This article was originally published in the "Guide to Wealth: Diving into Bitcoin" (Guide to Wealth: Diving into Bitcoin), a special report of "Baron" magazine published by "Wall Street Journal". This is the first article.

Two or three things you need to know to embrace the big bitcoin wave

Original title What to Know Before Trying To Catch the Bitcoin Wave

Translator: Winy

Translator: Winy

Cryptocurrencies have reached a turning point that investors cannot ignore. However, there are still many questions, including whether the rise in currency prices reflects that this is a bubble?

Most people like dollars. The dollar has lasted for centuries and has survived two world wars, the Great Depression and the siege of inflation. As the de facto global currency, it works very well. Do we really need a purely digital alternative? Without the backing of the Federal Reserve, it exists only on a computer network, consumes a lot of electricity, and has no intrinsic value.

Of course, this is talking about Bitcoin, and the reality is that Bitcoin is hugely popular right now.

Bitcoin's market capitalization topped $1 trillion and has soared 1,000 percent in the past year, suggesting it may have reached an economic turning point. Brokerages such as Morgan Stanley say investors should add it to their portfolios. Tesla (TSLA) and Mass Mutual both bought large amounts of Bitcoin. Users can deposit it into a digital wallet on PayPal (PYPL) with just a few clicks on their mobile phone, and then convert it into cash for purchases. If you want to trade, you can operate on Square (SQ) and Robinhood. Visa and Coinbase Global have also issued bitcoin debit cards.

But if you're wondering what bitcoin is and whether you should buy it, you're not alone. Bitcoin and other cryptocurrencies cannot be understood intuitively because they are "mined" from digital storage warehouses and circulated through a decentralized network of computers called a "blockchain." Retail and institutional investors snapping up already-scarce coins could drive prices higher. Proponents say bitcoin will be worth more than fiat currencies such as the dollar, yen and euro amid concerns about inflation and currency debasement. They believe that Bitcoin will eventually live in harmony with paper money in the global economy.

While the Bitcoin "genie" may have escaped the magic bottle, it's far from ubiquitous. Because there are still many obstacles, including technical difficulties, unstable prices, tax policies, and governments that do not want digital tokens to change their monetary policies and financial regulations. Additionally, there has been a plethora of illicit uses of Bitcoin, including money laundering and tax evasion. And the government has cracked down. China, for example, has become a leader in blockchain technology and mining, but bitcoin itself poses a threat: Beijing banned banks and financial firms from trading bitcoin and shut down domestic cryptocurrency exchanges. Now, Beijing is rolling out a central bank digital yuan, intending to undercut bitcoin’s appeal.

Another obstacle for Bitcoin is: how to mine without creating environmental burdens? BofA Securities estimates that the global bitcoin network now emits 60 million tons of carbon dioxide a year, roughly equivalent to Greece's annual emissions. Some analysts believe that most bitcoins are mined using clean energy sources, such as wind and solar power. However, research reports on Bitcoin’s energy consumption are based on some controversial assumptions. As bitcoin prices and trading volumes have risen, so has the environmental damage. Bank of America predicts that every $1 billion flowing into Bitcoin has the same impact as the emissions of 1.2 million cars.

Perhaps the most vexing question remains this: Is Bitcoin a trillion-dollar bubble? The market capitalization of Bitcoin is already larger than that of Mastercard, Home Depot, and Exxon Mobil combined. In aggregate, cryptocurrencies are equivalent to the entire high-yield bond market, according to Morgan Stanley. However, Bitcoin is more like a thinly traded stock than a liquid large-cap stock. Most of the bitcoins mined are held by long-term holders or "hold on to" people and are not actually in circulation. Also, buying bitcoin in large quantities can inflate its price. According to Bank of America, 95% of all Bitcoins are held by 2.4% of accounts. According to Chainalysis, 20% of the supply may be stored in lost digital wallets.

"How frothy is this market? I think it's pretty frothy," said World Bank chief economist Carmen Reinhart. “In a down market, it may not take any event to swallow most or all of the price gains. Unlike the Treasury market, Bitcoin’s price is very volatile.”

Other economists argue that while bitcoin is an innovative technology with compelling uses, it lacks intrinsic value to support its price. Willem Buiter, former chief economist of the European Bank for Reconstruction and Development, said: "Bitcoin is just a word. It cannot be eaten, touched, or used to produce." Even gold, which is closest to it, can also be used for Jewelry and Manufacturing. Concerns about inflation and devaluation of paper money are legitimate and investors may want to hedge, he said. "I don't think bitcoin is gold, it's purely a speculative bubble."

