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How exactly to categorize Bitcoin is a matter of controversy. Is it a type of currency, a store of value, a payment network or an asset class?

Fortunately, it's easier to define what Bitcoin actually is. It's software. Don't be fooled by stock images of shiny coins emblazoned with modified Thai baht symbols. Bitcoin is a purely digital phenomenon, a set of protocols and processes.

It also is the most successful of hundreds of attempts to create virtual money through the use of cryptography, the science of making and breaking codes. Bitcoin has inspired hundreds of imitators, but it remains the largest cryptocurrency by market capitalization, a distinction it has held throughout its decade-plus history.

(A general note: according to the Bitcoin Foundation, the word "Bitcoin" is capitalized when it refers to the cryptocurrency as an entity, and it is given as "bitcoin" when it refers to a quantity of the currency or the units themselves. Bitcoin is also abbreviated as "BTC." Throughout this article, we will alternate between these usages.)

The Blockchain

Bitcoin is a network that runs on a protocol known as the blockchain. A 2008 paper by a person or people calling themselves Satoshi Nakamoto first described both the blockchain and Bitcoin and for a while the two terms were all but synonymous.

The blockchain​ has since evolved into a separate concept, and thousands of blockchains have been created using similar cryptographic techniques. This history can make the nomenclature confusing. Blockchain sometimes refers to the original, Bitcoin blockchain. At other times it refers to blockchain technology in general, or to any other specific blockchain, such as the one that powers Ethereum ​.

The basics of blockchain technology are mercifully straightforward. Any given blockchain consists of a single chain of discrete blocks of information, arranged chronologically. In principle this information can be any string of 1s and 0s, meaning it could include emails, contracts, land titles, marriage certificates, or bond trades. In theory, any type of contract between two parties can be established on a blockchain as long as both parties agree on the contract. This takes away any need for a third party to be involved in any contract. This opens a world of possibilities including peer-to-peer financial products, like loans or decentralized savings and checking accounts, where banks or any intermediary is irrelevant.

While Bitcoin's current goal is a store of value as well as a payment system, there is nothing to say that Bitcoin could not be used in such a way in the future, though consensus would need to be reached to add these systems to Bitcoin. The main goal of the Ethereum project is to have a platform where these "smart contracts" can occur, therefore creating a whole realm of decentralized financial products without any middlemen and the fees and potential data breaches that come along with them.

This versatility has caught the eye of governments and private corporations; indeed, some analysts believe that blockchain technology will ultimately be the most impactful aspect of the cryptocurrency craze.

In Bitcoin's case, though, the information on the blockchain is mostly transactions.

Bitcoin is really just a list. Person A sent X bitcoin to person B, who sent Y bitcoin to person C, etc. By tallying these transactions up, everyone knows where individual users stand. It's important to note that these transactions do not necessarily need to be done from human to human.

Anything can access and use the Bitcoin network and your ethnicity, gender, religion, species, or political leaning are completely irrelevant. This creates vast possibilities for the internet of things. In the future, we could see systems where self-driving taxis or uber vehicles have their own blockchain wallets. The car would be sent cryptocurrency from the passenger and would not move until funds are received. The vehicle would be able to assess when it needs fuel and would use its wallet to facilitate a refill.

Another name for a blockchain is a "distributed ledger," which emphasizes the key difference between this technology and a well-kept Word document. Bitcoin's blockchain is distributed, meaning that it is public. Anyone can download it in its entirety or go to any number of sites that parse it. This means that the record is publicly available, but it also means that there are complicated measures in place for updating the blockchain ledger. There is no central authority to keep tabs on all bitcoin transactions, so the participants themselves do so by creating and verifying "blocks" of transaction data. See the section on "Mining" below for more information.

You can see, for example, that 15N3yGu3UFHeyUNdzQ5sS3aRFRzu5Ae7EZ sent 0.01718427 bitcoin to 1JHG2qjdk5Khiq7X5xQrr1wfigepJEK3t on August 14, 2017, between 11:10 and 11:20 a.m. The long strings of numbers and letters are addresses, and if you were in law enforcement or just very well-informed, you could probably figure out who controlled them. It is a misconception that Bitcoin's network is totally anonymous although taking certain precautions can make it very hard to link individuals to transactions.

