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Published Wednesday, December 27, 2017

In December of 2016, the cryptocurrency bitcoin was valued at a little over $600. Today it has reached nearly $18,000. So what's fueling bitcoin's increase in value? And with a 1,000 fold increase in bitcoin value over the past five years, are we staring down the barrel of a massive "bubble," similar to what we've seen with Tulips in the 1600s, the dot-com implosion and the 2008 financial crisis?

An investment in bitcoin differs from traditional stocks and bonds because it does not pay revenue to the owner, such as a stock paying dividends. Bitcoin is very similar to gold in this regard. According to an article in Ars Technica, "Gold's value defies conventional market analysis in much the same way bitcoin's value does. Gold doesn't pay a dividend and only about 60 percent of the world's gold supply is devoted to jewelry or industrial use." In addition to financial institutions being unwilling to upholding gold's value, a number of people believe the value comes from being gold held off the market.

Recently, financial entities have begun to give bitcoin their stamp of approval. In November, CME Group announced that they would begin to offer bitcoin futures contracts, which is essentially, pending regulatory approval, a wager on the bitcoin market. Likewise, NASDAQ and others have announced plans for bitcoin futures and derivatives in the first half of 2018.

While digital currency has created new millionaires in 2017, real world applications remain limited. Startups and traditional businesses are looking for uses of blockchain technology and cryptocurrencies with varying levels of success. Initial Coin Offerings (ICOs) are another factor fueling digital currency growth. Similar to an IPO from a traditional company, ICOs allow users to buy a stake in a new digital currency – the next bitcoin – with the hopes of making money once the value increases.

While much of this sounds exciting, bitcoin has historically shown itself to be very volatile, already having three major bubbles with ensuing plunges in value. Bitcoin has defied critics, however, by recovering and then increasing to new heights. Because of this, some are issuing warnings due to market unpredictability and immaturity. Security and Exchange Commission (SEC) Chairman Jay Clayton urged both main street investors and market professionals to, "please exercise extreme caution and be aware of the risk that your investment may be lost." This hasn't stopped some people, as Joseph Borg, president of the North American Securities Administrators Association, said, "We've seen mortgages being taken out to buy bitcoin."

Consumers also need to be aware of bitcoin's rapidly increasing transaction fees. In the first week of December, a bitcoin transaction cost $6. Now, this cost ranges between $20 and $26. This is problematic because it doesn't make financial sense to use bitcoin for smaller transactions. The transaction fees are somewhat complicated to explain, but, when the number of demanded transactions exceeds the network's capacity, users have the ability to attach an additional transaction fee allowing the expedition of their transaction. Those unwilling to pay this additional fee may wait hours or days for their transaction to occur. In addition to urgency requested and network capacity, the most important factor in transaction fee pricing is the size (in bytes) of the transaction. The size is dictated by the number of input and output coins in the transaction. In a simple example, inputs are similar to the amount of money you would have before making a purchase, and the outputs are the change that is made from the transaction.

Another word of caution: over the years, there have been a number of high-profile attacks aiming to steal bitcoins. From phishing to social engineering to malware, attackers have continued to find ways to steal digital currency. Security researchers have discovered more than 100 variants of malware targeting bitcoins. "In August 2016, the bitcoin exchange Bitfinex announced that hackers had stolen $77 million worth of bitcoins. The company foisted these costs on to users, forcing them to take a 36-percent reduction in the value of their deposits." It is important to note that these attacks have been on exchanges, digital wallet software and human error. Bitcoin's underlying technology has so far proven secure.

Lastly, it's worth mentioning  that the amount of electrical energy that the bitcoin network is consuming annually is massive, currently quoted at 32TWh – equivalent to the usage of country of Denmark. According to a December article in Ars Technica, Eric Holthaus, a writer for Grist, projects that, if the bitcoin network continues to grow at its current rate, by 2020, the energy consumption of the network will be equivalent to the current (2017) usage of the entire world. But, there is reason to believe that the bitcoin network will not continue to increase at the same rate. Bitcoin energy consumption is not tied to the number of transactions processed, but, more likely, to the effort put into bitcoin mining. Thankfully, the creator of bitcoin has stated only 21 million bitcoins will ever be created, and the reward (number of bitcoins) miners get for their work will continue to decrease, having fallen from 50 bitcoins in 2009, to 25 in 2012, to 12.5 in 2016 and set to fall to 6.25 in 2020. With this knowledge, we can remain hopeful that the bitcoin network will eventually find a sustainable amount of electrical consumption.

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