Bitcoin has been a hot topic lately. Prices for the digital currency have risen by more than 1,000% since the beginning of 2017, and bitcoin futures just started trading on two major U.S. exchanges.
This has left some investors wondering: What's the big deal with bitcoin? How risky is it, and is it something I should consider for my own portfolio? Here are some facts:
What is bitcoin?
Bitcoin is a digital currency - or "cryptocurrency" - that allows online payments to be made directly from one party to another through a worldwide digital payment network, without the need for a central third-party intermediary such as a bank. Records are held on a distributed public ledger called the blockchain that is stored and duplicated on thousands of computers throughout the world. While there are over 700 different types of cryptocurrencies, collectively called altcoins, several examples other than bitcoin include Litecoin, Ethereum, Ripple, and Zcash to name a few.
The global supply of bitcoins is increasing through computer "mining" - a record-keeping service that involves repeatedly verifying and collecting new transactions into a new group of transactions called a block. The total supply is fixed at a maximum of 21 million coins. To date, about 16.7 million bitcoins have been created - although Chainalysis, a digital forensics company, has estimated that somewhere between three and four million already may have been lost (for example, through irrecoverable passwords or people who accidentally threw away bitcoin collections back when they weren't worth very much).
Like physical gold, which is likewise not backed by any central bank or government, bitcoin's value stems primarily from its scarcity and public faith in bitcoin as a store of value, means of payment or hedge against inflation.
Why is bitcoin's price so volatile?
As of January 5, the price of a single bitcoin exceeded $16,000 and people around the world held approximately $282 billion in bitcoins.¹ At this price level, that exceeds the market capitalization of such bellwether companies as PepsiCo (NYSE:PEP), Boeing (NYSE:BA), and McDonald's (NYSE:MCD). It is relatively small, however, compared with the $6 trillion value of all outstanding gold bullion, and the market capitalization of $23 trillion for the stocks in the S&P 500 Index.
"Because bitcoin is limited to only 21 million coins ever, and an estimated four million have already been lost, there is a large demand and a relatively small supply. Typically, that is a recipe for high volatility," says Randy Frederick, Vice President of Trading and Derivatives at Schwab (NYSE:SCHW).
"Since two major futures exchanges have begun listing contracts on bitcoin, some buyers may be speculating that if more mainstream investors get involved, the price will rise as new buyers step in," Randy says. "Others have bought bitcoin due to the fear of missing out on something that has provided large profits - but also high risk - to many buyers."
How do you buy bitcoins?
Bitcoins can be obtained through various methods, including paying cash for them through an exchange like Coinbase, providing goods or services in exchange for bitcoin, buying from a bitcoin ATM, or by mining bitcoins with a computer.
Currently, it is not possible to buy bitcoins on any exchange regulated by the Securities and Exchange Commission (SEC), nor through an SEC-approved mutual fund or exchange-traded fund. Proposals submitted to the SEC for such products have been rejected, largely due to the current lack of bitcoin market regulation, Randy says.
However, Cboe Global Markets Inc. and the CME Group Inc. (NASDAQ:CME) both launched bitcoin futures trading in December 2017. Nasdaq has announced plans to offer a bitcoin product by mid-2018.
Know the risks
"Bitcoin's dramatic rise and fall has been driven primarily by supply and demand, not valuations," Randy says. "Bitcoin doesn't have earnings or revenues. It doesn't have a price-to-earnings ratio, price-to-sales ratio or book value. Traditional value metrics simply don't apply, so there are no current methods for assessing its value."
With a price gain of more than 4,000% in a little more than two years, bitcoin is definitely in a bubble by most definitions, Randy says. While that doesn't mean a crash is imminent or that prices won't continue to move higher, it's important for investors to understand that investing in bitcoin is extremely risky, he says.
- Financial loss: Bitcoin prices historically have been highly volatile, and fluctuations could result in significant losses for investors.
- Fraud and cybercrime: These already have occurred. For example, in 2011, Japan-based Mt. Gox, then the largest bitcoin exchange, experienced a security breach in which 850,000 bitcoins worth approximately $450 million were stolen. In November 2017, a cryptocurrency called Tether reported a $31 million theft.
- Theft or loss: A login ID and password are usually needed to access the exchange, so if that is forgotten, lost or stolen by a hacker or phishing scam, access could be denied or lost. Online purchases still require a link to a bank account and/or a credit card. While bitcoins can be stored in physical wallets so they can be spent without a computer, this creates the same risks as with all cash currencies: They could be lost, stolen or destroyed by accident.
- Computer outage or cyber attack: Bitcoin exchanges have been subject to computer outages caused by excessive demand or other problems. Also, because ledgers and most holdings are held on the internet, a large-scale cyber attack could limit access during times of national emergency, something that would not happen with physical cash or gold.
- Lack of regulation: Trading in bitcoin and other cryptocurrencies is largely unregulated. Washington has been devoting more resources to monitoring digital currencies, but regulators have not reached a consistent or universal stance.
"Bitcoin doesn't fit within traditional asset allocation models, as it is neither a commodity nor currency," Randy says. "Virtual currencies are highly volatile and still lack many of the regulations and consumer protections that legal-tender currencies have. Due to the high level of risk, investors should view bitcoin as a purely speculative instrument that should only be traded with money that they can afford to lose."
Can I trade bitcoin at Schwab?
At this time, Schwab does not allow clients to directly buy and sell bitcoin from their Schwab accounts, nor are bitcoin futures products currently offered to Charles Schwab Futures clients.
However, Schwab began showing real-time bitcoin futures quotes on StreetSmart Central and StreetSmart Mobile in December 2017. Schwab will continue to monitor client interest and may choose to offer bitcoin futures trading in the future.
What's the price of bitcoin right now?
Charles Schwab does not track the individual prices of cryptocurrencies. For clients interested in the Cboe or CME futures prices, real-time quotes can be monitored in StreetSmart Central and StreetSmart Mobile. For clients interested in tracking the price of the underlying cryptocurrencies, there are many different exchanges that offer quotes, such as Coinbase or Gemini. An easy way to track the price of bitcoin on Schwab platforms is to watch symbol $GXBT, which is the Gemini Bitcoin Trade Price Index.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.