Despite being absolutely public, or rather because of that fact, Bitcoin is extremely difficult to tamper with. A bitcoin has no physical presence, so you can't protect it by locking it in a safe or burying it in the woods.

In theory, all a thief would need to do to take it from you would be to add a line to the ledger that translates to "you paid me everything you have."

A related worry is double-spending. If a bad actor could spend some bitcoin, then spend it again, confidence in the currency's value would quickly evaporate. To achieve a double-spend the bad actor would need to make up 51% of the mining power of Bitcoin. The larger the Bitcoin network grows the less realistic this becomes as the computing power needed would be astronomical and extremely expensive.

To further prevent either from happening, you need trust. In this case, the accustomed solution with traditional currency would be to transact through a central, neutral arbiter such as a bank. Bitcoin has made that unnecessary, however. (It is probably not a coincidence Satoshi's original description was published in October 2008, when trust in banks was at a multigenerational low. This is a recurring theme in today's coronavirus climate and growing government debt.) Rather than having a reliable authority keep the ledger and preside over the network, the bitcoin network is decentralized. Everyone keeps an eye on everyone else.

No one needs to know or trust anyone in particular in order for the system to operate correctly. Assuming everything is working as intended, the cryptographic protocols ensure that each block of transactions is bolted onto the last in a long, transparent, and immutable chain.

The process that maintains this trustless public ledger is known as mining. Undergirding the network of Bitcoin users who trade the cryptocurrency among themselves is a network of miners, who record these transactions on the blockchain.

Recording a string of transactions is trivial for a modern computer, but mining is difficult because Bitcoin's software makes the process artificially time-consuming. Without the added difficulty, people could spoof transactions to enrich themselves or bankrupt other people. They could log a fraudulent transaction in the blockchain and pile so many trivial transactions on top of it that untangling the fraud would become impossible.

By the same token, it would be easy to insert fraudulent transactions into past blocks. The network would become a sprawling, spammy mess of competing ledgers, and bitcoin would be worthless.

Combining " proof of work" with other cryptographic techniques was Satoshi's breakthrough. Bitcoin's software adjusts the difficulty miners face in order to limit the network to one new 1-megabyte block of transactions every 10 minutes. That way the volume of transactions is digestible. The network has time to vet the new block and the ledger that precedes it, and everyone can reach a consensus about the status quo. Miners do not work to verify transactions by adding blocks to the distributed ledger purely out of a desire to see the Bitcoin network run smoothly; they are compensated for their work as well. We'll take a closer look at mining compensation below.

As previously mentioned, miners are rewarded with Bitcoin for verifying blocks of transactions. This reward is cut in half every 210,000 blocks mined, or, about every four years. This event is called the halving or the "halvening." The system is built-in as a deflationary one, where the rate at which new Bitcoin is released into circulation.

This process is designed so that rewards for Bitcoin mining will continue until about 2140. Once all Bitcoin is mined from the code and all halvings are finished, the miners will remain incentivized by fees that they will charge network users. The hope is that healthy competition will keep fees low.

This system drives up Bitcoin's stock-to-flow ratio and lowers its inflation until it is eventually zero. After the third halving that took place on May 11th, 2020, the reward for each block mined is now 6.25 Bitcoins.

Here is a slightly more technical description of how mining works. The network of miners, who are scattered across the globe and not bound to each other by personal or professional ties, receives the latest batch of transaction data. They run the data through a cryptographic algorithm that generates a "hash," a string of numbers and letters that verifies the information's validity but does not reveal the information itself. (In reality, this ideal vision of decentralized mining is no longer accurate, with industrial-scale mining farms and powerful mining pools forming an oligopoly. More on that below.)

Given the hash 000000000000000000c2c4d562265f272bd55d64f1a7c22ffeb66e15e826ca30, you cannot know what transactions the relevant block (#480504) contains. You can, however, take a bunch of data purporting to be block #480504 and make sure that it has not been tampered with. If one number were out of place, no matter how insignificant, the data would generate a totally different hash. As an example, if you were to run the Declaration of Independence through a hash calculator, you might get 839f561caa4b466c84e2b4809afe116c76a465ce5da68c3370f5c36bd3f67350. Delete the period after the words "submitted to a candid world," though, and you get 800790e4fd445ca4c5e3092f9884cdcd4cf536f735ca958b93f60f82f23f97c4. This is a completely different hash, although you've only changed one character in the original text.

