NetEase Research Bureau | Is it still worth investing in Bitcoin after it skyrocketed 1.5 million times in 4 years?

From the time Bitcoin (BTC) was born in 2009, 1 USD could buy 1,300 coins, to the high price of 1,200 USD in 2013, it took only 4 years to soar 1.5 million times; and recently, it took only a week to fall from 8,800 RMB to around 5,000 RMB. In 2016, which just ended, Bitcoin's investment return rate ranked first. Everything looks so good, but before investing, you must understand its current situation.

With the recent warnings from the People's Bank of China about the risks of Bitcoin and talks with related trading platforms, Bitcoin has once again attracted public attention. What is Bitcoin? Why do central banks around the world warn of the risks? Is it an excellent investment or a carefully planned Ponzi scheme?

The birth of Bitcoin: freedom and darkness coexist

If someone who has no technical background and does not understand digital currency wants to understand how Bitcoin works, it may take weeks to learn. Therefore, this article will not introduce the underlying operating principles, but will focus on introducing some of the history and characteristics of Bitcoin.

In 2009, on a forum, an online ID with the pseudonym Satoshi Nakamoto posted that he had invented a currency based on a brand new algorithm (the underlying technology is blockchain). This is the birth of Bitcoin.

Bitcoin is the world's first digital currency and the most famous private digital currency. Bitcoin and electronic legal tender are completely different things. Alipay or online banking are not digital currencies. The money you have in online banking is just a reflection of real banknotes (see "NetEase Research Bureau | Will paper money become a collectible? What is the central bank's digital currency").

Bitcoin has four main characteristics: no centralized issuer, limited total amount, no geographical restrictions on use, and anonymity. Bitcoin is an algorithm, not issued by a central bank, and anyone can use the computing power of a computer to obtain Bitcoin, which is called "mining". Under the current algorithm version, its number is constant at 21 million, which also means that "mining" will become more and more difficult. Most people believe that all Bitcoins will be mined by 2140. The use of Bitcoin has no restrictions and is not easy to regulate. It is also anonymous, so it has gradually become a criminal tool for purchasing drugs, money laundering, and financing terrorism.

At first, Bitcoin was only popular among programmers in a small range, and could be used for small payments or sponsoring some software. In 2009, an American programmer used 10,000 Bitcoins to buy two "Papa John's" pizzas, which was the first time it was used in the real world. If you mined Bitcoin when it first came out in 2009, you could easily mine hundreds of Bitcoins in a week using only a home computer. With the continuous appreciation of Bitcoin and the increase in computer computing power, the difficulty is now unknown. According to Huobi.com, Bitcoin mining has now entered the era of large-scale mining farms, with computer rooms with thousands of mining machines, 24-hour full-time maintenance personnel, air-cooling, water-cooling and insulation measures, etc., to ensure the continuous operation of the mining farm. Because electricity is cheap, most large-scale mining farms are built near hydropower stations, and Bitcoin mining can just consume some of the abandoned energy of hydropower stations. This kind of "currency issuance" sounds a lot like our ancestors digging for gold.

Figure 1 Bitcoin mining farm (Source: Babbitt Information)

The most important significance of Bitcoin is decentralization. According to the algorithmic rules of Bitcoin, unless the vast majority of users unanimously agree to modify the rules or upgrade the version, no one or organization can change or stop the operation of Bitcoin, so in theory no one can interfere with the issuance and circulation of Bitcoin. In fact, centralized traditional currencies have exposed many problems. For example, Zimbabwe's excessive issuance of banknotes has led to huge inflation, plundering the wealth of local people and triggering a domestic economic crisis; banks do not necessarily allow you to withdraw money at will, such as during the Greek debt crisis, when each person could only withdraw 60 euros per day for a period of time; the government can even directly declare people's banknotes invalid. In November last year, the Indian government directly abolished large-denomination banknotes. Under the Bitcoin system, it seems that these problems have been solved.

