What are the merits and risks of investing in Bitcoin?

Mat Cybula is used to people peppering him with questions when he tells them what he does for a living.

“Whenever we go out, I’m the Bitcoin guy and I end up explaining it,” he says. “It’s really difficult to wrap your head around how it works . . . initially. It’s an area that combines computer science — meaning cryptography — and economics and game theory and markets in an amazing new way.”

Cybula is the founder and chief executive officer of Toronto-based Cryptiv, a startup that provides companies with digital wallets — which work like bank accounts — so they can store, send and receive Bitcoin and other digital assets. Cryptiv’s clients are primarily Canadian financial firms.

Why should pension funds care about the Bitcoin guy? For one, he plans to ask them to invest in his company. “I would love to sit down and have a conversation with institutional investors,” says Cybula. No Canadian pension fund has put money in Cryptiv yet.

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Other providers in the Bitcoin space, including manufacturers of Bitcoin dispensing machines and online exchanges, haven’t garnered much attention from Canada’s defined benefit pension funds either. But supporters argue Bitcoin-related companies could be a high-growth investment because the demand for Bitcoin is expected to rise. Some people even consider it a good idea for pension funds to invest directly in Bitcoin despite the virtual currency’s price fluctuations and tarnished reputation.

“For a large investor, there’s one unique benefit that no other asset class would provide and that would be a hedge against the possibility of cryptocurrency playing a disruptive role in global commerce,” says Peter Rodriguez, senior associate dean at the University of Virginia’s Darden School of Business. “We’re seeing the possibility of that rising in small ways at the moment, but as is the case with so many other technologies, the disruption is fast.”

The Bitcoin platform allows users to transfer value within minutes without going through financial institutions, thus making transactions much cheaper. The sender opens a digital wallet to generate an address, protected with a private key, and sends the transfer request to the Bitcoin network. The network verifies the sender has the private key to the Bitcoin he or she wants to send and records the transaction in a digital public ledger called a block chain. Recipients get the value at their Bitcoin address and deposit the money into their wallet.

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There’s always someone available to verify and record transactions in the block chain because people get transaction fees and newly created Bitcoins for doing that work. That’s called mining. Anyone who has a computer capable of mining (using special hardware) can update the ledger because Bitcoin is an open-source platform.

“This technology can do to financial services what the Internet did to media,” says Gil Luria, managing director at Wedbush Securities, an investment firm in Los Angeles.

Still, Bitcoin and related companies don’t appeal to the Ontario Teachers’ Pension Plan, Canada’s biggest defined benefit pension fund. “It’s not a focus area for us,” Bjarne Graven Larsen, the fund’s chief investment officer, said at a March press conference in Toronto.

“We’re trying to stay innovative and stay agile, but it’s not the Bitcoin as such that’s going to save us.” Still, he noted his investment team might have allocated small amounts to the space because staff can use their discretion for investments up to a certain amount.

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Asked later to confirm whether the $171-billion fund has exposure to the currency or related companies, Teachers’ said it doesn’t discuss investments smaller than $150 million but reiterated it’s not an area of interest.

Canada’s third-biggest defined benefit pension fund, the $77-billion Ontario Municipal Employees Retirement System, doesn’t invest in Bitcoin or related companies either. But the pension fund’s venture capital arm, OMERS Ventures, is eyeing the space.

“Cyber security is [an] area we have been looking at . . . and in particular what bitcoin and block chain capability bring in terms of differentiated opportunities. We hope to find a couple of investments . . . related to bitcoin and the block chain, and the security side of that whole paradigm,” OMERS Ventures’ managing director Jim Orlando told the Techvibes website in August 2015. OMERS declined to comment for this story.


‘Very high upside’

Rodriguez says more large investors should consider small Bitcoin allocations. “There aren’t often that many opportunities to get in . . . on an investment with a very high upside. For some small fraction of a portfolio, this could make sense.”

Luria says if Bitcoin succeeds, its value could increase significantly; if it fails, it could be worth close to nothing. “It’s very much like buying a derivative or an option or taking a very high-risk investment in an early-stage company.”

One Bitcoin was worth about $590 as of late May. In early 2010, when the first Bitcoin transaction took place, the price was less than a cent; in late 2013, it peaked at $1,200. Fluctuations over the past two years have been less dramatic. “Bitcoin last year was less volatile than the euro . . . or the loonie,” says Luria.

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Although there’s no big player like Amazon behind it to drive mainstream adoption, Bitcoin demand is expected to rise given the increase in daily transactions, says Stephen Caldwell, vice-president and portfolio manager at Toronto-based Toron Asset Management International. For the year ending March 31, 2016, average daily Bitcoin transactions worldwide reached 151,458, a number twice as high as the year before. Between April 1, 2013, and March 31, 2014 average daily transactions stood at 56,677.

Some people expect Bitcoin demand to increase in developing countries with volatile currencies where few people have bank accounts. “It still hasn’t happened at scale; it’s happened around the edges,” says Cybula. “It’s young people in those countries that have the most raw need for a technology such as this.” A 2014 World Bank report showed about half of the world’s adult population — 2.5 billion people — lacked a bank account.

How many digital currencies are there?

bitcoin-iconThere are about 600 digital currencies. However, the greatest amount of digital infrastructure is devoted to Bitcoins.

Demand is also likely to jump in the area of remittances. Luria expects to see companies that offer cheaper remittance services because they use the Bitcoin network to facilitate the transfer instead of more expensive traditional channels. Their customers won’t even know their money goes through the block chain. “They’re going to go to the shop in London and give money to a teller and their relative in Kenya is going to take money from a teller in the local currency . . . They’ll just be happy [to pay] one per cent instead of 10 per cent,” says Luria.

