thursday announced it has settled the facilitating of trading in Bitcoin futures contracts on its platform. It has, in effect, officially recognised Bitcoin as a commodity and therefore tradable. It also gives the cryptocurrency the legitimacy that many Bitcoin advocates have been pushing for. By contrast, the Inland Revenue Service (IRS) has defined Bitcoin as property, but not currency. This means that gains from the sale of Bitcoins are taxable in the US (there is no capital gains tax in Singapore). In this article, we think about Bitcoin and ask ourselves what it means to us and, indeed, should we invest in Bitcoin?
What is Bitcoin?
According to bitcoin.org, Bitcoin is a payment network, which uses peer-to-peer technology to operate with no central authority or banks. Managing transactions and the issuance of bitcoins is carried out by the network collectively. Transactions are verified by network nodes and recorded in a public distributed ledger called a block chain. Bitcoins were created as reward for payment for processing work done by users who record and verify payments to the block chains. This activity is called mining. Besides mining, bitcoins can also be purchased with other currencies, or exchanged for products and services.
Why use Bitcoin?
Bitcoin can be used as a form of payment, and merchants have an incentive to accept it because the transaction fees are far lower than the 2-3 percent that merchant banks impose. In addition, the fee is paid by the buyer of the product, and not the seller, which further increases the attractiveness of merchants to accept this form of payment.
Implications of Bitcoin
On the plus side, it is very attractive to not have the authorities snooping behind each transaction that we make, collecting "big data" and analysing our threat or contribution to the economy. Based on peer-managed system, with social proof a primary badge of honour, it will help keep vendors honest. With a upside potential behind it, and with it becoming tradable as a commodity, this may be a new investment vehicle for us, especially where the price of other commodities are depressed and the markets moving down. However, one needs to be cognisant of the downside of Bitcoins.
For one, there is a huge potential for money laundering. In January 2014, two men were arrested in the US for money laundering using Bitcoin. Charlie Shrem, the head of the now-defunct BitInstant bitcoin exchange and a vice chairman of Bitcoin Foundation, had allowed the other party to purchase large quantities of bitcoins for use on black-market websites. Other illicit trades may explode with Bitcoin. Prostitution, drugs and arms proliferate under such conditions.
Another risk is that of online theft. Because of its open source nature, there is a huge potential of merchants losing their bitcoin balance. One such example is Mt Gox, which filed for bankruptcy protection amidst alleged theft of 744,000 bitcoins. Mt Gox was the original site for trading "Magic: The Gathering" cards, but grew to become the dominant bitcoin exchange by 2014. The exchange has declined because of difficulties in withdrawing funds.
This brings up another downside to Bitcoins: the viability of the exchanges within which Bitcoins are purchased. Because anyone can set up an exchange, there is huge risk that the exchange may just fold. According to a study in the US, 45 percent of changes failed in 2013, taking clients' bitcoins with them. Volatility of the price is yet another risk. In 2011, the price of one bitcoin was US$0.30. It rose rapidly to US$32 before falling back down to US$2. Then in 2013, during the Cyprus crisis, the price jumped to US$266, before falling down to US$50. The all-time price of one bitcoin was US$1,242, done on 29 November 2013. In 2014, the price fell sharply, and today is trading at US$230 per bitcoin.
What should you do with Bitcoin?
Regulation of bitcoin is essential. Rather than relegating it to the black market, authorities need to acknowledge that the peer-to-peer arena will grow in significance and affords for people a sense of control. After all, all currencies have their own internals risks which Bitcoin can overcome. With regulation, there will be a proliferation of well-run high frequency exchanges which can then stabilise the price. Bitcoin can be a game-changer in the currency space that has not seen any innovation for decades. If you were an adventurous investor, you may like to set aside some money for Bitcoins, if possible, earning it through mining, or putting aside some of your cash for it. Find a good exchange, one which has the wherewithal to hold onto your balances. With greater acceptance of Bitcoins as currency, you will find your initial investment paying off. What you might like to do now is to monitor the price of Bitcoins. As of Friday, the rate was US$230.25, not much change from previous days before the CFTC announced its decision. Perhaps because of a much smaller market, the rate of uptake of the news is much slower, therefore allowing you to see how this news will impact prices. By all intents and purposes, it should be very positive. And if not, then you know that the market may have discounted this impact, perhaps knowing that there are many other fundamental issues left to be resolved before being jubilant. Yet Bitcoin still has a huge upside and it may pay off to keep half an eye on this commodity.