The hash technology allows the Bitcoin network to instantly check the validity of a block. It would be incredibly time-consuming to comb through the entire ledger to make sure that the person mining the most recent batch of transactions hasn't tried anything funny. Instead, the previous block's hash appears within the new block. If the most minute detail had been altered in the previous block, that hash would change. Even if the alteration was 20,000 blocks back in the chain, that block's hash would set off a cascade of new hashes and tip off the network.

Generating a hash is not really work, though. The process is so quick and easy that bad actors could still spam the network and perhaps, given enough computing power, pass off fraudulent transactions a few blocks back in the chain. So the Bitcoin protocol requires proof of work.

It does so by throwing miners a curveball: Their hash must be below a certain target. That's why block #480504's hash starts with a long string of zeroes. It's tiny. Since every string of data will generate one and only one hash, the quest for a sufficiently small one involves adding nonces ("numbers used once") to the end of the data. So a miner will run [thedata]. If the hash is too big, she will try again. [thedata]1. Still too big. [thedata]2. Finally, [thedata]93452 yields her a hash beginning with the requisite number of zeroes.

The mined block will be broadcast to the network to receive confirmations, which take another hour or so, though occasionally much longer, to process. (Again, this description is simplified. Blocks are not hashed in their entirety, but broken up into more efficient structures called Merkle trees.)

Depending on the kind of traffic the network is receiving, Bitcoin's protocol will require a longer or shorter string of zeroes, adjusting the difficulty to hit a rate of one new block every 10 minutes. As of October 2019, the current difficulty is around 6.379 trillion, up from 1 in 2009. As this suggests, it has become significantly more difficult to mine Bitcoin since the cryptocurrency launched a decade ago.

Mining is intensive, requiring big, expensive rigs and a lot of electricity to power them. And it's competitive. There's no telling what nonce will work, so the goal is to plow through them as quickly as possible.

Early on, miners recognized that they could improve their chances of success by combining into mining pools, sharing computing power and divvying the rewards up among themselves. Even when multiple miners split these rewards, there is still ample incentive to pursue them. Every time a new block is mined, the successful miner receives a bunch of newly created bitcoin. At first, it was 50, but then it halved to 25, and now it is 12.5 (about $119,000 in October 2019).

The reward will continue to halve every 210,000 blocks, or about every four years, until it hits zero. At that point, all 21 million bitcoins will have been mined, and miners will depend solely on fees to maintain the network. When Bitcoin was launched, it was planned that the total supply of the cryptocurrency would be 21 million tokens.

The fact that miners have organized themselves into pools worries some. If a pool exceeds 50% of the network's mining power, its members could potentially spend coins, reverse the transactions, and spend them again. They could also block others' transactions. Simply put, this pool of miners would have the power to overwhelm the distributed nature of the system, verifying fraudulent transactions by virtue of the majority power it would hold.

That could spell the end of Bitcoin, but even a so-called 51% attack would probably not enable the bad actors to reverse old transactions, because the proof of work requirement makes that process so labor-intensive. To go back and alter the blockchain, a pool would need to control such a large majority of the network that it would probably be pointless. When you control the whole currency, who is there to trade with?

A 51% attack is a financially suicidal proposition from the miners' perspective. When Ghash.io, a mining pool, reached 51% of the network's computing power in 2014, it voluntarily promised to not exceed 39.99% of the Bitcoin hash rate in order to maintain confidence in the cryptocurrency's value. Other actors, such as governments, might find the idea of such an attack interesting, though. But, again, the sheer size of Bitcoin's network would make this overwhelmingly expensive, even for a world power.

Another source of concern related to miners is the practical tendency to concentrate in parts of the world where electricity is cheap, such as China, or, following a Chinese crackdown in early 2018, Quebec.

Bitcoin Transactions

For most individuals participating in the Bitcoin network, the ins and outs of the blockchain, hash rates and mining are not particularly relevant. Outside of the mining community, Bitcoin owners usually purchase their cryptocurrency supply through a Bitcoin exchange. These are online platforms that facilitate transactions of Bitcoin and, often, other digital currencies.

