In 2009, a Norwegian student named Kristoffer Koch bought 5,000 bitcoins for roughly $27 as part of his thesis on encryption technology. He put them in his digital wallet and promptly forgot about them. Four years later, his $27 investment was worth $886,000 – a nearly unimaginable return of more than 38,814 times his initial investment. If Mr. Koch had held all that bitcoin, his $27 investment would have skyrocketed to $78 million. (Based on the price of $15,600 per bitcoin as we write this on December 26th, 2017.)
Mr. Koch didn’t keep all of his bitcoins. He sold approximately one-fifth to pay for an apartment in Oslo. But let’s assume he sold all of them to one buyer. That buyer would have turned $886,000 into a stash of bitcoins worth $78 million today – a return of 8,700% in just 4 years. At $15,600 per coin, bitcoin is currently 15.15 times higher than where it started in 2017. It is one of the top, if not the top, performers of last year.
It is easy to see why bitcoin has been garnering so much press and been taken seriously by many in the Wall Street establishment. The incredibly rapid appreciation of this crypto-currency gives bitcoin a current market cap of approximately $264 billion – a little less than one-third the size of Apple’s $875 billion market cap. Bitcoin is serious money – especially when you consider it has blown the doors off nearly every other stock market investment, including the rock star, FAANG stocks.
From Fringe to “Front and Center”
Not surprisingly, Wall Street has been trying to create products to make trading and investing in bitcoin easier. Two attempts by the Winklevoss brothers of Facebook fame – operators of Genesis, one of the biggest online bitcoin exchanges – to launch a bitcoin ETF that allows individual traders to buy bitcoin were shot down by the Securities and Exchange Commission (SEC) in March 2017.
While there will undoubtedly be more attempts to create a bitcoin ETF, the only way to trade bitcoin outside of individual online exchanges is in the futures market. A decision by the Commodity Futures Trading Commission (CFTC) to classify crypto-currencies as commodities – like gold, silver or crude oil – led to the recent launch of two new futures contracts which allow speculators and hedgers to easily and transparently conduct transactions involving bitcoin.
These contracts have a few critical advantages over the electronic exchanges currently used to buy and sell bitcoin, especially when it comes to transactional transparency and counterparty risk. They also have some privacy disadvantages as well. We’ll cover these, as well as attempt to explain what bitcoin is (and isn’t!) in the simplest language possible.
(Please note that we are not going to cover other crypto-currencies like Ethereum or Litecoin because they haven’t reached the same critical mass as bitcoin and have no futures contracts available.)
Let’s start with a price history of bitcoin:
Bitcoin Has Always Been Volatile
An up-to-date version of the chart above can be easily accessed by plugging the phrase “bitcoin price chart, Coindesk” into your favorite search engine. It covers the entire price history of bitcoin – starting with its initial public launch in 2010 when it traded for less than one cent, and then rallied 900% to 8 cents in just five days.
Bitcoin was born volatile and remains so. The $15,767.49 price you see on the lower left of the chart was for one bitcoin on December 26, 2017. Bitcoin rallied from less than one cent in July 2010 to $15,767.49 in roughly 7 years. It shot up 13.30% in just one day when this chart was printed.
The “supply” line in the bottom right hand corner of this chart shows that 16,764,325 bitcoins have been “mined” as of December 26, 2017. All bitcoin mining will cease once 21 million bitcoins have been created. This “scarcity” is built into the algorithm. (More later.) Bitcoin bulls often mention this “guaranteed limited supply” when they talk about how high their currency of choice can go. Forecasts of $1 million per bitcoin make this assumption as well.
In order to understand how bitcoins are mined, one needs to have a basic knowledge of blockchain technology. To comprehend the basics of blockchain as it relates to bitcoin, it helps to compare it to how we traditionally buy and sell things.
How We Pay For Things Now
We make transactions in three ways: 1) we pay cash; 2) we write checks (or use debit cards), and 3) we use credit cards. The first transaction, a cash exchange, is made between the parties of that transaction and can be completely anonymous. Anonymous transactions are virtually untraceable and, more-often-than not, irreversible.
Transactions 2) and 3) require intermediaries. A check requires a bank account. Credit card transactions require at least two banks – one to guarantee the initial transaction and a second to process the payment; in the case of transactions involving foreign currency, it requires a third.
Each intermediary collects fees as compensation for their part of the transaction, whether or not that fee is disclosed. Your bank earns interest on the money you’ve deposited. It may also charge you a fee to write a check, and another fee if your account balance dips below a set amount. Credit card companies charge retailers and other businesses fees as high as 3% of every transaction. Some charge credit card holders steep annual fees as well. Today, over two-thirds of transactions rely on plastic. Most of these involve credit cards.
To assure these transactions are legitimate, banks and credit card companies (often the same entity) have huge, centralized databases containing critical information about their customers. This information must be kept up-to-date in real time, so they can be shared with other centralized databases to verify transactions. Credit card companies use the fees they charge to maintain these extensive databases and generate a profit.
