As both an investor and a geek, Bitcoin is very close to my heart. Understanding the deep technological aspects of Bitcoin together with understanding how capital markets work helps me a lot in the decision making of investing in cryptocurrencies.
A bit about me — I sold my company on 2016 to Oracle. Once I received the cash from the deal, I was unsure about what to do with it. Do I just go with my friend’s suggestions and let other people who know more about money invest it for me, or do I do it myself? I figured a 50/50 approach would be interesting and kind-of safe, which is what I ended up doing.
In the process of investing my own money, I gained a lot of information about how companies work, how stock picking works, what is the S&P500 index and why it is such a good investment, trading commodities, gold, and angel investing.
My Bitcoin era started in 2012 where I bought a few Bitcoins in 2012. Back then I barely had any spare money, but I decided to still do it when Bitcoin was around $200. Since then I have been following it and investing a bit more of my money into cryptocurrencies.
Over the years, I figured out a lot of things that people sometimes miss out on, so I thought it’s time to share the analysis of investing in Bitcoin and other cryptocurrencies.
Here are a few points which talk about the risks and properties of digital currencies, and the different ways of mitigating those risks.
The TL;DR here, by the way, is that the safest thing to do is to invest only in Bitcoin.
Bitcoin is not a technology. It is a registration of how many coins you have on a ledger.
When you buy Bitcoin (or any other specific cryptocurrency for that matter), you include yourself in a ledger as an owner of some Bitcoin. The ledger notes all transactions made on the Bitcoin blockchain, and owning Bitcoin simply means that one of these transactions include a row that says that someone sent money to a wallet which you have the private key for (so you can send other people Bitcoin if and when you wish to). This is very important to understand, because many cryptocurrency investors believe that other cryptocurrencies can outperform Bitcoin in technology, where in fact it is the other way around.
Bitcoin’s developers have a lot of responsibility on their hands, which is why they do not rush to introduce new technologies into the Bitcoin protocol. This is because technologies need to be tested out in the real-world for years until they can be announced as “safe” and “good”. Luckily, there’s a very vibrant community of developers who decide to “challenge” Bitcoin’s superiority by developing better, smarter technologies into Blockchain. Things like smart contracts, proof of stake, zero knowledge and other decentralized technologies are being developed on a daily basis. These technologies are almost never introduced into the Bitcoin protocol. But eventually, the good ones will.
What does this mean from an investor’s perspective?
It means that Ethereum or other digital currencies do not need to be chosen on top of Bitcoin because Bitcoin’s technology is not as good as other cryptocurrencies, because the slowness of the adoption is actually an intentional aspect of the development and not because of a core disadvantage.
Bitcoin is the de-facto standard of cryptocurrencies
Why is gold worth a lot of money? Simply because others believe it is worth a lot of money. Gold has some intrinsic value, but most of its value really comes from the fact that everyone wants it, and that it is scarce enough for people not to be able to mine it without investing a lot of effort / money in the process.
The exact same logic applies for Bitcoin as an asset. Ethereum’s reputation is just not as good as Bitcoin’s, and that’s the reality. Will Ethereum ever be more famous and wanted than Bitcoin? maybe. But it is the same as asking if platinum would be traded more than gold. It is possible, but unlikely. Another good analogy is Facebook. Facebook is a very large social network, and it is very hard to de-throne it from its supremacy by trying to build better technology, like Snap is trying to do. No matter how hard Snap will work, Facebook can always copy and develop the same technology, and use its social graph as the “moat” for superiority over Snap.
Will Snap someday overtake Facebook? Maybe. Maybe not. But it’s relatively unlikely, as much as it is relatively unlikely that Ethereum will overtake Bitcoin.
How can you mitigate this risk? Some say holding only Bitcoin is the way to go. But perhaps a more formal “solution” to this problem is to hold an “index” of the major coins, with proportional and dynamically adjusted holdings to market size of each coin, similar to standard stock market indices such as the S&P500.
I personally hold mostly Bitcoin as the solution to this risk.
Bitcoin’s politics are a risk
A while back, there was a big feud about Bitcoin which ended up in a “fork”. Whenever there is disagreement between the Bitcoin maintainers, a very dangerous phenomenon happens when two different ledgers are created from the original ledger, essentially creating two times the amount of money but in different forms. A few years ago, such a feud occurred between two different groups which created something called “Bitcoin Cash”. The people who believed in the original Bitcoin ledger could, for example, sell their Bitcoin Cash which they had from forking the ledger, and covert it into standard Bitcoins, whereas the people who believed that “Bitcoin Cash” was the real “Bitcoin” did the opposite. Eventually, the original “Bitcoin” won. (Read more here).