Bitcoin exchanges such as Coinbase bring together market participants from around the world to buy and sell cryptocurrencies. These exchanges have been both increasingly popular (as Bitcoin's popularity itself has grown in recent years) and fraught with regulatory, legal and security challenges. With governments around the world viewing cryptocurrencies in various ways - as currency, as an asset class, or any number of other classifications - the regulations governing the buying and selling of bitcoins are complex and constantly shifting. Perhaps even more important for Bitcoin exchange participants than the threat of changing regulatory oversight, however, is that of theft and other criminal activity. While the Bitcoin network itself has largely been secure throughout its history, individual exchanges are not necessarily the same. Many thefts have targeted high-profile cryptocurrency exchanges, oftentimes resulting in the loss of millions of dollars worth of tokens. The most famous exchange theft is likely Mt. Gox, which dominated the Bitcoin transaction space up through 2014. Early in that year, the platform announced the probable theft of roughly 850,000 BTC worth close to $450 million at the time. Mt. Gox filed for bankruptcy and shuttered its doors; to this day, the majority of that stolen bounty (which would now be worth a total of about $8 billion) has not been recovered.

Keys and Wallets

For these reasons, it's understandable that Bitcoin traders and owners will want to take any possible security measures to protect their holdings. To do so, they utilize keys and wallets.

Bitcoin ownership essentially boils down to two numbers, a public key and a private key. A rough analogy is a username (public key) and a password (private key). A hash of the public key called an address is the one displayed on the blockchain. Using the hash provides an extra layer of security.

To receive bitcoin, it's enough for the sender to know your address. The public key is derived from the private key, which you need to send bitcoin to another address. The system makes it easy to receive money but requires verification of identity to send it.

To access bitcoin, you use a wallet, which is a set of keys. These can take different forms, from third-party web applications offering insurance and debit cards, to QR codes printed on pieces of paper. The most important distinction is between "hot" wallets, which are connected to the internet and therefore vulnerable to hacking, and "cold" wallets, which are not connected to the internet. In the Mt. Gox case above, it is believed that most of the BTC stolen were taken from a hot wallet. Still, many users entrust their private keys to cryptocurrency exchanges, which essentially is a bet that those exchanges will have stronger defense against the possibility of theft than one's own computer.

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How exactly to categorize Bitcoin is a matter of controversy. Is it a type of currency, a store of value, a payment network or an asset class? Fortunately, it's easier to define what Bitcoin actually is. It's software. Don't be fooled by stock images of shiny coins emblazoned with modified Thai baht symbols.

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'Crypto kryptonite': A digital euro would be dual threat to banks and fintechs, a critical new report warns

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The European Central Bank could decide by April whether to push ahead with planning for a digital euro, a move closely watched by banking and tech sectors.

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Have you ever traveled in a different country? One of the first things you probably did was visit a bank and exchange your money for the local currency. A Benjamin can buy you a nice dinner in the States, but if you want to enjoy fine dining in Italy, then you'll need some euros!

Investing in cryptocurrency is similar to exchanging your money in a new country. Bitcoin, Litecoin, and Ether are a few examples of "foreign currencies" that work in a very specific context within certain online communities.

Exchanging any type of currency is built upon shared trust. We value dollars and Euros because we know that we can purchase goods or services with them.

The question is, can you trust cryptocurrencies? And should you jump into the world of crypto investing?

WHAT IS CRYPTOCURRENCY?

Cryptocurrencies are digital assets people use as investments and for purchases online. You exchange real currency, like dollars, to purchase "coins" or "tokens" of a given cryptocurrency. There are many kinds of cryptocurrencies. Bitcoin is the most famous, but Ether, Bitcoin Cash, Litecoin, and Ripple are a few others. All sorts of big tech and finance companies want a slice of crypto pie. Even Facebook has created a cryptocurrency called Libra.

The word cryptography means the art of writing or solving codes. (Sounds like the setup of an Indiana Jones movie, doesn't it?) Each "coin" is a unique line of code. Cryptocurrencies cannot be duplicated, which makes them easy to track and identify as they're traded.