But the other side of freedom is darkness. According to Wall Street Journal, in 2012, the FBI listed Bitcoin as an important challenge to combating criminal activities. Bitcoin has attracted so much attention from regulators because Bitcoin will seriously threaten taxation, combating crime and macroeconomic regulation, and each of these three items is a top priority for modern civilized countries. On January 21, 2016, according to Reuters, the Dutch police raided 15 locations in the country and arrested ten Dutch youths who were suspected of using Bitcoin to launder money for drug trafficking websites. The scale of money laundering reached 15 million to 20 million euros.

Central banks around the world are taking action to fight against currency issuance rights

Decentralized private digital currencies threaten the currency issuance rights of central banks around the world, and the monopoly of currency issuance rights is the basis for the smooth implementation of central bank monetary policy, so almost all central banks around the world do not like Bitcoin. After causing a sensation in 2013, the virtual currency Bitcoin has been plagued by negative news. This once "financial star" has once lost its starlight, and central banks around the world have also begun to ban Bitcoin or warn of risks.

According to Xinhua News Agency, in July 2013, a senior official of Thailand's Foreign Exchange Management and Policy Department stated that due to the lack of applicable laws and capital control measures, and the fact that Bitcoin spans multiple financial businesses, the following Bitcoin activities are considered illegal in Thailand: buying and selling Bitcoin, using Bitcoin to buy and sell any goods or services, and having Bitcoin transactions with anyone outside of Thailand. Thailand is the first country to completely ban Bitcoin. Somewhat ironically, this ban was caused by local Bitcoin companies' efforts to make Bitcoin a legal currency in Thailand. Thailand had previously ruled that Bitcoin was not a currency, and this effort eventually alerted Thailand's foreign exchange management agency, which completely banned Bitcoin on the grounds of lack of relevant laws and difficulty in capital control.

On December 5, 2013, the People's Bank of China, the China Securities Regulatory Commission, the China Securities Regulatory Commission and the Ministry of Industry and Information Technology jointly issued the "Notice on Preventing Bitcoin Risks", which clarified the nature of Bitcoin and believed that Bitcoin is not issued by monetary authorities, does not have monetary attributes such as legal compensation and compulsion, and is not a real currency. The central bank believes that Bitcoin is a specific virtual commodity in nature, does not have the same legal status as currency, and cannot and should not be circulated and used as currency in the market. However, as a commodity trading behavior on the Internet, ordinary people have the freedom to participate in Bitcoin transactions on the premise of assuming their own risks.

On the same day that China warned of the risks of Bitcoin, the Bank of France also said that the price of Bitcoin is inherently volatile and users may find it difficult to convert it into real currency. In addition, the anonymity provided by Bitcoin to users also poses risks because they may be used to launder money and finance terrorism. The Bank of France said in a notice: "Even if Bitcoin is not yet a reliable investment tool and therefore does not pose a serious risk to financial stability, it still represents a financial risk for those who hold it." Previously, the Dutch Central Bank also warned of the risks of Bitcoin.

According to the International Finance News, the Reserve Bank of India pointed out in its advice on December 24, 2013 that virtual currencies do not have assets to provide guarantees or protection, so their value seems to be just speculation. Of course, the huge volatility of the value of virtual currencies is also worthy of attention. Although the Reserve Bank of India has not issued a ban or restriction on Bitcoin, since these digital currencies are not regulated by the central bank or monetary authorities, users have no recourse to rely on in the event of problems. Subsequently, the Indian government raided and closed the country's largest Bitcoin website.

According to Wall Street News, in January 2014, following the central banks of China, India, France and other countries, the German central bank also warned of the speculative risks of Bitcoin. Carl-Ludwig Thiele, a member of the German central bank committee, said that Bitcoin is "highly speculative" due to its high volatility and unique structure. Without any government guarantee, Bitcoin investors may lose all their money. Previously, Germany has been one of the few countries that recognize the legal status of Bitcoin (in August 2013, Bitcoin was recognized as a "unit of account" by the German Ministry of Finance).