These types of disagreements can happen all the time, and the risk of them happening again is always imminent.
Moreover, these disagreements can also happen if two large countries fight over Bitcoin since countries like China have control over their miners in some ways. Since roughly 65% of Bitcoin miners are in China, it means that China’s government can control Bitcoin if they really wanted to.
This is an inherent risk in Bitcoin, and is unfortunately part of the risk that we have to take on when investing in cryptocurrency. The only way to mitigate such risks is to choose the least centralized digital currency, but even that won’t help because the developers of the coin are the only ones who truly control the code of the official client, and can always decide to fork it again if there is a disagreement between the developers of that coin.
The only way to mitigate this risk is to stay up to date with the emerging disagreements around the cryptocurrency’s internal politics. Mitigating this risk by holding several coins in my opinion introduces other risks, so maybe the way to go is just to accept it and hope that humanity will ensure that the large coins such as Bitcoin and Ethereum will be treated fairly.
If an entity controls more than half of the global hashing power of a certain cryptocurrency for even a short amount of time, that entity can also disrupt the ledger for a short while, and possibly create a scenario where it can steal or create new money, because of how distributed ledgers work.
Today, this risk is not an actual risk for large coins. However, the smaller the coin, the higher the chance it can suffer from such attack.
This attack is only relevant to the Proof-of-Work algorithm and not the Proof-of-Stake algorithm (which will probably replace Proof-of-Work in Bitcoin), since carrying out a Proof-of-Stake 51% requires holding 51% of the global currency, which is highly unlikely for a highly distributed cryptocurrency.
To avoid this risk, investing in large cryptocurrencies such as Bitcoin is a good idea.
Distrust because of loss of money due to hacks or lost keys
Perhaps the scariest risk in Bitcoin, and in which the world did not find a solution to yet, is the loss of money.
Since digital cryptocurrencies do not have an undo button, hacks are irreversible. It is as easy to steal 1 Bitcoin as it is to steal 1,000,000 Bitcoins. And if someday, $1B worth of cryptocurrency will be stolen, then it can create both a huge distrust in all digital cryptocurrencies, not just Bitcoin. If the stealer also attempts to sell off those Bitcoins as fast as it can, it can also create imbalance in the coin, which can cause a cascading effect and make the coin worth less and less until the point where people don’t believe it’s worth as much as it was worth, which will create a major, irreversible distrust in the specific cryptocurrency being sold.
There are huge wallets that hold most of the Bitcoins today. If anyone would discover the private keys / secret seed of these wallets, such a scenario can definitely happen.
Another issue, probably less major because it is unlikely that it happens for large wallets, is the loss of private keys. Loss of private keys can happen due to different factors, such as:
- Forgetting passwords
- The death of the person who knows where the keys are or the passwords which protect the keys / the seed
- Forgetting where the money is
- Disk corruption
- Lost/stolen computers or phones
- A fire in your house or another disaster such as a nuclear attack or a zombie apocalypse in your area
Unfortunately, this is the only risk which simply cannot be mitigated. An investor needs to take care of himself in the best way possible (don’t lose your key and guard it with your life), but the macro risk just can’t be mitigated, until technology will be developed to mitigate the loss of Bitcoin. This is definitely a problem which can be solved, and should be solved as soon as possible. I personally know people who did try to solve this problem, but solving this problem requires proven and safe technology to allow to reverse specific transactions, while keeping the ledger truly distributed and thinking about the real-life implications of reversibility.
Regulation and banning cryptocurrencies
There is some risk in holding cryptocurrencies because of the inability of governments to control them. Banning or limiting the use of cryptocurrencies can eventually reduce their value because they cannot be bought or sold, which in turn causes them to be less attractive to others.
However, due to many countries potentially benefitting from the wealth caused by making cryptocurrencies legal, it is unlikely that over time the world’s governments will decide to unanimously ban cryptocurrencies.
Unfortunately, there isn’t really a way to mitigate such a risk. However, the chances of cryptocurrencies being heavily affected by such issue over time is minimal. It is more likely that such issues will cause investors in specific countries to be limited in terms of converting cryptocurrencies into cash and vice versa.
In my opinion and as someone who held Bitcoin since 2012, my opinion has not changed since then. Bitcoin is the safest way to go.