Centralized Databases Are Extremely Vulnerable
to Hacking and Loss of Privacy
The centralized nature of these databases make them extremely efficient. However, this centralization is vulnerable to hacking and, once hacked, can expose millions of credit card and bank account holders to monetary and identity theft. That’s what happened when the credit rating company Equifax was hacked in 2017 and the Social Security numbers, birth dates and home addresses of up to 143 million Americans – 44% of the US population – were stolen.
Stolen personal data is not the only threat. What these companies do with your data, even when they are not hacked, represents a loss of privacy as well. All of your transactions, including what you bought, how much you bought and where you bought it, are up for sale to companies who use that data to market to you.
Why Bitcoin Is Different
Bitcoin is based on technology known as a “blockchain.” This is essentially a database composed of individual “blocks” of data – or in the case of Bitcoin, blocks of transactions. Each block in the Bitcoin blockchain has a time stamp and is related to the block that comes before it. There are no names, addresses, phone numbers or other personal information associated with Bitcoin transactions. All transactions take place purely in code, which make them completely anonymous.
Once a new “block” of Bitcoin transactions is added to the chain, its time stamp and relationship to an earlier block means Bitcoin transactions cannot be easily altered or deleted without altering every subsequent transaction in the chain.
Imagine a brick building that is being perpetually constructed as workmen add more and more bricks every day. Every single brick (or block) represents an independent transaction. Every brick has a relationship with the bricks directly surrounding it, yet every brick is also an essential part of the whole structure.
Imagine trying to change or remove a single brick (or block) without knowing where that brick was in the structure or when it was placed there. Now imagine trying to do this without altering the structure as a whole. Any attempt to change any part of the blockchain would be noticed immediately. It would be like removing a single brick from a wall; it would stick out like a gaping hole.
While an imperfect analogy, this gives you an idea of how difficult it would be to “hack” the Bitcoin blockchain. The expense and computing power to attempt such a task would be astronomical and uneconomical. This is one of the reasons why the Bitcoin blockchain has never been hacked. The bigger the blockchain, the harder it is to alter any block in the chain, and the more computing power it takes to manage it. This becomes particularly important when it comes to “mining” bitcoin.
Bitcoin Does Not Need a Centralized Database
Like the bricks in our metaphorical building, bitcoin is made up of individual blocks that when viewed together contain the whole encrypted record of every bitcoin transaction ever made. This eliminates the need for a central database and makes bitcoin extremely mobile. The Bitcoin blockchain ledger can reside anywhere or everywhere on the web. It is borderless.
Because each block in the chain is only related to a previous block, no one making transactions on the Bitcoin ledger has access to the entire database. Bitcoin users only access those parts of the blockchain they “own” by using private encrypted keys.
Private “keys” (basically, unique pieces of encrypted code) allow a user to rewrite only those parts of the Bitcoin ledger that involve themselves and the entities on the other side of the transaction. Bitcoin “keys” are used to access addresses that contain units of currency, which can then be transferred directly to a recipient.
Once a private transaction takes place, it is added to the blockchain and becomes part of the ledger, creating an unalterable and undeletable record. This eliminates the need for centralized record-keeping. The same architecture responsible for facilitating the transaction creates and stores the record. Aside from Bitcoin miners who verify the integrity of the transaction, no middlemen are required to ensure its legitimacy.
The only parties that can access the details of a specific transaction are the parties involved in that transaction who hold the same encrypted “key.” No names, addresses or other personal data is required. This makes Bitcoin and its other crypto-currency cousins very valuable to those wishing to keep their financial comings and goings on the “down low”. It is why bitcoin gained its initial notoriety on the “dark web” as the preferred means of exchange for drug transactions – a dubious distinction it still holds…
Editor’s Note: Stay tuned for “Parts 2 and “3” which will be released over the next few weeks. In “Part 2” we’ll examine the bitcoin mining process and attempt to determine whether Bitcoin is “real” money, a store of value or just a flash in the pan. We’ll also take a brief look at the way Bitcoin is traded now, including who is buying it and why.
“Part 3” will examine the new Bitcoin futures contracts and how they could be used to gain certain advantages over the electronic exchanges currently used to trade bitcoin. We’ll also explore some long and short Bitcoin trading strategies that could provide powerful Alpha to any traditional portfolio.
The RMB Group has been helping clientele trade futures and options since 1984. RMB Group brokers are very familiar with the new Bitcoin futures contracts covered in “Part 3” of this report. A full PDF version of this report is available now. Call us toll-free at 800-345-7026 or 312-373-4970 direct to receive one. RMB Group trading customers who wish to receive the full report now can also contact their personal broker.
If you are new to futures and options and want to learn more about them, download the RMB Short Course in Futures and Options. This free, easy-to-read guide covers all the basics. Call us toll-free for your free copy or go to our website at www.rmbgroup.com. Click the “Education Tools” tab at the top of the home page and scroll down to find the report.
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The RMB Group
222 South Riverside Plaza, Suite 1200, Chicago, IL 60606
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