

Earlier this year the U.S. Securities and Exchange Commission rejected a bid by Tyler and Cameron Winklevoss, the twins infamous for claiming that Mark Zuckerberg stole the idea of Facebook from them while they were undergrads at Harvard, to launch a bitcoin-based ETF (exchange-traded fund). The decision from the SEC came nearly four years after they filed for regulatory approval. In the immediate aftermath of this news, the price of bitcoins, which had nearly tripled over the last year, significantly dropped to less than $1,000.

Although other bitcoin-based ETFs are awaiting approval, and this decision did not directly affect their status, the wording of the SEC ruling did not initially appear to bode well for the prospects of bitcoin-based exchanges anytime soon.

The SEC determined that the proposed bitcoin ETF failed to meet these standards because the markets for bitcoins were unregulated. Of course, the primary problem for future bitcoin-based ETFs is that by their very nature, bitcoins will always trade on an unregulated market. It was surprising then, when just a couple of months later on April 24th, the SEC agreed to review its decision on the creation of a bitcoin ETF. In the four months since the SEC's decision to review its earlier rejection, bitcoin prices have rallied an amazing 163%.

A bitcoin sitting on top of other gold coins

To be clear, there is no physical manifestation of a bitcoin that looks like this; it is a digital currency. Image source: Pixabay.

What is bitcoin?

Bitcoin is a digital payment system with no intermediaries or banks; it was invented by a person or group using the alias Satoshi Nakamoto, and released as open-source software in 2009. The U.S. Treasury has categorized it as a decentralized virtual currency though some believe it is best described as a "cryptocurrency." helpfully defines cryptocurrency as "a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank."

Bitcoin uses blockchain technology to record its transactions. Essentially, the blockchain is a publicly distributed ledger for certain financial transactions. It is currently mostly used for bitcoin, but many believe it could be used in a wide variety of financial applications in the future.

As used in bitcoin, blockchain is a public ledger of all bitcoin transactions that have ever been made. When a transaction is completed, it is recorded on a new "block." When the block is full of such transactions, it is added to the end of the "chain" in sequential order, and a new block is created. Full blocks are a part of the blockchain's permanent database. Each node -- a computer connected to the bitcoin network for the purpose of verifying transactions -- automatically gets a downloaded copy of the blockchain upon joining the network. The blockchain records information like the time and amount of each transaction, but it does not store any personal information on the parties involved.

Even industry experts who believe that bitcoin is not a sustainable monetary unit think blockchain technology could radically change the way financial transactions are facilitated in the future. The benefits of this system are that it is transparent, secure, and streamlined, so that there are less parties involved in facilitating each and every transaction. 

Even as the existing payments system in developed countries becomes ever more convenient and secure, the space is still littered with middle parties taking a small amount from each transaction. These players include payment processors, payment networks, issuing banks, and acquiring banks. The dream of bitcoin and other monetary systems based on blockchain technology is for payers to be free of these inherent costs of exchanging currency for goods.

For a much more detailed explanation of what bitcoin is, where bitcoins come from, and how they work, please check out fellow Fool Matthew Frankel's article on this subject from earlier this year, "What Is Bitcoin?"

The potential problems with investing in bitcoin

There are a few primary concerns surrounding bitcoin that potential investors should be aware of. First, it is not backed or regulated by the good faith of a government or other entity. This stands in stark contrast to the dollar, yuan, pound, and other forms of currency used around the globe. So, many people view bitcoin as something akin to Monopoly money, because it is neither a fiat currency nor is it based on something of tangible value like gold. In other words, a bitcoin is worth exactly what people perceive its worth to be. While, in a sense, this is true of any currency, the value of a bitcoin is much more fickle than other forms of currency because of its unregulated nature.

Second, bitcoins are not traded on Wall Street. They cannot be bought or sold through a brokerage. Instead, one must set up a bitcoin "wallet," which can probably best be thought of as a bank account exclusively for bitcoins. Once this account is set up, its holder can link to a traditional banking account and use those funds in local currency to buy and sell bitcoins.

If this process sounds a bit cumbersome, it is. This means bitcoin is much less liquid than traditional equities, creating more volatility and wild swings. For instance, in the past month alone, the value of one bitcoin fell from prices over $2,500 to under $2,000 before regaining all-time highs over $3,400. Those are incredibly volatile swings within one month -- something virtually unheard of with any other type of currency!

Finally, the unique way of buying and selling bitcoins not only contributes to its illiquid nature, but has also contributed to higher rates of fraud and theft through uninsured bitcoin exchanges. While these problems were far more prevalent in years past, it should still be mentioned that none of the bitcoin exchanges have yet established a long business track record.

This brings us back to the SEC's review of the Winklevoss twins' proposal to launch a bitcoin-based ETF. Such an ETF would have solved at least some of these problems. It would have made trading bitcoin much more liquid, and assuaged many investors' fears of potential theft. Viewed in this light, bitcoin's massive sell-off on the initial news of the rejection and subsequent rise on the appeal of the decision makes a lot of sense.

The Foolish conclusion

Where do the price and value of bitcoin go from here? Unfortunately, my crystal ball is broken. I personally believe that within a few years, bitcoin could fall anywhere -- from being known as a worthless experiment, to being the greatest disruptive force the financial industry has ever seen.

If I knew investors who wanted to purchase a small, speculative position in bitcoin, I wouldn't try to talk them out of it. However -- and I cannot stress this enough -- nothing should be invested in bitcoin currency that an investor isn't comfortable losing.

Investors intrigued by the concepts of bitcoin and blockchain technology, but unwilling to take the plunge on such a speculative investment, may want to consider investing in one of the many financial and technology companies actively working to find other applications for blockchain.

For example, the Hyperledger project is one such global collaboration; its participants include Cisco Systems, IBM, Intel, JPMorgan Chase, and Wells Fargo. The project is exploring uses for an open-source blockchain platform in supply chains, legal agreements, and commercial business transactions.

For potential investors, the large takeaway should probably be that blockchain technology will probably exist in one form or another for years to come. The fate of bitcoin, however, is far more uncertain. 

Matthew Cochrane owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems and Intel. The Motley Fool has a disclosure policy.