According to Xinhua News Agency, in February 2014, the Office of the Russian Prosecutor General issued a statement explicitly prohibiting the use of Bitcoin in Russia. The Russian Prosecutor General stated in the statement: "Bitcoin is a currency substitute and no citizen or legal entity may use it." The agency cited the law signed and implemented by Russian President Putin in 2002, saying that the official currency of the Russian Federation is the ruble, and the introduction of other currency units and currency substitutes is prohibited.

On February 28, 2014, Mt. Gox, the world's largest Bitcoin trading platform, announced that it had filed for bankruptcy protection at the Tokyo District Court in Japan because all 850,000 Bitcoins on the trading platform had been stolen. Japanese officials then said that according to Japanese law, Bitcoin is not a currency and needs to be regulated if necessary.

According to the Wall Street Journal, on October 23, 2015, the European Court of Justice ruled that Bitcoin must be treated as a currency for tax purposes rather than as a commodity. At the same time, the ruling also resolved a debate within Europe about how to treat this virtual currency. The British tax authorities have previously made it clear that Bitcoin is a currency, but countries such as Sweden and Germany believe that Bitcoin should be treated as a commodity, which means that the conversion of Bitcoin will need to be subject to sales tax laws.

The United States has always been relatively tolerant of Bitcoin. According to Xinhuanet, in November 2015, the Commodity Futures Trading Commission of the United States announced that Bitcoin would be officially classified as a commodity, which means that Bitcoin is now classified as a commodity like gold and oil, and trading behavior will be subject to all commodity derivatives market rules. Previously, the European Court of Justice ruled that Bitcoin and other virtual currencies should be exempt from VAT in Europe like traditional currencies, allowing Bitcoin to compete with traditional currencies on a more equal platform.

Before retiring, former Fed Chairman Ben Bernanke gave Bitcoin a "cautious blessing" and believed that Bitcoin "may have a long-term future." Later, he changed his tone and warned that Bitcoin had "serious problems" and that although this digital currency looked very interesting from a technical perspective, it was far from ready to replace traditional currencies. Current Fed Chairman Janet Yellen made it clear that the Fed did not have the authority to supervise and manage Bitcoin, but Congress should consider legislation to regulate Bitcoin.

It should be pointed out that so far no country has been able to completely ban Bitcoin, and the government can only regulate the Bitcoin trading venues.

He Bin, a special researcher at the Public Policy Research Office of the Institute of Economics of the Chinese Academy of Social Sciences, told NetEase Finance that whether Bitcoin is a currency is not determined by a certain country's government, because currency has not been something designated by the government since ancient times, but is a general equivalent, that is, a commodity that serves as a general equivalent. The government's issuance of currency is only a modern thing. Currency existed before the government appeared. However, Bitcoin is indeed not a legal tender. If it is approved by the country, the monetary nature of this commodity will be more perfect.

Bitcoin has huge hidden risks and is a big pit that cannot be avoided

If the monopoly of currency issuance is the only reason, it is not enough to alert the central banks of the world. After all, some countries do not care about currency issuance, let alone the independence of monetary policy. For example, Zimbabwe abolished its own currency after massive inflation and used other countries' currencies. The author believes that there are deep-seated reasons behind the central banks of the world repeatedly warning of risks and unanimously agreeing that supervision should be strengthened.

The ups and downs of Bitcoin in recent years have exposed many fatal risks.

In essence, Bitcoin itself does not correspond to any assets, nor is it backed by any national credit, so some people question whether private digital currencies are a Ponzi scheme. After Bitcoin became popular, private digital currencies such as Litecoin and Dogecoin also rose one after another. At the same time, a large number of virtual currencies controlled and issued by fraudulent companies appeared on the Internet, claiming to be decentralized currencies like Bitcoin, but most of them are virtual currencies "issued" by themselves, which are essentially pyramid schemes or Ponzi schemes. Although Bitcoin itself is not a Ponzi scheme, the wave of private digital currencies it triggered has provided Ponzi schemes with opportunities to fish in troubled waters.

