Bitten by the bitcoin bug?

Investors need to weigh risks and rewards of alternative asset class carefully before betting on it

Last Thursday, the price of bitcoin, a crypto currency, hit an all-time high of Rs 2.30 lakh a unit in the Indian market ($2,700 in international markets). By Saturday, it was down to Rs 1.64 lakh a unit — down 30 per cent in less than 48 hours. It provided a reality check for investors who thought that they had missed out on another chance to make a quick buck (See Great Returns). 

The frenzy in bitcoins is being attributed to Japan’s legitimisation of digital currencies and Russia’s intention to follow suit. In fact, even the Indian government has woken up to crypto currencies and has floated a discussion paper to debate whether these should be regulated or whether the industry should be allowed to self-regulate. Investors need to weigh the risks and rewards of this alternative asset class carefully before betting on it. 

Regulatory changes needed: Though the Reserve Bank of India had warned as recently as in February that these are not legal tenders, the government seems to be looking at various options. The industry, consisting of bitcoin trading exchanges and blockchain companies, has formed an association and appointed Nishith Desai Associates as advisor for developing self-regulatory norms. If the government wants to regulate digital currencies, it may require a Bill to be passed in Parliament — which may not be easy.  
 

Growing interest in India: Crypto currencies like bitcoin, ethereum, etc, have given exorbitantly high returns to investors since inception in 2008-09, sparking interest in India as well. (In 2009, bitcoin was traded at just 5-8 cents.) 

These currencies can be traded on exchanges using the latter’s app. First, investors have to fulfil KYC (know your customer) norms after which they can buy these by transferring money from their bank account. India’s largest exchange, Zebpay, has crossed half a million downloads while unocoin, the second largest, has crossed 300,000. 

On most days, bitcoins trade at a 20-30 per cent premium in India over global prices as these are not mined (or produced) in India. 

Medium of exchange and investment: One bitcoin is currently quoting at around Rs 1.8 lakh. You can purchase bitcoins worth as little as Rs 2,000, in lieu of which you will get coins in decimals. The currency can also be used as a medium of exchange: Barter deals are available on bitcoin trading exchanges. You can also use it to pay your cable and mobile phone bills, and purchase pizza vouchers and Amazon gift vouchers, often at a discount.  Ashrith Govind, a 23-year-old IT professional who runs a Wi-Fi analytics start-up, has been investing in bitcoins for more than three years. Says Govind: “Three years ago, I was accepting fees from overseas clients in bitcoins and now I invest in it also. I started one-and-a-half year ago with a small SIP (systematic investment plan) with unocoin. I have been trading in this cryptocurrency for the past three years.” 

The acceptability of bitcoins is growing. Says Madhur Todi, managing director, Mera Money Advisors, an Ahmedabad-based wealth management firm: “In the next three-five years the price of bitcoin may rise 10 times. That is the potential.” Soon even the second-most traded digital currency, ethereum (price around $200), may be available in India.

Limited supply fuelling price rise: Optimism regarding the price of bitcoins stems from its finite supply. Twenty-one million bitcoins can be mined in its lifetime and 16 million have already been mined. Mining the rest may take several years. The way it has been programmed, the more you mine, the tougher it gets to mine more, and hence it also gets costlier. 

Desai points to another positive aspect. “Bitcoins are more easily traceable than government-issued fiat currency or cash. If an illegal transaction happens in cash, one can’t easily discover and establish the trail.” Bitcoin trails are recorded in block chain from the day the coin is mined till the end. 

Volatility and risks: Volatility has always been high in bitcoin, which raises the question of whether it could pose a risk to the financial system. At a total market cap of less than $100 billion, it is still a marginal sized asset class. Even Apple (market cap around $800 billion), gold (estimated total value of $8.2 trillion) and US bond market (worth an estimated $31 trillion) carry greater heft. 

One possible risk could arise if the price of bitcoin rises too high, leading to a bubble. As in any other financial mania, it could lead to overinvestment. When things go wrong, there can always be a ripple effect. Bitcoins are purchased using banking channels. If the money invested is leveraged, it could lead to bigger losses. Also, no one knows what contracts or derivatives have been linked to cryptocurrencies, and how deeply embedded they are in the system. 

Chinese exchanges earlier permitted margin funding and even futures trading in bitcoins. But the Chinese Central Bank PBoC asked the exchanges to stop these practices. Last August, the Chinese exchanges were hacked. All the other bitcoin holders also had to share the massive losses from this event. 

Should you invest? Indian investors thinking of investing in this asset class should weigh all the pros and cons before taking the plunge. Says Todi: “I have bought bitcoins at lower levels and am holding them. We advise investors that 2 per cent of their portfolio should be in alternative asset classes, including digital currencies like bitcoins.” Thus, as with any asset class, investors should enter at attractive levels. They should also limit their exposure, given its volatile nature.

The Ethereum Rush 

• Ethereum, another digital currency competing with bitcoin, has seen a sharp jump in its price from January 1 — from $8.24 to $221 now
• Ethereum supports smart contract applications — a computer programme which can automatically execute the terms of a contract. Barclays uses this technology to trade in derivatives
• Enterprise Ethereum Alliance (EEA) was recently founded to connect companies with technology vendors in order to work on projects using the block chain. Companies involved in the launch include JPMorgan, Microsoft and Intel. Another 86 firms joins this alliance on Tuesday
• Market capitalisation of all digital currencies is $78 billion; Ethereum’s share is $20 billion 
• Indian exchanges are planning to offer ethereum trading from August