What is Bitcoin? The story begins with Satoshi Nakamoto, a mysterious person or group. He developed a digital currency that anyone can send and receive through a decentralized computer network. Transactions are verified and recorded by independently operating computers, known as "miners." These computers compete to solve cryptographic puzzles (hence the name "cryptocurrency"), which we call "proof-of-work."

After miners solve a puzzle, they first share the results on the network. Other miners verify that the solution is correct. Once consensus is reached, transactions are packaged together in digital "blocks" and added to an electronic record or ledger, known as the "blockchain," over which no one person can control or see.

In return for running the network, miners receive newly minted bitcoins and a portion of transaction fees. The higher the price, the more profitable mining that relies on electricity and computing power.

To transact with bitcoin, you need to open an account with an exchange or app and store it in a digital wallet. Buying bitcoins has become easy with apps made by companies like PayPal and Square.

Launched in 2009, the system is unique because of a few core features. One is decentralization, where no one person or institution controls the blockchain. Transactions are recorded only after all independently operating computer nodes have proven their validity, which enhances the security of the ledger. In reality, it would take a lot of mining power to alter the blockchain, which is unlikely, but not impossible. As a peer-to-peer network, the system provides pseudo-anonymity, although both transactions and accounts are traceable.

The scarcity of Bitcoin is also a key point. According to the design of the system, the global supply of Bitcoin is 21 million. About 18.6 million bitcoins have been mined through mining so far. However, the number of newly issued bitcoins is halved every four years. New coins are now being minted at a rate of 6.25 every 10 minutes, suggesting that mining will end in 2140.

Although Bitcoin has been around for over a decade, it is only now entering the mainstream world. Trading in bitcoin futures and related stocks has gained momentum as Wall Street and financial technology firms have drawn attention from investors as they launch new ways to invest. Banks, brokers, exchanges and advisory firms build the infrastructure to convert bitcoin into assets such as stocks or bonds, with the expectation that it will be rolled into 401(k)s and other retirement accounts. Fidelity Investments, VanEck and other fund promoters are trying to convince regulators to approve a bitcoin ETF following Canada’s approval of a bitcoin ETF.

Coinbase has been one of the most-watched IPOs of the year. On its first day of trading on April 14, its market capitalization hit $86 billion, a valuation that surpassed that of Nasdaq, Cboe Global Markets and New York Stock Exchange parent Intercontinental Exchange.

Bitcoin has also gained legitimacy from some influential investors. Elon Musk bought $1.5 billion in Bitcoin for Tesla. Well-known American fund managers Paul Tudor Jones and Stanley Druckenmiller have also invested in Bitcoin. Howard Marks, the co-chairman of Oaktree Capital, recently wrote that his skepticism about bitcoin is “unproven,” adding that his son is “very thankful that our family has a meaningful amount of money.” A representative for Oaktree declined to comment.

Of course, none of us know if Bitcoin will crash, which may explain the reluctance to discuss it publicly. Indeed, there are many factors that could make Bitcoin turbulent.

The first factor is competition. Bitcoin is just one of thousands of cryptocurrencies, many of which were "forked" from the Bitcoin blockchain. Ether on the Ethereum network has certain advantages. Ether can be programmed using "smart contracts".

Central banks are also now starting to focus on digital currencies built on blockchain technology. China’s move to create a digital yuan makes it a forerunner for a central bank digital currency. CBDCs are pegged to paper currency and will fluctuate with standard exchange rates; they will not replace bitcoin or other cryptocurrencies that operate independently of a central authority. But as a medium of exchange, they can compete with cryptocurrencies. For example, send money internationally at a lower cost.

The Bitcoin network itself is rather slow, processing only 14,000 transactions an hour, while Visa's network can handle 236 million transactions an hour, according to Bank of America. Efforts are underway to increase the speed of bitcoin processing, including the development of the "Lightning" protocol, but it still lags far behind automated exchanges (ACH).

People trade in dollars, yen and euros, which are stable, widely accepted and deeply embedded in the financial fabric. Bitcoin's volatility makes it unsuitable for large-scale purchases or contract transactions. Moreover, rising transaction fees also create economic friction. Selling bitcoins to buy other things may also be taxable. Because the IRS classifies Bitcoin as property, not currency.

Harvard University economist Kenneth Rogoff says bitcoin's quasi-legality could eventually make it disappear. Throughout history, governments have crushed challenges to money and monetary policy, he said. Bitcoin poses a threat because it can also be used for criminal activities and is difficult to regulate. "I think financial innovation is very promising. But governments are not going to sit idly by forever when transactions cannot be monitored," Rogoff said.

Bitwise Financial Advisor Predicts Bitcoin's Price Trend in Five Years

Another hurdle that isn't widely discussed might be: What kind of environmental damage will Bitcoin do? The Cambridge Bitcoin Electricity Consumption Index shows that Bitcoin’s annual energy consumption has ballooned to 135 terawatt hours, doubling in the past year. That's more electricity than countries like Sweden and Ukraine consume in a year.

