Bitcoin and cryptocurrency: Long-term potential or short-term buzz

What is cryptocurrency/bitcoin?

What is Cryptocurrency?
Cryptocurrencies like Bitcoin are digital currencies built on a technology called blockchain. Blockchain enables secure peer-to-peer digital payments that do not require a third party, like a bank, to verify them.

What is Bitcoin?
Bitcoin is one of several digital cryptocurrencies built on a technology called blockchain. Should I invest in Cryptocurrency or Bitcoin? Every situation is different. While we don't offer a way to hold or purchase cryptocurrencies, you should talk with your local Edward Jones financial advisor about the risks involved and your financial strategy.

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Graphic details: From left to right, Bitcoin miners discover unique blocks of numbers, known as hash, to add to blockchains. By approving these blocks and adding data to the blockchain, miners are rewarded with bitcoins.

Blockchain is a digital ledger—or record—of transactions managed by a decentralized network of computers and plays a crucial role in cryptocurrency systems.

For ledger entries to be successfully added to a blockchain, all computers on the network must agree that the entries are accurate. If they all agree, the ledger entries are added and a cryptocurrency such as bitcoin is issued as a payment.

Bitcoins are created by a process known as “mining”—a critical component of blockchain technology that keeps the system working.

Bitcoin miners are gatekeepers to the blockchain technology, approving transactions and preventing fraud. By approving blocks and adding data to the blockchain, miners are rewarded with bitcoins. This reward offsets the costs (computer hardware and power consumption) associated with approving blocks.

Contrary to popular belief, miners are not solving complex math problems but instead are attempting to discover a unique 64-digit number to approve new blocks to add to the blockchain. This number is known as a “hash.” The blockchain adjusts the difficulty of mining bitcoins based on how many miners (also known as nodes) are operating on the network. The more nodes, the higher the difficulty.

The first bitcoins could be mined with one guess. The odds today of guessing the correct hash for a bitcoin are 1 in 17.5 trillion. This is why massive computing power is needed. Miners are trying to maximize the amount of guesses per second to discover correct hashes before other miners. Large groups of shared computing power are known as mining pools, and these mining pools account for the majority of cryptocurrency-mining activity.

Although the driving forces behind Bitcoin's recent price appreciation are not totally clear, the media has attributed the increase to the following:

• The market is seeking Bitcoin as an inflation hedge. Unlike many major global currencies (including the U.S. dollar), Bitcoin has a fixed supply of 21 million units.
• Large digital payment companies like Paypal, Venmo and Square are now accepting bitcoin as a form of payment or exchange on their platforms.
• Several companies, including Tesla and data analytics firm Micro Strategy, have announced large purchases of bitcoin. They have also announced they will start accepting Bitcoin for payment.

Bitcoins cannot be bought or sold directly, unless you buy the cryptocurrency directly from the owner. They are usually purchased on exchanges, such as Coinbase, where users can exchange currencies or other cryptocurrencies for Bitcoins. Purchases are usually for fractional shares of a bitcoin.

Bitcoin appears to trace previous bubble patterns. After rising more than 1,300% in 2017, bitcoin began 2018 with a precipitous decline, losing over half its value in the first month of trading. Bitcoin's rise in 2017 far surpassed previous bubble peaks, such as the dot-com bubble of the late 1990s and the recent U.S. housing market bubble, and bitcoin's rapid recent decline are tracing the decline patterns of those bubbles as well. While predicting the near-term or even long-term direction of bitcoin is impossible, we believe extreme volatility is likely to continue.

While blockchain holds promise, mainly due to increased security, it has limitations. The main one is it’s difficult to scale a public blockchain. For context, the current limit of transactions per second on the bitcoin blockchain is approximately seven, while Visa's network can process 1,700 transactions per second. The bitcoin blockchain's low number of transactions is due to protocols limiting block sizes to one megabyte and aiming to keep the time between new blocks added to the blockchain to about 10 minutes.

The other limitation is that as mining becomes more difficult and the network becomes more congested, the amount of computing power needed is amplified. These power needs increase the costs of building the appropriate hardware, likely cutting out smaller players. This will concentrate mining (and nodes) in the hands of larger players, limiting the decentralized nature and original premise of blockchain technology.

The value of bitcoin or any given cryptocurrency remains highly uncertain, and they have all exhibited significant price fluctuations.

Cryptocurrencies are not common stocks of companies and do not trade on stock exchanges. Unlike an investment in a stock or mutual fund there are no underlying fundamentals (cash flows, profits, tangible assets, etc.) to support their valuations. The uncertainty this creates has led to extreme volatility in cryptocurrencies such as bitcoin, ethereum and litecoin. Other risks include price manipulation by unknown market participants, the potential for government interference, and competition from other cryptocurrencies. The SEC and other financial regulators have recently issued letters warning investors of these risks.

We believe cryptocurrencies are highly speculative and don't offer a way to purchase or hold cryptocurrencies or future contracts on cryptocurrencies.

Additionally, Edward Jones doesn't offer a way to purchase cryptocurrency-related funds, exchange traded funds (ETF), or exchange traded notes (ETN) that own cryptocurrencies directly, or cryptocurrency-related over-the-counter (OTC) traded securities.

We recommend following time-tested investment principles and not letting the fear of missing out negatively impact your long-term investment strategy.

Remember to always do your homework before deciding on any investment, including investments in emerging technologies and markets.

Working with your Edward Jones financial advisor can help you determine whether a particular investment is suitable for your portfolio.