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Higher Bitcoin demand is expected to inflate prices because of the limited supply of the currency. About 14 million Bitcoins exist today. As a property of the Bitcoin system, supply will be capped at 21 million around the year 2140. Afterwards, miners’ rewards will be in the form of transaction fees because, by then, there should be more transactions to make the work worthwhile, according to Cybula.

Supporters insist capping the supply won’t restrict transactions because a Bitcoin has 1 million units and can be divided further if necessary.

But with many of the Bitcoins currently in existence being hoarded, there’s a small chunk available for investing and transacting, Caldwell notes. Given that pension funds look for large deals because of their size, there may not be big enough opportunities for them to invest in Bitcoin, he suggests.

Investing in companies another option

Given the limitations, Caldwell says it makes more sense for pension funds to invest in Bitcoin-related companies.

Because they’re not listed on stock exchanges due to their small size, they’re only available to large investors anyway.

And, Rodriguez says, such startups are promising because of the digital infrastructure they use. “If you can imagine that PayPal was a worthy investment, then you have to imagine than the . . . digital infrastructure around Bitcoin would be at least as potentially viable in the long run.”

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The block chain the companies use can also play a role in the online transfer of other assets, such as stocks and bonds, from one investor to another, says Caldwell, who cites the potential for quicker and cheaper transactions. “It works just like Bitcoin, but you’re not transferring Bitcoin,” he says. One firm using the block chain that way is itBit, a company headquartered in New York.

And, of course, the digital infrastructure used by companies can apply to other cryptocurrencies as well. So by investing in a Bitcoin-related company rather than the currency itself, investors remove the risk of a rival currency becoming more successful, says Luria. “If there’s another type of cryptocurrency that is better and more suited for handling some transactions than Bitcoin, that company can then shift to that cryptocurrency. It’s not locked into Bitcoin,” he says.

“Even the most ardent supporters of Bitcoin concede that if a better technology comes along or some flaw is discovered in Bitcoin, the currency may end up being worth nothing or next to nothing,” he adds, noting he sees that scenario as the biggest risk of investing directly in Bitcoin.

Still, he suggests it’s unlikely that a better system will emerge because the Bitcoin platform is already well-suited for digital payments.

A better alternative to Bitcoin?

Some people see Ethereum, a block chain platform that went live in 2015, as a serious alternative. The monetary unit associated with it is Ether, which was worth almost $16 in late May.

“Ethereum has the potential to be more disruptive and more powerful than Bitcoin,” says Cybula, who mines Ethereum from his apartment as a hobby.

Unlike Bitcoin, whose mysterious creator identifies himself as Satoshi Nakamoto, Ethereum was spawned by a known person, a Russian-Canadian named Vitalik Buterin.

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For Cybula, another advantage of Ethereum is its untarnished reputation. The mention of Bitcoin often evokes associations with illegal activities. As digital currency news website CoinDesk has noted, it’s the de facto currency of the dark web that hosts numerous virtual black markets (picture online platforms for drugs, fake identification and other illegal things). The dark web is hidden from search engines and accessing it requires software that allows users to buy and sell things anonymously.

“I can’t believe how many times . . . I’ve talked about Bitcoin and . . . [someone would] say, ‘Oh, didn’t they shut that down? Didn’t the CEO get arrested?’” says Cybula, referring to Silk Road, a defunct billion-dollar drug market on the dark web. Its American creator, Ross Ulbricht, was sentenced to life in prison in May 2015.

But Luria says Bitcoin’s reputation is unfair, insisting there’s nothing nefarious about the currency. “Because law enforcement didn’t have a lot of experience in monitoring Bitcoin transactions, bad guys exploited that and, to a certain extent, still are exploiting it. That is exactly the same as bad guys using hundred-dollar U.S. bills. There’s no fault in hundred-dollar U.S. bills.”

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Can people mine bitcoins with a laptop?

mine-iconNo. A regular computer won’t work for mining Bitcoins. A miner has to use a network of several special computers that are able to run the algorithm Bitcoin relies on, a process that requires much more electricity than a regular machine. Some people mine Bitcoins as a hobby, but it can certainly be a full-time job, says Cryptiv’s Mat Cybula.

Bitcoin actually provides less anonymity than cash since users leave a digital trail because every transaction is recorded on the public ledger. Although a user’s identity is unknown, it could be revealed by tracking the Internet protocol address associated with a Bitcoin address. While investigating Silk Road, the FBI discovered two of its agents had tried to steal Bitcoin from the marketplace.

Hacking is another risk that comes with investing in Bitcoin and related companies. “Bitcoin exchanges may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware,” the U.S. Securities and Exchange Commission cautions on its website. “Bitcoins also may be stolen by hackers.”

If that happens, investors may have “limited recovery options” because no institution backs the Bitcoin platform, the government agency warns.

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Cybula understands the skepticism of governments and investors. He used to be a skeptic himself. When he first researched Bitcoin, he was unimpressed despite being a financial technology entrepreneur. It was only in late 2013, when he read Nakamoto’s 2009 white paper that unveiled the Bitcoin concept, that he finally grasped its power and created Cryptiv.

Now that he’s on board, he hopes large investors will follow suit. “This block chain thing isn’t going away. People are going to build on that and create more complex things on top of that.”

Yaldaz Sadakova is a Toronto-based freelance journalist.

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