You've probably heard of people making (or losing!) hundreds of thousands of dollars by investing in cryptocurrencies. It feels like a modern-day gold rush. But cryptocurrencies have actually been around for about 10 years. The earliest cryptocurrency was Bitcoin, created in 2009 by an unknown person who goes by the name Satoshi Nakamoto.

HOW DOES CRYPTOCURRENCY WORK?

Cryptocurrencies are exchanged from person to person on the web without a middleman, like a bank or government. It's like the wild, wild west of the digital world. There's no marshal to uphold the law.

Here's what I mean: Have you ever hired a kid in your neighborhood to mow your lawn or watch your dog while you were out of town? Chances are, you paid them in cash. You didn't need to go to the bank to make a formal transaction. That's what it's like to exchange cryptocurrencies. They are decentralized: No government or bank controls how they're produced, what their value is, or how they're exchanged.

As a result, cryptocurrencies are worth whatever people are willing to pay or exchange for them.

Now hang with me, people. We're about to get techy! You store your cryptocurrency in a digital wallet-usually in an app or through the vendor where you purchase your coins. Your wallet gives you a private key-a unique code that you enter in order to digitally "sign off" on purchases. It's mathematical proof that the exchange was legit.

Cryptocurrencies operate on what is called blockchain technology. A blockchain is like a really long receipt that keeps growing with each exchange. It's a public record of all of the transactions that have ever happened in a given cryptocurrency.

What can you buy with cryptocurrency?

At this point, most people still see cryptocurrencies as an investment. But cryptocurrency spending could become popular as these currencies gain trust. There are online retailers, such as overstock.com, who accept cryptocurrencies. And of course, any two individuals who value the tokens can exchange them for goods or services.

Some major retailers, such as Whole Foods and Nordstrom, are experimenting with accepting Bitcoin as a valid source of payment. But for the most part, cryptocurrencies are still on the fringe.

4 THINGS TO KNOW BEFORE INVESTING IN CRYPTOCURRENCY

Okay, y'all, I've got my coaching hat on. I might even get a little riled up! Before you say good-bye to your dollars and hello to Bitcoin or Ether, there are a few things you need to know.

1. Cryptocurrencies are volatile. The value of cryptocurrencies goes through extreme ups and downs. In 2017, the value of Bitcoin swung between $900 and $20,000! Someone sneezes and the price drops! Investing in cryptocurrency is risky, to say the least. Of course, all investing carries a degree of risk. But you should always avoid unnecessary risks, especially when it comes to your hard-earned money. Don't play poker with your financial future.

2. There are lots of unknowns. There's still a lot that needs to be ironed out with how cryptocurrencies work. Think about it: Nobody even knows who the founder of Bitcoin is! Relatively speaking, only a small percentage of people in the world understand the system and know how to operate it. Ignorance makes you vulnerable. I always advise people that if you can't explain your investments to a 10-year-old, you have no business investing in them to begin with. You're setting yourself up to do something stupid.

3. Cryptocurrencies can be used for fraudulent activity. People who want to remain anonymous and avoid regulation from banks or the government will use cryptocurrencies to make shady deals on the black market. Money laundering is also a problem in the crypto world. Now hear me on this: I'm not saying that everyone who uses cryptocurrency is a bad person. But I am saying that if someone wants to commit criminal activity and avoid being tracked, the crypto world is an ideal place for them.

4. Cryptocurrencies have an unproven rate of return. Trading in cryptocurrency is like gambling. Because it's exchanged peer to peer without any tie to regulatory standards, there's no pattern to the rise and fall of its value. You can't predict changes or calculate returns like you can with growth stock mutual funds. There just isn't enough data, or enough credibility, to create a long-term investing plan based in cryptocurrency.

SHOULD I INVEST IN CRYPTOCURRENCY?

Here's the deal: If you're out of debt, have an emergency fund that will cover three to six months of expenses, and you're already investing 15% of your income in growth stock mutual funds-which are hundreds of times more secure than crypto-then you may make the choice to play around with cryptocurrencies.

But I want to warn you: When you invest in crypto, be prepared to say good-bye-o to your money. It's not a good way to build wealth. There are thousands of millionaires who agree with me.

Don't give in to stupid just because there's a lot of hype. I've personally talked to people who have taken out a mortgage or cashed out their entire 401(k) early to invest in cryptocurrency! No, no, no! Don't put it all on the line and risk your financial future, your retirement dreams, and your family's well-being.

