Bitcoin: A Brief Update for U.S.-Based Individual Investors

Bitcoin: A Brief Update for U.S.-Based Individual Investors
<a href="">MichaelWuensch</a> / Pixabay

The following post will attempt to provide an overview of bitcoin‘s current status. Please note that although we have made an effort to include relevant and up-to-date information, this is a rapidly evolving space and we don’t purport that this summary is conclusive or all-encompassing, nor does it constitute financial advice. In it, we will seek to address the following questions at a high level (click to jump to that section):

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  1. What is bitcoin, and how does blockchain technology work?
  2. What are the primary use cases for bitcoin?
  3. Why has there been so much recent media buzz around bitcoin?
  4. How is bitcoin treated from a legal and tax perspective?
  5. What are the biggest obstacles or headwinds to further price appreciation, and to broader adoption of bitcoin?
  6. How does bitcoin fare when viewed through an Environmental/Social/Governance (ESG) lens?
  7. Should I own some bitcoin in my portfolio? If so, how much, and where do I buy it?

1. What is bitcoin, and how does blockchain technology work?

Investors and Wealthspire clients should refer to our Deputy CIO Dmitry Katsnelson's 2018 white paper, "The Cryptocurrency Question," for background on the origins of bitcoin and the blockchain technology that underpins it.

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2. What are the primary use cases for bitcoin?

Proponents of bitcoin assert that it has the potential to function as a store of value, akin to "digital gold." Gold has maintained its value throughout the ages in large part because of its scarcity and its high stock-to-flow ratio (in other words, the difficulty and expense of procuring each additional unit of gold has made it impractical to dramatically inflate - and therefore devalue - the existing supply relative to its demand). Similarly, bitcoin's source code dictates that only 21 million coins will ever exist, and that these coins will be cryptographically "mined" according to a predetermined schedule, resulting in an asset that is digitally scarce and (so far) impossible to corrupt or counterfeit due to its decentralized nature and globally-distributed ledger. Relative to gold, bitcoin is more easily and efficiently stored, exchanged, and transported. An oft-cited post-apocalyptic example in crypto forums   is the fact that a bitcoin holder (or "hodler") could theoretically cross international borders with millions of dollars' worth of bitcoin stored in one’s head if one had memorized the seed phrase needed to access one’s cryptocurrency wallet, obviating the  need for guarded bank vaults full of gold.

So, how does the price of bitcoin hold up relative to gold or other asset classes like stocks and bonds, particularly in a crisis? It’s  far too soon to say - gold has been around for millennia and stock exchanges date back to the 17th century, while bitcoin was created in 2009, just 11 years ago. (Gold bugs would argue, of course, that that's precisely the point: gold is one of the few commodities that has withstood a wide variety of geographic and political regimes.) However, if we take the onset of the COVID- 19 pandemic as a recent example of an (arguably) exogenous shock to the financial system and look at how bitcoin performed,    we see that it briefly sold off in mid-March and lost as much as half of its value before bouncing back to end Q1 2020 down - 10.7%. For comparison, the S&P 500 finished the first quarter down -19.6% and the ETF GLD (which we will refer to here as a proxy for gold) was up +3.6% over that same period. As the Winklevoss twins (bitcoin enthusiasts and founders of the Gemini cryptocurrency exchange) observed on a recent  podcast, the first quarter of 2020 demonstrated that there's just no substitute  for cash in a liquidity crisis.

The other primary use case for bitcoin would be as a medium of exchange - a currency in the traditional sense of the word. One of the most innovative aspects of bitcoin is the fact that it has the potential to function as a system in which two individuals who perhaps don't know each other and may not trust each other can exchange value without relying on a trusted third party, such  as a bank or escrow agent. Through a proof-of-work chain, it purports to solve the Byzantine Generals' Problem, a philosophical and computational conundrum in which two parties seek consensus over untrusted communication channels.

Due to high costs and the time required to confirm a transaction, it is not yet practical or economical to purchase your morning coffee in bitcoin. In this regard, bitcoin has a ways to go, though technological experiments like the Lightning Network are underway.

