The Bitcoin Phenomenon
Let’s start with the basics of this Bitcoin spectacle because the intricacies of Bitcoin production, valuation, and exchange are very difficult to comprehend.
In 2009, a proof of concept was published about a new form of money that uses cryptographic algorithms to control its creation and transactions, rather than a central authority (i.e. federal government). The Bitcoin protocol would have open source development that is completely decentralized – meaning the entire network of software development, exchange transactions, and mining of Bitcoins (Bitcoin mining is the process by which transactions are verified and added to the public ledger and also the means through which new Bitcoins are released) would be unregulated and relied on only by consensus among users (i.e., “blockchain” technology).
As a consumer used to hard currencies with legal tender status, Bitcoin is a difficult concept to grasp. How can one rely on a virtual monetary system using digital tokens with no central banking authority? Why would any vendor accept a new virtual currency that has no intrinsic value? Trying to value gold in the marketplace is hard enough, but at least gold has centuries’ old appeal, is in rare supply, and governments recognize it in their reserves. Bitcoin has none of these qualities, except for a mathematically limited supply.
Mining for Bitcoin
Bitcoin only exists online, and mining has become a very competitive and costly process. The original miners used their home computer software to guess increasingly difficult encrypted math problems (think placer miners sifting through soil in their metal pans searching for gold bits). Over the past few years, however, large mining companies have brought in their proverbial hydraulic drills. By using a vast network of expensive computer systems, they have mined the complex math equations in a frenzy for these illusive Bitcoins. As more miners enter the network, the difficulty to find solutions increases. As more Bitcoins are created, the potential payoff falls (basic law of diminishing returns). There are now over 12 million Bitcoins in existence, and the system is logically designed so that the total number of Bitcoins won’t exceed 21 million in supply.
Do Bitcoins have value simply because they are a useful form of money? How do we bridge the gap between fundamental value and the recent astronomical surge in the price of Bitcoin? A long-term advocate of Bitcoin might say its low transaction costs will displace credit cards, its inherently limited supply protects us against inflation, and central banks will someday use it as a reserve component complementing gold. This media hype and speculation have taken hold, driving the price up exponentially. In fifteen-minute intervals in the past, Bitcoin has been known to rise or fall 25% to 50% in value. Its volatility is eight times that of gold and ten times that of the S&P 500. This product is not for the faint hearted. Jamie Dimon the CEO of JP Morgan put it more bluntly: “I don’t personally see any value in something that has no actual value…If you’re stupid enough to buy it you will pay the price for it one day.”1
Every Bitcoin transaction is essentially taxable. If you use Bitcoin to purchase something, any realized gain above your cost basis is taxable income. Therefore, a recordkeeping system is necessary. Virtual currency is treated like property by the IRS, using applicable short-term or long-term capital gain tax rules. Thus, one could follow a normal tax harvesting strategy for capital assets, between offsetting gains and losses.
Should I Invest?
Now the inevitable million-dollar question – should I invest in Bitcoin? Calling Bitcoin an “investment” is a stretch, as there is no underlying asset that you are purchasing. It is more of a highly speculative bet – like buying a lottery ticket. If you play Powerball, you know you could win big or walk away with nothing. The intrigue comes from speculator idealism, that if Bitcoin’s price were somehow, someday, tied to the price of gold – one coin could be worth $1 million. Conversely, governments could decide they don’t want nongovernmental entities issuing currency, making it essentially worthless except on the black market. Mr. Dimon agrees, “Governments are going to crush it one day. Governments like to know where the money is, who has it, and what they’re doing with it. In case you haven’t noticed. Governments like to control their currency, they like to control their own economy.” 1
Bitcoin’s value comes only from people willing to use it as currency and accept it as payment. Other than that, it’s just a flash in the pan.