The Future of Bitcoin
By: Jake Willms, Quantitative Analyst
Bitcoin, the world’s most recognizable cryptocurrency, has gained some serious momentum since the beginning of 2021. With a year-to-date return of approximately 79%, it’s hardly something retail or institutional investors can ignore. As Bitcoin passes the $50,000 milestone, it’s only natural to ponder the future for the cryptocurrency and whether you should invest in it or not.
First, let’s cover the basics behind Bitcoin.
As with all cryptocurrencies, Bitcoin is purely digital and operates independently of a central bank. All transactions are tracked on a blockchain – a public, anonymous ledger.
Bitcoins enter circulation when they are awarded to auditors (miners) who are paid to verify the legitimacy of Bitcoin transactions. 
Bitcoins are awarded at a fixed rate that is cut in half every four years.
Unlike government-backed “fiat” currencies (which can be create in unlimited quantities by the central banks that regulate them them), there are only 21 million Bitcoins that can be mined in total.
As shown in the chart below, the 5-year breakeven inflation rate has been steadily rising. Because Bitcoin’s supply is limited and completely unrelated to its market price, Bitcoin has become an attractive option for investors seeking protection from inflation or a falling dollar. With interest rates so low, investors are starting look to Bitcoin and other cryptocurrencies as a means of managing potential risks that rising interest rates may bring in the future.
This growing popularity can be best seen when comparing Bitcoin’s allocations in investment portfolios to gold and oil, which are similar scarce assets that offer the same protections.
Market speculators and new investors are picking up Bitcoin too. Elon Musk, the often-times loud spoken CEO of Tesla, has influenced Bitcoin the most recently with his massive $1.5 billion investment, which triggered 16% rise in the price of Bitcoin. This recent surge in valuation isn’t the first time this has happened to Bitcoin, but previous spikes do not compare to what we are seeing happen recently.
Some economists and investors argue that Bitcoin could have a real shot at rivaling the USD as the world’s reserve currency. It’s not as crazy as it might sound. The general requirements are:
Medium of Exchange – For something to function as a global reserve currency, it must maintain an effective, stable, means of exchange. Bitcoin volatility hurts it in this regard.
Store of Value – For something to meet this requirement, the currency must hold value over the long-term. Bitcoin it relatively new, but each year that passes Bitcoin’s case grows.
Unit of Account – The last requirement is that Bitcoin become a standard unit of measurement for valuation or cost of goods. This may be the most challenging, or the most feasible, depending on who you ask. Some consider the volatility of the currency to be too much to serve as an effective unit of account, while others say that things could change dramatically if one or more countries with an unstable currency chose to link their currency to Bitcoin instead of the USD.
All that being said, investing in Bitcoin is a risky proposition for a number of reasons, including:
Uncertain Future - Bitcoin, like other cryptocurrencies, is still under development. Something completely unexpected could happen that would significantly undermine its value, such as the arrival of a more advanced cryptocurrency or a change to its blockchain.
Volatility Risk – Bitcoin’s current volatility is extremely high when compared to alternatives, which makes this a less attractive investment for more conservative investors. Large price fluctuations are more common with Bitcoin than most other currencies.
Legislative Risk – Governments could adopt new laws meant to undermine Bitcoin and other cryptocurrencies in an effort to protect their own currencies.
User Error – Secret keys are needed to access cryptocurrencies, and there is no way for a lost key to be recovered.
Despite all the question marks surrounding its anonymous blockchain design and anecdotes of millionaires losing a password to their riches, in my view cryptocurrencies have a legitimate place in the market and can serve multiple roles at once. While I share some skepticism surrounding Bitcoin as a reserve currency, it seems plausible that a cryptocurrency that is separate from a central bank will serve in that role someday.
 To earn bitcoins, you need to meet two conditions, (which takes a tremendous amount of computing power). You must verify approximately 1MB worth of transactions and you must be lucky enough to be the first miner to arrive at the right answer, or closest answer, to a numeric problem. This process is also known as proof of work.  The 5-year breakeven inflation rate is the difference between the 5-Year Treasury Constant Maturity Rate (in this case the most recent rate is 1.95%) and the yield on an inflation protected security with 5-years remaining to maturity