Since peaking in Nov. 2021 at close to $3 trillion, the cryptocurrency market has lost about 50% of its value. And Bitcoin (BTC +4.30%), the world's most valuable digital asset, with a market cap of $600 billion (as of May 9), has followed this trend. It's down 28% in 2022.
The Federal Reserve's plan to hike interest rates throughout the year to curb soaring inflation is leading investors to turn away from riskier assets, a category cryptocurrencies belong in. But I try not to let what's happening with prices dictate my investment strategy. Instead, I keep my eyes on the next decade.
When it comes to Bitcoin, I do believe in its long-term investment merits. However, there are some key risks that I'm continuously paying attention to. Let's take a closer look.
CRYPTO: BTC
Key Data Points
The threat of regulation
Unsurprisingly, perhaps the single largest risk facing Bitcoin, and cryptocurrencies more generally, is the threat of tighter regulation. In 2021, China, the world's second-biggest economy, effectively made it illegal for citizens to mine or hold any cryptocurrency. And the government in India, a country of 1.4 billion people, imposed a 30% tax on crypto transactions in an effort to rein in the market.
Governments, whose power to direct monetary supply and tax its people, do not want to give up control, something Bitcoin undermines. However, nations that ban crypto can fall behind in terms of innovation and attracting investment and talent. That's why the Biden administration's approach, tasking various governmental agencies with researching and finding ways to safely support digital assets, is a positive in my view. It keeps the U.S. at the forefront of the crypto industry.
Two countries, El Salvador and Central African Republic, have made Bitcoin legal tender within their borders. I think other developing nations, particularly those whose economies are tied to other countries' currencies, will likely follow this route. Bitcoin aims to give power back to the people, and I believe this force will ultimately overcome any single country's efforts to ban it.
Scaling issues
Bitcoin's network operates a proof-of-work mechanism to validate transactions. This means expensive and energy-intensive computers are used to solve complex math problems to add new blocks to the Bitcoin blockchain. It's a slow process, as a typical transaction takes almost 10 minutes to process. And Bitcoin can only handle three transactions per second (TPS).
Compare this to Visa, which runs the largest payments network in the world. Visa has the capacity to process 65,000 TPS, a level that clearly supports its utility in people's daily lives. For Bitcoin to have a shot at mainstream use-cases, like remittances or even basic transactions to purchase things, its throughput must expand significantly.
Image source: Getty Images.
The Lightning network is the solution aiming to solve this problem. Sitting on top of Bitcoin's network, it's a layer-2 blockchain that creates a direct connection between two separate users to facilitate fast and cheap transactions. An example is a tenant who pays rent to their landlord on a monthly basis. Because balances sit on the Lightning network and are only sent to the main Bitcoin network for posting when the two parties want to finish the payment relationship, it works around Bitcoin's capacity constraints. Therefore, Lightning can be a huge contributor to Bitcoin's utility.
Volatility remains high
I personally don't view volatility as risk, but many people do. And I believe the constant fluctuations in Bitcoin's price will keep individuals and institutions on the sidelines when it comes to buying Bitcoin as a store of value, which is its biggest use-case today.
The most popular bull-case argument for Bitcoin is that it eventually gets on par with gold as a store of value. It is estimated that the value of all the mined gold on Earth is worth north of $12 trillion, so if this situation ever became reality, Bitcoin has an incredible runway for price appreciation. What's more, Bitcoin's key properties -- it's divisible, it's absolutely finite, and it's transactable -- make it superior to physical gold.
However, because Bitcoin is extremely volatile, investors might never have the stomach to own it. This is especially difficult in today's internet-driven society, where we are constantly bombarded with news and price updates sent to our phones. Being able to handle the ups and downs by ignoring the inevitable fluctuations is critical for holding Bitcoin in your portfolio.
Understanding these important risks should help you figure out whether buying Bitcoin is a good investment or not.
