Bitcoin bubble may be sign of cryptocurrency investment trouble

The high appreciation of bitcoin, rising by 15 times in value over the last year, has sparked investor interest in cryptocurrencies. A cryptocurrency is a digital, decentralized currency and worldwide payment system with transactions that are verified by cryptographic analysis (solving secret codes) by computers. Transactions in this currency are secure and totally anonymous, leading some to believe that this is a currency of choice for underworld crime networks. Bitcoin is the most famous example of a cryptocurrency, but there are over a thousand cryptocurrencies, or alternative coins such as Ethereum, Ripple, Dash and Litecoin.

My gut reaction is that this phenomenon has the earmarks of a price bubble (see “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay, originally published in 1841).

This opinion is scorned by young techies who are “stunned that I could doubt the future of blockchain technology,” a tremendous breakthrough that powers cryptocurrencies and will have future ramifications for financial markets. Staying on point, I am quick to clarify that speculating on bitcoin is not the same as investing a dollar on blockchain technology, and their confusion on this point makes me worry even more.

Our investment philosophy, and our common sense, dictates that you should invest in an asset only if the price is right, or within a reasonable range. At the time of writing, bitcoin is trading at over $12,000 (and has gone higher since*), with over $200 billion worth in circulation.

What is bitcoin really worth? It is hard to know, but there is a real danger if you assume that it is worth what people are willing to pay for it, and then expect that you might be able to sell it for even more tomorrow. As a reality check, we should ask what it actually costs to earn a new bitcoin.

Then, we could more practically answer the question: Should I be buying or selling bitcoin at the current price?

BITCOIN MINER

The cryptocurrency payment system needs tremendous computing power to verify transactions. This effort is performed by “bitcoin miners” who are compensated by being paid in bitcoin credited to their accounts.

To be a bitcoin miner you need a powerful computer that can solve cryptographic puzzles. Simplifying a bit, you earn a tiny fraction of a bitcoin as a reward whenever you verify a secret transaction, and this takes numerous calculations that are more or less profitable based on computing speed and the cost of electricity.

I volunteered to become a bitcoin miner as my own guinea pig in this experiment. Instead of a shovel and pick axe, I am mining via third-party software with my home-built personal computer that was engineered for virtual reality applications. This high-end machine costs at least $5,000 in parts and, while not originally designed for bitcoin mining, it uses two high-powered graphics cards that are well suited for solving cryptographic puzzles.

After forming a wallet on Coinbase and downloading NiceHash mining software, I began actual mining operations. As my computer started solving mathematical puzzles, liquid cooling systems were activated and nine air fans began whirring, expending heat out the back panel, all the while sucking lots of energy.

PROFITABILITY ANALYSIS ON MINING

The profit analysis will vary greatly by performance of the computer, electricity cost and especially the top-line price of bitcoin and other cryptocurrencies. Nevertheless, I am making a 25-cent-a-day profit even after fully depreciating my computer. In the grass plains of Inner Mongolia, there are new industrial parks with racks of specialized processors validating bitcoin transactions, supported by cheap electricity.

Needless to say, if even I can make a profit with some inherent disadvantages, then they must be making a killing! In fact, China mines more than two-thirds of all bitcoin globally.

INVEST OR NOT?

There are two major competing forces impacting the price of bitcoin. One force is speculation, in addition to ordinary demand as a currency. People are buying bitcoin because they believe it will appreciate rapidly; they may also enjoy the prestige of owning bitcoin and have a fear of missing out. This force tends to raise the price of bitcoin, and the extraordinary appreciation in 2017 was compelling evidence of speculation.

The second force is supply, which is somewhat controlled for bitcoin but not for cryptocurrencies in general, where there are new brands being proposed daily. Because of the excess profit potential, new enablers of cryptocurrencies (like me!) are encouraged to enter the market as miners, and that also includes more formidable miners with purpose-built computers, application-specific integrated circuits (ASICs) and cheap electricity. This force enables an increasing supply of crytocurrencies that should moderate prices.

Circling back to the question of whether bitcoin is a good investment or not, it may be theoretically possible to earn a return by investing in a cryptocurrency. However, given the degree of speculation evident in the market, it is wise to first consider whether the current starting price may be too high for comfort. My profit analysis demonstrates that the current price of cryptocurrencies may be too high, because even I can make a profit by mining bitcoin despite all the relative disadvantages that were mentioned. Therefore, at current prices, we should think twice about buying or investing in bitcoin.

My personal computer is still churning as I write this note on my laptop.** At current prices, I will leave it running a while longer. The heat coming out the back of the computer is gently warming my office this season while I am mining and selling bitcoin. If the price of bitcoin crashes, I will switch it off and use my gas fireplace instead, saving all the more on my electric bills.

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NOTES

*The price of bitcoin has since risen to over $17,000.

**As I write this, my mining operations have been suspended for several days as the Nicehash mining site experienced “maintenance issues.” We later learned that the site had been hacked and that $62 million of bitcoin had been stolen from its clients' accounts.

The mining company released the following statement: “While the full scope of what happened is not yet known, we recommend, as a precaution, that you change your online passwords.” Buyer beware! Miner beware!