SMSFs can now legally invest in a new asset class unlike any other. Carissa Pritchard explains what bitcoin is and how it works.
Bitcoin provides exceptional returns, 123 per cent in 2016, with strong compound annual growth rate (CAGR) predictions, 45 per cent annually for the next nine years, and instantly diversifies investment portfolios and SMSFs. But what is bitcoin? Albert Einstein said: “The definition of genius is taking the complex and making it simple.” Here’s how to understand bitcoin, explain it to others and look like a genius at your next dinner party. According to the Reserve Bank of Australia, bitcoin is defined as a “digital representation of value that may be accepted by some parties as a means of payment and can be transferred, stored or traded electronically”. It’s also an algorithm; a digital/virtual/crypto/currency; a chain of digital signatures and a blockchain. These labels describe the characteristics of bitcoin. But definitions don’t provide meaning.
So what does bitcoin mean for investors?
The federal government classifies bitcoin as an asset and legislation now allows bitcoin investment in SMSFs. Due to its low correlation across standard asset classes, it instantly diversifies investment portfolios while increasing the fund’s standard return by 1.65 per cent to 7.69 per cent.
The bitcoin network is based on a distributed system where everyone agrees on its value and the protocol evolves by consensus. Unlike fiat currency or standard assets, it is not controlled by a central government, bank or authority, thus it cannot be devalued, seized or stolen.
The physical outcome of bitcoin investment may appear simply as high returns and long-term growth, yet financial security isn’t about forecast figures. It doesn’t matter what the numbers say if they can’t be trusted.
Nor is financial security only relevant in retirement. Knowing tomorrow is secure affects how you feel today; it creates confidence, comfort and safety. These feelings are priceless.
Yet the current geopolitical climate is far from stable, secure or comforting. History has proven fiat currencies decline in value due to their expanding monetary bases. Over the past 20 years, the United States dollar has lost 53 per cent of its value, the British pound 47 per cent, the euro 40 per cent and the Australian dollar 64 per cent.
In our current economic system, the origin and provenance of our money is hidden; we don’t know how much the government prints, but we know they lend significantly more than the fraction they hold in reserve. We’re not sure how bankers and hedge funds create derivatives, derivatives of derivatives or collateralised debt obligations. There is zero transparency, collusion is rife, short-term gains are rewarded and there are no consequences. The $700 billion financial-sector rescue plan of 2008 marked the fourth time the government interceded to prevent the ruin of a private enterprise or the entire financial sector.
The US Financial Crisis Inquiry Commission into the 2009 global financial crisis (GFC) reported its findings in January 2011. It concluded the crisis was “avoidable; caused by widespread failures in financial regulation; the Federal Reserve’s failure to stem the tide of toxic mortgages; dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; an explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; key policymakers were ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels”.
Famed Swiss financial adviser and fund manager Marc Faber, also known as Dr Doom in the investment world, told media outlets “the US is most likely in a recession … when you talk about doom and gloom for 2016, I have to point out … with the exception of people that held bitcoins, the performance of all asset classes has been poor”.
Why bitcoin?
In 2009, a digital currency was launched by Satoshi Nakamoto. The name is merely a pseudonym; the creators choose to remain anonymous. The bitcoin community capped the total supply of bitcoin at 21 million with a predefined, known distribution schedule. Why? Satoshi Nakamoto explains: “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”
Accordingly, as financial crises ripple the world, bitcoin’s value continues to rise.
Figure 1: Bitcoin price rise in reaction to geopolitical events
How bitcoin works – technically
There’s a lot of information, mostly confusing, about how bitcoin works. Cryptographic algorithms, mining, chunks, blocks, hashes, what? Worse, people will tell you not to worry about understanding the algorithm, just understand mining – which is like describing the egg without the chicken.
Let us consider the following scenario. A class of seven-year-old children is studying maths. Their teacher, Miss Robertson, writes an equation on the board: ? + ? = 10. There are numerous correct combinations, yet Miss Robertson has decided the answer is 1+9. The challenge for the children is to be the first to guess the chosen combination; the winner gets a big, gold, sparkly sticker.
Milly guesses: 5+5.
Tara: 7+3.
Georgia says: 1+9.
Correct. She wins the sparkly sticker.