The external security of Bitcoin transactions cannot be guaranteed. If you deposit Bitcoin in an exchange, the exchange may go bankrupt and run away. According to statistics, 45% of Bitcoin platforms have gone bankrupt. You should know that Mt. Gox, once the world's largest Bitcoin exchange, went bankrupt in 2014 due to the theft of 850,000 Bitcoins. There are countless cases of Bitcoin theft in the world.

Is there any way to prevent Bitcoin from being stolen? Yes, withdraw Bitcoin from the exchange to your own hard drive (usually a mobile wallet), and do not connect to the Internet, and only take it out when you need it. But the disadvantage of this approach is that once the hard drive is lost or damaged, or the data is accidentally deleted, the money cannot be recovered because Bitcoin is anonymous. Even if the existing technology cannot brute force Bitcoin, there are precedents of hackers finding loopholes to swipe Bitcoin, and recently blockchain technology has detected many high-risk security vulnerabilities (such as Dogecoin, the dog currency mentioned above), which are all possible hidden dangers.

Even if the usage problem is solved, Bitcoin still has many macro risks that cannot be avoided. First of all, the constant total amount of Bitcoin will lead to deflation. Its growth rate does not match the needs of the social development process, which inhibits its large-scale application. Due to the lack of attention in the early stage, many large amounts of Bitcoin mined in the early stage were discarded and can never be found. According to blockmeta data, the total balance of Bitcoin addresses that have not had any expenditure for more than 3 years is as high as 3.23 million Bitcoins. The number of Bitcoins in circulation is decreasing. This process of counter-inflation violates the common sense of previous currencies, making it impossible for Bitcoin to become legal tender. Because human society is creating value every minute and every second, this means that only holding Bitcoin will automatically increase wealth. You can use less money every second to buy things. Will people still use Bitcoin at that time? Of course, all Bitcoins are saved in your hands, and Bitcoin will gradually withdraw from circulation.

Secondly, the price of Bitcoin fluctuates greatly, which creates a huge obstacle for Bitcoin-based payments. Central banks or regulatory authorities in almost all countries believe that Bitcoin is too speculative and the currency value fluctuates too much. Bitcoin transactions are not zero-cost. Each transaction involves a lot of calculations and announcements of the entire network, and these calculations will constitute the transaction cost of Bitcoin. With the exhaustion of new Bitcoin issuance and Bitcoin deflation, transaction costs will only get higher and higher. It is hard to imagine that a "currency" with extremely high transaction costs can really circulate.

Figure 2: There may be no other investment product in the world with greater volatility (Source: blockchain)

Finally, Bitcoin bypasses national regulation and, to a certain extent, enables the free flow of capital, which affects the stability of national monetary policy and exchange rates. The government has the power and obligation to control the economy and capital, and thereby ensure the stability of the country's macro-economy. The emergence of decentralized Bitcoin may affect the effectiveness of policies and cause large-scale capital outflows, so governments around the world are looking for ways to regulate Bitcoin.

Talking about the future of Bitcoin, He Bin specifically pointed out that Bitcoin is not the only digital currency. This is precisely because it is free, so it will not be protected by any government or law. Therefore, similar competing currencies may appear at any time, and it is still unknown who will win in the end. If the government continues to suppress it in the future, transaction costs increase, or the central bank issues a central bank digital currency with national credit, Bitcoin may also fail. If it is a pure investment behavior, it needs to be treated with caution.

It is still unknown whether Bitcoin has a bright future, as the world has not yet reached a specific regulatory consensus. However, digital currency is undoubtedly the trend of future currency development, and countries around the world are now seizing the opportunity to innovate and develop digital currency. The promotion of central bank digital currency in China has been going on for nearly three years, and the payment system of banks in the future will inevitably undergo major changes.