Some or most of the electricity may be generated from renewable sources such as wind, solar, hydro and geothermal activity. Most of the mining activity in the world is carried out in China (65%), as well as in Iceland, Canada and other countries where energy is relatively cheap. In fact, renewable energy accounts for 73% of the mining network’s energy mix, according to Bitcoin asset management firm CoinShares.

In China, miners migrate seasonally. In the summer, they set up mines in areas with cheap water power and abundant resources, and then moved to places such as Inner Mongolia, where electricity generation mainly comes from coal, as power generation dwindled. But it's unclear exactly how much renewable energy is being used in mining. Christopher Bendiksen, head of research at CoinShares, said: "China's mining industry is mainly using clean energy, but it is difficult to get exact data."

Even China's mining industry is relatively green. But other regions where mining is concentrated, including Kazakhstan and Iran, are far less environmentally friendly. As the currency price rises, so does the electricity bill. According to Bank of America, if the bitcoin price rises from $58,000 to $1 million, it will surpass Japan as the world's fifth-largest carbon emitter.

Bitcoin proponents don't see these issues as deal breakers. On the one hand, cryptocurrency momentum is now self-perpetuating. The higher the price, the more capital is required to develop the financial ecosystem, which in turn can handle larger transactions and broaden its appeal to institutions. Bitcoin has become the "North Star" of the crypto world, according to Citigroup.

Custody, security and liquidity have yet to penetrate mainstream finance. But their situation improved as firms like BNY Mellon and Fidelity stepped in. After several large-scale hacks and thefts, bitcoin exchanges have become more secure. OTC desks can handle large orders, while institutions use prime brokers that offer best execution practices and get insurance against theft. Derivatives trading is also booming, creating more liquidity for exposure. Citi said the system was "increasingly professionalised".

Bitcoin may never become legal tender. But assuming fiscal policy can monitor it, it can continue to enter the system against all odds. Banking regulators don't want to stifle innovative blockchain technology, and said in January that banks could participate in blockchain networks and use "stablecoins," or digital tokens, to guarantee the link between cryptocurrencies and their native currencies. Smooth transfer. Stablecoins are pegged to the base currency at a ratio of 1:1. There are now about $20 billion in stablecoins in circulation.

Even if Bitcoin doesn't function as a transactional currency, it can be an alternative asset. As digital gold, Bitcoin may already be suppressing the price of real gold. The method of valuing Bitcoin correlates to the total amount of gold held by private companies, which is about $2.5 trillion. By that measure, a bitcoin should be worth $146,000, nearly three times its current price, according to JP Morgan.

Proponents argue that Bitcoin may be a better hedge against inflation than gold. Morgan Stanley recently wrote that a 2.5% position in cryptocurrencies can boost portfolio returns. But its strength depends on its correlation with assets such as stocks and bonds. JP Morgan also said that as Bitcoin becomes more mainstream, its correlation with cyclical assets appears to be rising.

Competing cryptocurrencies can coexist. Investors can hold Bitcoin as an investment or inflation hedge while using other, more stable cryptocurrencies as trading currencies. Ether, as a programmable currency, may be more suitable for transactions. But it's less attractive as a store of value, in part because its scarcity isn't well understood. “No one can tell you how much ether you have because the ethereum network is constantly changing,” said Adam Pokornicky, a bitcoin advocate and digital assets registered investment advisor.

Even those who say Bitcoin is a bubble think Bitcoin is likely here to stay. The World Bank's Reinhart noted that Bitcoin's price is being driven by a number of trends: the search for yield, government stimulus plans, demographic shifts and technology. Some are long-term trends. And, while we don't think bitcoin can replace the dollar, in places like Lebanon, Nigeria, and Venezuela, that view is extremely attractive. Because in these countries, the currency is unstable, hyperinflation is high, and even savings have the potential to be confiscated. "If you live in a capital-controlled country, there is uncertainty about the future of the currency, and that's the heart of the matter," she said.

There will always be plenty of places in the world where bitcoin can be used, Rogoffagrees said, despite its current value well beyond those end uses.

Worried about inflation or the devaluation of the dollar? Some advisors still insist that it is better not to use Bitcoin. Mike Klein, a high-net-worth client advisor at Baird, recommends commodities, real estate and the stock market because these assets will appreciate in an inflationary environment. "If you want to invest in an asset that isn't about speculation, this is it," he said.

Indeed, while stocks lie in yield and bonds follow interest rates, Bitcoin's price support may simply come from the belief that it will strengthen the dollar in the future. In other words, unless you think the price of the coin will rise, there is no good reason to buy Bitcoin.