What is the sticker worth? It has no intrinsic value, but to the kids in the class it does. Perhaps Milly says to Georgia: “I’ll swap you my new pencil for that sticker.” Now Tara wants the sticker from Milly and trades a sparkly pen. Chloe trades a new set of textas for the sticker. Max gives Chloe his entire pencil case.
A sparkly sticker that originally had no inherent value is now worth a pencil case full of assets because of the agreed value created by the children. Chloe can now go into the playground and trade the contents of the pencil case with other children – for lollies, a ball, whatever she wants.
Let’s imagine all the children throughout the process kept a record of these transactions on a ledger they could all see and verify. Everybody knows what the sticker was last traded for and that Max now owns it.
This is like the blockchain of bitcoin – a transparent, distributed ledger that everyone can view in real time.
Where does Max keep the sticker? Does he give it back to Miss Robertson to look after? No need; he keeps it in his own little wallet. Miss Robertson cannot seize the sticker – nor can she devalue it – the children each have a copy of their ledger recording the provenance and rising value.
This is how bitcoin began, but with pizza. In 2010, programmer Laszlo Hanyecz solved an equation generated by the bitcoin algorithm and was awarded 10,000 bitcoins – the process referred to as mining. Hanyecz went to his local pizza place in Florida and offered the owner 10,000 bitcoins in exchange for two pizzas. The owner agreed. Together they established the first value of bitcoin. Today, at about $1600 per bitcoin, the pizza transaction equates to $16 million. Is Hanyecz bitter? “It wasn’t like bitcoins had any value back then, so the idea of trading them for a pizza was incredibly cool.”
The future value of bitcoin
Like land, they aren’t making any more bitcoin. If you invested $10,000 in 2011, it would be worth $30 million today. Further, considering Bitcoin’s market cap is currently at $20 billion, compared to Apple’s $240 billion, it creates perspective on how early in the game it is for bitcoin.
How to buy and invest in bitcoin
Bitcoin Trader founder and chief executive Nathan Van den Bosch explains: “Bitcoin is an entirely new concept, let alone a new asset class – thus there are immense mental and logistical obstacles to acquisition. Understanding the blockchain, hot wallets, cold storage, private keys, public keys … It’s fine for techies who have endless hours to invest in research, but it’s a huge barrier for everyday investors. Ironically, this is one reason bitcoin returns are so high; but we won’t always see a CAGR like 2016, 81.7 per cent compared to gold at 8.88 per cent or real estate at 5.68 per cent.” Van den Bosch, after seeing people’s entire life savings wiped out by the GFC, says he was “outraged; it was entirely the result of a fraudulent, fractional banking system. Then I witnessed the devastation in Cyprus – people’s funds were confiscated straight out of their so-called ‘safe’ bank accounts – again in Greece. People had worked 40 or 50 years to put that nest egg away. It was outright thievery. Imagine the devastation of having your entire life savings stolen? Obviously people can invest in gold bullion; but when you retire, how can you use it? You can’t spend it on eBay. Now there’s a technological solution that can prevent such a catastrophe from ever occurring again.”
Bitcoin Trader was established “to provide guidance on compliant investments in bitcoin given the minefield of legislative considerations”, he says.
This minefield included understanding ATO classifications, capital gains tax implications, goods and services tax considerations, the treatment of bitcoin for personal use; the Corporations Act 2001, Australian financial services licence considerations, the Anti-Money Laundering and Counter-Terrorism Financing Act 2006, compliance and reporting under the Superannuation Industry (Supervision) Act 1993 for SMSF investors, trustee considerations, legal requirements for SMSF deeds and since there wasn’t one, creating the first compliant bitcoin annual audit process.
“On top of all that,” Van den Bosch muses, “our SMSF clients didn’t want to store their bitcoin under the bed.”
Bitcoin Trader sourced the best cold storage device, vault solutions (safety deposit boxes), custodial services and bitcoin insurance. “Now all you need to do is fill out a few forms, make a bank transfer and your super is safe,” Van den Bosch.
Ultimately, what does Bitcoin mean to Van den Bosch?
“My eight-year-old daughter was having a tantrum one morning. I warned her if she kept carrying on I wouldn’t give her money for a chocolate milk from the school canteen. It only got worse. Eventually I exclaimed, ‘That’s it. I’m not giving you any money for your drink’. “She said, ‘I don’t need your money – I’ve got my own.’ Then she went to her piggy bank and withdrew $1.
“Bitcoin is my piggy bank.”