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The BitCoinundrum: To Buy or Not to Buy BitCoin?

In recent times there has been the emergence of a new financial “thing”, the Bitcoin. This is a new virtual currency, and addresses some of the problems of both virtual and physical currencies.

You can buy and sell Bitcoin online using your own currency, and now, you can use that bitcoin to buy and sell other things as well, with e-commerce sites like Baidu (China) getting in on the act.

I’ll do a quick primer thing. Forget the history. Some bloke invented the bitcoin as an algorithm, yada yada yada.

A bitcoin is a digital signature type of thing. You can’t just create one of your own. It’s “mined” through an algorithm. As a bit coin owner, you will have a wallet with a public key and private key. People can send you bitcoins using your public key, and you send bitcoins using your private key. Every transactions of every bitcoin is publicly stored in a “blockchain”. Only thing is – the people doing the transaction may be hidden or it may be difficult to get to them. But from a bitcoin, you can find out which wallet it now belongs to.

There are only about 21 million bitcoins that are possible to mine, due to the technology in there. Out of this about half are already there, and more get created as transactions happen. This makes bitcoins valuable in terms of other currencies – so in USD terms, Bitcoins have moved from $22 to $800 (and as high as $1120)

Now, this is attractive in three ways:

  • As an investment: You buy bitcoin in dollars or rupees and store it. The bitcoin appreciates in terms of rupees and dollars, and you make more dollars and rupees as you sell it. This has been a great approach as the value has appreciated from $3 to $300
  • As a currency: A bitcoin is easily portable. (It’s digital). You can buy and sell using fractional bitcoins also, which means it doesn’t have the issues that gold does (breaking it up is painful). You can easily transfer it, and the digital blockchain ensures that anyone can verify that a bitcoin is yours to transfer, and once it’s transferred it’s not yours. This is great to use as a currency to buy things. If something’s priced at $100 and you own 1.3 bitcoins worth $400 per bitcoin, you can transfer 0.25 bitcoin. Bitcoin is already being accepted as currency in Chinese websites like Baidu, by Chinese real estate developers, and even for space flights.
  • As a cheap payment and money transfer mechanism: Bitcoins are darn easy to transfer unlike regular currency. Recently a $147 million transfer was made via Bitcoins.

So what’s the problem?

It can easily get stolen.

The money in your bank account is also, for the most part, digital. But would you be okay if your bank gets robbed and your account cleaned up?

Bitcoin has this problem in spades. Wallet services have shut down, taking all the bitcoins with them. People have stolen bitcoins from compromised sites. There are “fraud” sites and wallets designed only so people use their bitcoins there, and after a while, vanish with the bitcoins.

The lack of a security mechanism, such as a global police force, limits action that can be taken and money retrieved.

It has money laundering potential

Given a bitcoin I can probably find out who owned it, by going through the blockchain (public) and asking – or demanding – from wallets about the owner’s identity. But even that is difficult if the wallet owner is in a different country – like China.

But, given a person, can you find out what bitcoin he owns? This is extremely difficult. You might think this is difficult anyhow, if people own other stores of wealth, like e-gold in a different country, or an insurance policy or such. But increasingly, countries require providers of such products to provide information about buyers to the government, even to governments abroad (through acts like FATCA in the US, or tax treaties by countries like India).

Bitcoins have currently no such information sharing, and thus you could use it to keep money that is yours but isn’t identifiably yours just yet. This could create issues, like countries banning bitcoin ownership until such time as this information of ownership becomes universally available.

Notable exception: Gold. India doesn’t ask for identification details of people buying gold (they should ask, in my opinion) and most countries treat it as a trade item, not a currency.

It’s deflationary

Assume you fixed all of these problems, you might have a great investment. There are only 21 million bitcoins possible, so the more the demand, the higher the price because supply is limited.

There is also no chance of “creating money” through credit. If you lend out a bitcoin, then it’s as good as selling it – you can’t use the money. In regular currency, if you put $100 in a bank, the bank lends it out to (say) me, and I put that borrowed $100 in the same bank. Now you have $100 (you think) and I have $100 (I think). So money has just “multiplied” through credit. You can’t do this with bitcoin – the minute my bitcoin is lent to you, I cease to own it.