3. Why has there been so much recent media buzz around bitcoin?

A number of factors and events seem to have increased bitcoin's visibility in financial media so far this year, such as:

  • The May 11, 2020 bitcoin halving, a pre-determined date at which miners' reward is cut in half.
  • Macro trends, including unprecedented Central Bank stimulus in response to economic fallout from the pandemic and fears that we could be headed into an inflationary environment, against which bitcoin may serve as a
  • Two publicly-traded companies, Microstrategy (MSTR) and Square (SQ), recently announced that they have moved a portion of their treasury reserves into bitcoin ($425M and $50M, respectively).
  • The founders of BitMEX, a well-known cryptocurrency exchange, were recently indicted by the Department of Justice for violating the Bank Secrecy Act by failing to maintain an adequate Anti-Money Laundering ("AML") The Commodities Futures Trading Commission (CFTC) also filed a related civil enforcement action.
  • On October 21, PayPal announced that users would soon be able to buy, sell, and hold (but not withdraw or deposit) cryptocurrencies on its
  • Finally, its price appreciation: year-to-date through 11/19/20, BTC has grown 150% in value. Any move that big is bound to capture the attention of both traders and financial

4. How is bitcoin treated from a legal and tax perspective?

The legal and regulatory landscape around bitcoin is still developing, and for the purposes of this blog post we will focus on its treatment within the United States. While it is legal for individuals to hold and trade bitcoin, it (and cryptocurrencies more generally) defies neat legal and regulatory characterization, as you can see in the summary table below:


Despite what its name might imply, under current law, crypto is not treated as a currency for tax purposes, but rather as a capital asset. In an article entitled Income, from Whatever Exchange, Mine, or Fork Derived: The Basics of U.S. Cryptocurrency Taxation, published in Banking & Financial Services Policy Report in 2018, attorney Kathleen Semanski explores the tax treatment of bitcoin for both individual investors and cryptocurrency exchanges:

"...the distinction between property and currency is critical to understanding U.S. federal income taxation of cryptocurrencies. Generally, when a U.S. individual or business uses cash to purchase property, the holder of the cash is not taxable on any gain or loss inherent in the cash used for the purchase...Gain on nonfunctional foreign currency exchanges (i.e., currencies other than the main currency used by a trade or business) is generally ordinary income...In contrast, gain or loss on the sale of property can constitute either ordinary income or capital gain, depending on whether the property sold is or is not a capital asset..."

Individual investors are expected to report and pay capital gains tax on the difference between the sale price and one's cost basis. As you can imagine, this has the potential to impede bitcoin’s function as a broadly used medium of exchange.

The IRS has signaled that they intend to take this position seriously. In summers 2019 and 2020 the agency sent a spate of "educational" letters to cryptocurrency account holders warning taxpayers who try to skirt these obligations that they could be "subject to future civil and criminal enforcement activity." The agency also released guidance in October 2019 and reiterated their commitment "to helping taxpayers understand their tax obligations in this emerging area," though many in the crypto community felt the guidance raised as many questions as it answered. Notably, beginning in 2020, there will now be a question about cryptocurrency holdings on the Form 1040 used by individual U.S. tax filers: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Although this is simply a "yes or no" question, it is clearly intended to prompt taxpayers to fulfill their reporting and payment obligations for bitcoin and other cryptocurrency assets. Many well-known cryptocurrency exchanges will now send users a Form 1099-K if their transactions exceed a certain threshold (in value or frequency), but this form does not report gain/loss and ultimately the burden lies with the taxpayer to maintain adequate records.

5. What are the biggest obstacles or headwinds to further price appreciation, and to broader adoption of bitcoin?

Most individual investors (to say nothing of institutions that must answer to clients or shareholders) may not have the risk appetite to engage with or hold an asset class whose legal status - although increasingly well-established - is still somewhat precarious. Whether bitcoin travels well is also unclear; relative to other countries around the world, the U.S. has established a reputation for being somewhat crypto-friendly - perhaps because it is not viewed as a serious threat to the dominance of government-issued currency. Even among enthusiastic bitcoiners, government regulation around the world is viewed as one of the most serious threats to the digital currency's longevity and continued expansion. Although it is possible - perhaps even likely - that bitcoin would continue to exist underground even if most countries outlawed exchanges, the average citizen living in a country with a stable government currency is unlikely to continue to want to hold the digital coin in the face of potential legal ramifications.

