Bitcoin, the cryptocurrency, has breached an important psychological barrier against the US dollar — the $20,000 mark — after having fallen just short during its 2017 rally. As of 17 December 2020, Bitcoin was trading above $23,000. The rally to these levels, which has sustained over the last four months, has also seen various stakeholders taking steps towards legitimising the cryptocurrency. But before one decides to invest in Bitcoin, there are a number of factors to be considered.

The origin of Bitcoin is unclear, as is who founded it. A person, or a group of people, who went by the identity of Satoshi Nakamoto are said to have conceptualised an accounting system in the aftermath of the 2008 financial crisis. Nakamoto published a white paper about a peer-to-peer electronic cash system, which would “allow online payments to be sent directly from one party to another without going through a financial institution”. According to Bitcoin.org, a website originally co-owned by Nakamoto, Bitcoin from a user’s perspective is “nothing more than a mobile app or computer program that provides a personal Bitcoin wallet and allows a user to send and receive Bitcoins with them”.

Bitcoins are generally identified with a Bitcoin address, which comprises 26-35 alphanumeric characters starting with either “1” or “3”. This address, which remains anonymous, represents the destination of a Bitcoin, or a fraction. Originally, the Bitcoin was intended to provide an alternative to fiat money and become a universally accepted medium of exchange directly between two involved parties. However, after Bitcoins picked up momentum, some entities started establishing exchanges — on lines of stock exchanges — for people to buy and sell Bitcoins against fiat money such as dollars or euros or pounds. Early proponents of the cryptocurrency argued that once an exchange was established, all the strengths of a Bitcoin went away, considering a third party institution was involved once again for money to change hands.

Nakamoto mooted an idea for a publicly available, open ledger that would contain all the transactions ever made, albeit in an anonymous and an encrypted form. This ledger is called blockchain. Considering the public and open nature of the ledger, proponents of this currency system believe it could help weed out corruption and inefficiencies in the system. In a traditional financial deal in which two parties are using fiat money, a third-party organisation — usually a central bank — assures that the money is genuine and the transaction is recorded. With Bitcoin, a chain of computers is constantly working towards authenticating the transactions by solving complex cryptographic puzzles. For solving the puzzles, these systems are rewarded with Bitcoins. This process is called Bitcoin mining.

One can either mine a new Bitcoin if they have the computing capacity, purchase them via exchanges, or acquire them in over-the-counter, person-to-person transactions. A Bitcoin exchange functions like a bank where a person buys and sells Bitcoins with traditional currency. Depending on the demand and supply, the price of a Bitcoin keeps fluctuating. Miners are the people who validate a Bitcoin transaction and secure the network with their hardware. The Bitcoin protocol is designed in such a way that new Bitcoins are created at a fixed rate. No developer has the power to manipulate the system to increase his profits. One unique aspect of Bitcoin is that only 21 million units will ever be created. However, transactions can be denominated in sub-units of a Bitcoin. A Satoshi is the smallest fraction of a Bitcoin.

According to those closely watching the currency, the prices have been driven by various factors, including increased acceptance during the pandemic. Globally, large players like payments firm PayPal, and Indian lenders like State Bank of India, ICICI Bank, HDFC Bank and Yes Bank, have given legitimacy to cryptocurrency through some of their decisions. For example, these Indian banks reportedly have allowed their customers to use their bank accounts to fund cryptocurrency trading. In India, accounts of several exchanges were frozen by financial institutions back in 2018 following a fiat from the Reserve Bank of India that barred banks from using their systems for cryptocurrency-related transactions. However, the Supreme Court ruled against this order in March this year.

The biggest factor (in the recent rise of Bitcoin prices) has been the fact that some pension funds and insurance funds took permission to park a small part of their portfolio in Bitcoins. Once that happened, availability is an issue leading to the spike in prices,” said Sathvik Vishwanath, co-founder and CEO of Bitcoin exchange Unocoin. Vishwanath however feels that there would be a correction in the prices when people see a bubble around the prices, “but we don’t know at what level that would happen”.

The first advocates of Bitcoin did not intend it to be used as an asset, but the mushrooming of exchanges turned it into one. Traditional investment experts are wary of Bitcoin as an investment. “We are not offering advisory on Bitcoin investment. I don’t see any underlying fundamental that drives its price and I think it’s mostly driven by supply and demand and technical factors and hence we are not offering our advice. It is an alternative currency which is digital in form and one has to be careful while going for it,” said Surya Bhatia, founder of Delhi-based financial services and investment advisory firm Asset Managers.

It is important to note that the price of Bitcoin fell sharply from over $18,000 in December 2017 to around $3200 in December 2018. It then went up to over $10,000 in July 2019, then fell to around $5,500 in March 2020. It has had a sharp rally since then. Market participants say the huge volatility in the price without any major fundamental reason should make retail investors cautious.

Is there a case for Bitcoin to be regulated?

People in the investment fraternity point out that there is no underlying asset in case of Bitcoin, and the value is “fictitious”. Before investors can look at it as an asset, several things need to fall in place. If the cryptocurrency is regulated, it could result in the volatility reducing, and its acceptability and monetisation needs easing up. “You can’t recommend it to anyone as it is mostly a speculative thing as of now. No one knows why the prices crashed by 80% in 2018 and have jumped four times this year. This kind of volatile product is not for small investors,” said a top official with a financial services firm who did not wish to be named.

However, given that Bitcoin was intended to come across as a global decentralised currency, any central authority regulating it would effectively defeat that purpose.