This limitation makes the currency deflationary. Yes the price of a Bitcoin rises in rupee or dollar terms. But if you start thinking in Bitcoins, then the value of goods that you purchase will “deflate” in value. Let’s say something was worth $100, which was 1 bitcoin. As bitcoin prices move up, tomorrow it may only be worth 1/2 a bitcoin. So why should I spend my bitcoin buying today, when I know it will be cheaper tomorrow?

That is the ultimate deflationary problem, that people prefer to hold cash and do not transact. The lack of transactions leads to hoarding of cash, which makes cash even more valuable by constricting supply. It’s a spiral, and most central bankers will try to offset that by printing more currency. You can’t do that with Bitcoin.

In effect, it’s a lousy thing to use as a currency, but a great investment if you are using something ELSE as a currency. And it’s a good payment system with low transaction costs.

It’s likely to be illegal in India

The RBI has clamped down on any form of unregulated organized virtual stores of wealth, including Paypal. As long as Bitcoin is an investment, no one will care. But if it should start being used as a currency, you can bet that the RBI will design it to be illegal. Other countries have a more logically lax view,and US courts have recently affirmed that’s it is okay as a currency.  (RBI should cut out those rules completely, in my opinion, but they exist) ‘

The income tax department is also likely to question all Bitcoin transactions because of the apparent anonymous nature of the beast. Worse, this may go against all sorts of FEMA laws, some of which carry criminal sentences, so you have the wonder if it’s worth all the trouble.

What’s the Ruling?

Think about buying an apartment on the 10th floor of a building not yet constructed, where the builder refuses to give you any documents, and where you think the price will go up.

Think about buying a ULIP where the salesman tells you your money will double in three years.

Think about buying an IPO because it will double on listing. Like Justdial. Or anything pre-2007.

If these make you salivate, you can consider buying Bitcoin.

But many of you will know how these stories tend to end. While there is a chance that you make substantial amount of money, there’s a fairly big risk – and the risk is that the “herd” chasing it will desert it, just before you exit. So yeah, I wouldn’t buy, too risky.

Note: I do not recommend any sites for buying Bitcoin. Too many go down or get compromised for me to feel safe.

  • Jason Braganza says:

    Thank you. was always curious about this, but even researching it gave me the heebie jeebies. Also was interested on what a fellow Indian’s perspective would be

  • Comprehensive and showing the right direction – I like the conclusion heading *what is the ruling**
    Risk reward ratio is not infavour of rewards. When there are many other opportunities available to get hand some returns legally, why should one go behind these kind of things?

  • Raja says:

    Great note -clarifies a lot of things about Bitcoins – thanks Deepak

  • Dinesh says:

    Is there any reliable site where in you can buy and sell the Bitcoins If you come across any.

  • nitin says:

    Well, let me ask you some of the questions:
    1) Can RBI or Govt. of India shutdown internet?
    2) Can any govt. body clamp down category of website from showing up? (e.g. illegal trades / porn etc.)
    So they can do all the ruling but putting a complete stop is not possible by anyone. I think Bitcoin or any digital cryptocurrency is of that nature. RBI can say it is illegal to trade but how they will track if I buy something over website (hosted in some country) and get delievered to india( either product or services).
    The deflationary nature of currency will actually bring more people to hold and transact in Bitcoin. In other words, just because I can buy 2 items instead of one next year at the same cost, will not prevent me from buying items/services which I want it now. Saving will get a push, definately yes.
    Lets see how the future rolls up. Thank for the article.

    • Only point here – they can’t track if you bring gold in your pocket from Dubai also. But the point is, if you get caught, you’re in trouble. Bitcoin transactions can be caught – what you buy is delivered via some route or the other, and if that is caugh, you will have to explain how you paid for it, and bingo, the bitcoin’s out. You can’t transfer it as real money to a bank account because that will get you caught.
      Assuming it is made illegal of course. Right now they haven’t said anything to that effect.

  • Leo says:

    what this says is we are getting into virtual currency …. smart phones .bitcoin …we are getting their with bumps but not yet