Legal ambiguity aside, self-sovereignty is a key component of the bitcoin ethos. "Not your keys, not your bitcoin" is a commonly repeated slogan within the community - meaning that individuals are responsible for securing their own coins, unlike traditional banks or financial custodians who undertake that responsibility on their clients' behalf. There have been several well-publicized heists of digital coin exchanges, perhaps the most famous being the 2014 Mt. Gox attack in which 850,000 bitcoins were stolen. Likely an even greater threat than hackers, however, is human error - if one loses the private key that is needed to claim one's  coins from a wallet, there is no way to retrieve it - no customer service number to call, no federally-guaranteed insurance  coverage, and no recourse. In fact, an estimated 4 million bitcoins (roughly 20% of the current supply) are already irretrievably lost. Security concerns are likely to remain a significant barrier to entry, as it is not clear that most individuals (particularly those who do not view themselves as tech-savvy) are interested in investing the time and energy needed to adequately secure their own bitcoin. That said, the market for "friendlier" custody solutions is evolving, as is the array of traditional financial services (including collateralized lending, etc) that is available.

Saifedean Ammous's book The Bitcoin Standard includes a discussion of other potential threats that are beyond the scope of this post, including relatively technical concepts like a 51% attack, hardware backdoors, and a rise in the cost of nodes - most of which have thus far been mitigated by economic incentives. Those interested in reading further should refer to the chapter "Bitcoin Questions."

Bitcoin also faces public-image challenges and in some circles is still considered taboo or "unserious." Many people's familiarity with bitcoin is limited to news stories about ransomware attacks in which criminals demand payment in bitcoin in exchange for releasing their control of a network. They may also associate bitcoin with shadowy transactions on the dark web and recall the 2013 Silk Road bust in which the FBI confiscated what was then about $4M worth of the cryptocurrency. Of course, most nefarious transactions worldwide occur in cash - but that does not mean we eschew the use of cash for legitimate business. It is also becoming increasingly clear that bitcoin is not anonymous, and cryptocurrency exchanges that attempt to circumvent "Know Your Client" (KYC) regulations to allow unidentified users to transact within the U.S. face legal issues.

The very fact that bitcoin's success is dependent on network effects (that is, the probability that bitcoin is seen as a store of value increases as more people buy into it) leads critics to compare it to a multi-level marketing or Ponzi scheme. (A counterargument would be that fiat currencies are dependent on network effects, too: we have collectively agreed to view the U.S. Dollar as representative of the stability, creditworthiness, and wealth of our central government. Bitcoin, on the other hand, is underpinned by the blockchain.) Others consider its network penetration too weak (or its concept still too nascent) to merit substantial investment - fearing it to be equivalent to MySpace or Friendster, with the advent of Facebook around the corner. As discussed earlier in this post, scalability also remains a serious challenge.

Finally, it should be said that there remains the possibility that some other unforeseen event could jeopardize the cryptocurrency's status. Time will tell.

6. How does bitcoin fare when viewed through an Environmental/Social/Governance (ESG) lens?

From an ESG perspective, bitcoin gets (at best) a "mixed" report card.

Bitcoin mining requires a huge amount of electricity and computing power. The website Digiconomist (accessed 11/19/20) reports that a single bitcoin transaction has a carbon footprint equivalent  to  approximately  740,000  VISA  transactions, consumes as much electrical power as an average U.S. household would in 24.12 days, and produces "two golf balls" worth of electronic waste. The Cambridge Bitcoin Electricity Consumption Index tracks the energy use of bitcoin in real-time - and it isn't pretty. Most estimates suggest that over the course of a single year, the bitcoin network uses as much or more energy than several countries.