At some point in the future, cryptocurrencies might become legitimate and widely used. But for now, be safe and be smart.

INVEST WITH CONFIDENCE

Get-rich-quick schemes seem too good to be true because they are. The reality is, the road to building wealth is slow and steady. Millionaires don't build wealth through risky investments like cryptocurrencies. In fact, in The National Study of Millionaires, we found that the number one wealth-building tool of millionaires is their workplace retirement plan, like a 401(k). If you're looking for a proven plan to build wealth (and more advice on crypto), I encourage you to check out our SmartVestor program. These pros have been vetted by our staff at Ramsey Solutions and want to guide you through the process of investing.

Step Up Your Investing Game

Investment decisions are a big deal, so why not get some guidance? SmartVestor is a free service that immediately connects you with up to five investment professionals in your area.

Find Your Pro

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4 Things to Know Before Investing in Cryptocurrency

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Have you ever traveled in a different country? One of the first things you probably did was visit a bank and exchange your money for the local currency. A Benjamin can buy you a nice dinner in the States, but if you want to enjoy fine dining in Italy, then you'll need some euros!

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Blackrock's chief investment officer of global fixed income told CNBC on Wednesday that the world's largest asset manager had "started to dabble" in bitcoin.

This was all the excuse bitcoin needed to charge ahead to a new record high of $52,533.

The institutional buzz around bitcoin started when US-listed Microstrategy, a business intelligence company, revealed in August 2020 that the company had invested $250m of its excess cash in bitcoin as a hedge against the dollar.

One inadvertent consequence of the treasury management move was that Microstrategy's shares would soon be considered a precious "listed" proxy for owning bitcoin outright, especially by those money managers bound by strict risk-controlled investing mandates that stop them dabbling in crypto.

The incident proved a gateway moment for institutional interest in bitcoin, culminating in December's big reveal by Ruffer, the UK-based asset manager, that it too had made a primary investment worth £550m.

Bitcoin has been on a tear ever since then, propelled even higher in recent weeks by electric carmaker Tesla's announcement that it too has been diversifying its treasury holdings into the crypto asset.

The truly big question is what does it mean for bitcoin now that institutional names are dipping their toes in the asset class and potentially bringing major money inflows with them (beyond the obvious of "number go up").

A commodities investing echo?

One good precedent to look at is the impact pension funds had on commodity prices when they similarly decided around 2005/6 that they needed to look to alternative investments to diversify against their dollar exposure.

While the idea of pension funds investing in commodities such as oil, metals and even agricultural goods (usually through futures) is entirely normal today, back in the mid-noughties it represented a big step away from conventional money-managing mandates. The big point of controversy at the time was the lack of yield (a source of controversy with gold itself as well) and hence the overt price risk this would expose the funds to.

To lower the risk, pension funds and institutional managers mostly piled into commodity index products that tracked the Goldman Sachs Commodity Index (GSCI) or into commodity ETFs.

Institutional money's collective impact on the commodities futures curve over this period is still hotly debated, but it has long been theorised that it may have contributed to the overpricing of commodity futures relative to their spot-price fundamentals, leading to the normalisation of a contango structure in commodity prices, especially after the 2008 financial crisis.

This, in turn, sent a signal to the market to keep producing commodities irrespective of natural demand because the contango structure made it financially lucrative to produce for the simple purpose of storing rather than consuming them.

None of this would have been financially viable if not for the institutional wall of money sitting on the futures curve happy to lose value at every consecutive monthly roll of futures positions into a contango structure. The effect of this was a negative yield for such commodity investing funds.

For as long as the price of commodities kept going up to compensate for the yield destruction the positions proved manageable. But once commodity prices reversed, it didn't take too long for institutions to figure out sitting idle on the curve was a lossmaking strategy that could be exploited by physical producers and trading houses on the ground. When that happened, backwardation returned to the market unlocking all the previously stored-up commodities that had been funded by the contango structure.

The effect was a total collapse in the price of commodities (led by oil) over the course of 2015 (GSCI chart courtesy of Trading Economics):

Institutional crypto yield generation?

Unlike core commodity markets, bitcoin's futures are illiquid and immature. Even so, the natural state of bitcoin's futures curve has for a long time (much like gold's) tended towards a contango structure, not backwardation like it does with most other commodities. This is down to its financialised nature.

The other big difference with bitcoin is that, unlike bulky industrial commodities, which require active professional and expert management to physically hold, the crypto asset can be easily stored by institutional managers.

These two elements are important because they provide institutional managers with the opportunity not just to expose themselves to higher bitcoin prices, but also (if they wish) to lock-in a healthy yield with their holdings.

For as long as the bitcoin curve remains in contango, that means it's a very different proposition for institutional managers than commodity investing was. (For more on how contango trades work, see here.)

How a bitcoin contango trade (and you can bet your bottom cryptodollar there will be hedge funds already doing so) works in theory is simple.

An institution buys physical bitcoin ($51,811 at pixel time) but sells a future ($52,045 at pixel time on the CME) at a premium to the price they acquired the original bitcoin for at the same time. The process hedges their exposure to the price of bitcoin (thus removing risk) while locking-in a risk-free yield that can be collected provided the position is held to the settlement point. It pays to put the position on for as long as the yield generated outnumbers the cost of managing and securing the physical bitcoin, and the cost of capital to fund the position.

But there are some caveats to its risk-free nature. The trade is only as riskless as your futures counterparty. (For more about that see here). This is why until bitcoin futures were traded on a reputable and regulated exchange like the CME, which had proper experience in managing risk and margins, anyone conducting the trade was at risk of having their profits wiped out by the non-performance of their counterparty. And in the early era of the bitcoin Wild West that was a bona fide risk.

The launch of CME bitcoin futures, however, heralded in a new risk-controlled crypto era. Not only did CME futures make it possible to short bitcoin without having to worry about counterparty risk, enabling better price discovery in general, they also facilitated the introduction of contango trades. This was especially the case for regulated and creditworthy institutions who had the capacity to both fund the margin capital needed to operate at the CME and met the exchange's minimum credit standards.

The contango trade as the ultimate HODL

As institutional money moves into cryptocurrency it will become increasingly important to analyse not just what the institutions are investing in but how they are investing in it.

In theory, institutional managers starved of risk-free yield in the core financial sector, should be hugely tempted to synthesise yield with bitcoin contango HODLs.

Whether they do or not, however, will come down to the nature of their investing mandates.

In many cases, despite the free money on the table, the associated security risk and other complexities of holding physical bitcoin could keep the crypto asset out of their reach in pure form. In that case, institutions might choose to buy proxies like Microstrategy, ETFs (as and when they are issued) or, more perilously, futures instead.

If institutional managers did decide to invest most heavily in bitcoin futures, the risk remains they would end up taking the other side of hedge fund or broker/dealer contango trades. This would risk institutions replicating the negative yield exposure they experienced with commodities investing. It would also engineer a compartmentalised system of exposures across the industry.

The signals from the markets would also not be what they seemed. In terms of pure positioning analysis (as derived from CFTC commitment of traders reports), if hedge funds and broker/dealers were indeed playing the contango trade they would appear to be shorting bitcoin even if in reality they were stringently HODLing underlying bitcoin.

Of course, there is one other bitcoin yield-generating strategy that institutions could be inclined to adopt: lending their physical bitcoin holdings for a fee to counterparties for shorting purposes (as they already do with equities). This would become all the more tempting if and when bitcoin's price began to plateau or depreciate.

If and when bitcoin's price did stabilise, it might even pay for institutions to compensate for bitcoin's lack of yield by lending out their holdings to corporations for capital investing purposes, in traditional merchant banking mode.

At which point some clever crypto entrepreneur will propose the creation of an average bitcoin lending rate to benchmark deals against. And we will have not just recreated Libor but anchored it to a settlement system that cannot be bailed out with extraordinary central bank intervention.

And that, in an environment where it's proving much more difficult to expire old Libor than first appreciated, could be quite a proposition.

Related links:
Markets must speed up efforts to ditch Libor, warns watchdog - FT
2020: The year bitcoin went institutional - FT Alphaville

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Blackrock's chief investment officer of global fixed income told CNBC on Wednesday that the world's largest asset manager had "started to dabble" in bitcoin. This was all the excuse bitcoin needed to charge ahead to a new record high of $52,533.