The social implications of bitcoin adoption are somewhat rosier. Many see it as a potentially enormous catalyst for growth in the developing world, freeing individuals from reliance on a banking system that has been historically inhospitable. As our colleague Dmitriy highlighted in his paper published a few years ago, if bitcoin succeeds in scaling, the implications for global remittances system are significant. Individuals working in developed economies could theoretically send money to friends or family situated elsewhere more efficiently and without the intervention of (or facilitation by) third parties. Additionally, although the scenario is foreign to U.S. citizens and residents who are accustomed to a stable currency regime, individuals living in countries where the currency has been devalued (e.g. Venezuela, Argentina) - in some cases, repeatedly - may find that bitcoin functions as an effective store of value and thus preserves wealth better than government paper.

Because of its decentralized nature, governance is perhaps bitcoin's greatest strength. Although there are many publicly-facing "cheerleaders" and thought leaders in the bitcoin community (and at least as many notable naysayers, including Warren Buffet and Ray Dalio), there is no c-suite calling the shots (or abusing their positions of power), and no single point of failure.

Cryptocurrencies are ruled by consensus, and each "seat at the table" is earned by miners who are incentivized to maintain the integrity of the system. It remains to be seen, however, how bitcoiners will continue to navigate certain thorny issues such as forking that are critically important to achieving broader use of the coin.

7. The critical question: Should I own some bitcoin in my portfolio? If so, how much, and where do I buy it? A word of caution.

The bitcoin community is regarded as one of the most outspoken and opinionated groups on the internet (heterogeneous as it may be). Cryptocurrencies - and bitcoin in particular - are so multifaceted and touch upon such a wide variety of fields (including computer science, finance,  philosophy, and politics/governance) that it is easy to find the scope of material overwhelming. In     fact, the experience of newcomers getting buried in an ever-growing, self-referential sea of books, articles, podcasts, and  community forums is so common that it is often referred to as "going down the crypto rabbit hole." Social media algorithms also tend to reinforce the narrative that one is already acquainted with. Follow one bitcoiner on Twitter, and the platform will suggest several others you may be interested in - which could subsequently lead you to the Bitcoin forum on Reddit, a series of videos on YouTube, and so on. The net effect is that there is a very real danger of getting caught in a bitcoin maximalist-dominated echo chamber in which the perpetual rise of bitcoin is viewed as all but inevitable.

That experience - particularly when it occurs in the context of bitcoin's price appreciation so far this year - can result in a     powerful sense of FOMO ("Fear of Missing Out") and, if left unchecked, inappropriate risk-taking. As with any other potential investment opportunity, the most important question that individuals should consider is whether and how bitcoin ownership fits into one's long-term financial goals. As anyone who got caught up in the frenzy of bitcoin's late 2017/early 2018 bull run knows, it remains a volatile asset and what goes up may still come down - precipitously. Many buyers during that period later sold their bitcoin at a substantial loss, and those who held may still be "under water" based on the coin's current price.

Those who wish to allocate funds to bitcoin should do so with the view that this is still considered speculative in nature and as such should constitute a modest proportion of one's overall net worth. How much, exactly, is "a modest proportion?" That's for each investor to evaluate within the context of one’s personal circumstances, but for most this should be no more than a percentage point or two of one's liquid portfolio. Many consider bitcoin's fate to be binary in nature, and its theoretical price floor is zero if broader adoption does not occur for whatever reason. In other words, do not invest (or perhaps more accurately, do not speculate with) more than you can stand to lose.

There are a number of well-known cryptocurrency exchanges available to U.S.-based individuals, but users should do their own research regarding the security, fees, and other features of these platforms (Wealthspire has not vetted these sites and takes no responsibility whatsoever for their usage). Grayscale Bitcoin Trust*, which was established in 2015 and became an SEC reporting company earlier this year, is also available as a publicly-traded fund or private placement investment vehicle.

Through it, investors can achieve exposure to bitcoin's price through avenues that were previously unavailable (within brokerage accounts and IRAs) while avoiding many of the aforementioned security/complexity issues, but they pay a hefty premium and do not personally own any of the underlying bitcoin.

*Wealthspire has not conducted due diligence on this fund/company nor do we in any way endorse it.

Hopefully, this post has inspired further curiosity about the bitcoin ecosystem while underscoring that those who do not or cannot commit to continual self-education within this rapidly changing space should approach with extreme caution. Despite its many compelling attributes, bitcoin's ultimate "success" (however defined) is far from guaranteed.

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