Investment Comparison: Bitcoin and Ethereum

1. Introduction

1. Introduction The following essay discusses the two influential virtual currencies in the marketplace today, Bitcoin and Ethereum. The goal is to provide insights into the differences and similarities between these two digital currencies in terms of their use cases, store of value, and investment opportunities. A brief historical overview will also be provided to familiarize the reader with the origins of these two virtual currencies. A brief look at how these two compare in terms of market capitalization. Bitcoin was the very first virtual currency to be established. It was created in 2008 by an unknown person using the alias Satoshi Nakamoto. The reason why Bitcoin was created was due to the increasing use of credit cards and other forms of digital payments. The unidentified creator wanted to create a currency that would be independent from a central authority and could be transferred electronically with low transaction fees (Investopedia, 2017). This would effectively create the first decentralized digital currency. The first bitcoins were mined in 2009. Since then, it has grown exponentially, with more and more businesses and individual users adopting this digital currency as a form of payment. Currently, Bitcoin has the most developed ecosystem and the largest number of users. With a market capitalization of over 70 billion USD, Bitcoin is still a force to be reckoned with in the cryptocurrency space.

Bitcoin & Ethereum Investment Comparison: Bitcoin and Ethereum

1.1. Overview of Bitcoin

In 2008, a person or group of people known by the pseudonym of Satoshi Nakamoto published the white paper for Bitcoin. It was later released in 2009 and Nakamoto implemented Bitcoin as open source code. Though there is much speculation surrounding the true identity of Nakamoto, their invention of Bitcoin has had an everlasting impact on the world of digital currency. Bitcoin was created with the intention of having decentralized currency. The most important characteristic of Bitcoin is that it has no central issuing authority or political institution that is in control. This makes it different from traditional currency. The price of traditional currency (money) is heavily reliant on central banks and governments. Any changes or decisions made by these institutions will have a direct impact on the currency’s price and is designed to manipulate it. Bitcoin operates on a mechanism that is purely based on supply and demand. Because it has a fixed supply of 21 million and a mining mechanism that slows down over time, many believe that Bitcoin’s price will continue to rise over the years, making it a good investment. This differs from printing money or quantitative easing, where fiat currencies are subject to depreciation in price over time. Bitcoin is designed to be a store of value that will maintain, if not increase, in value over time. This is rather compelling to many people. With banks providing barely any interest on savings accounts due to low interest rates, many savers are losing money in real terms due to inflation. Bitcoin provides a way to store value and earn significant returns over time compared to a traditional savings account in a bank.

1.2. Overview of Ethereum

For those who may not be familiar, while the Bitcoin system has been described both as a socio-technical system and a socio-technical ecosystem, Ethereum, which was proposed in late 2013 and development was crowdfunded in 2014, is best described as a distributed public blockchain network that focuses on running the programming code of any decentralized application. Importantly, it features its own cryptocurrency, Ether, but also enables many other cryptocurrencies to be issued on its network via a standard interface and is a platform for the development and deployment of smart contracts and decentralized applications. While Blockchain 1.0 is described as Bitcoin enabling the transfer of value as a peer to peer electronic cash system, and Blockchain 2.0 is a new generation of applications in which the different cryptocurrencies are the native currencies that enable the applications to function in new ways such as incentivizing file storage with filecoin, Golem an open sourced decentralized supercomputer, enabling micropayments iptables firewall using runcrypto to microcharge package forwarding, releasing company stock on distributed ledgers to trade on equity with the issuer using their homegrown dividends to vote on company decisions and having a completely decentralized poker or prediction market which are enabled by the platform, many would describe the Ethereum network as a Blockchain 3.0 generation that enables unprecedented automation via complex applications. A succinct but somewhat inaccurate way to describe the difference is that Bitcoin contracts are like using simple script languages with predefined templates, whereas Ethereum is like using a Turing complete language, because while there is a spectrum ranging from scripts to full-blown applications in both communities, the analogy is somewhat appropriate in that the Bitcoin script is limited, and limited is what it was intended to be, while the Ethereum Virtual Machine is capable of running smart contracts using any conceivable algorithm.

2. Factors to Consider

The market capitalization for both Bitcoin and Ethereum is significantly higher now than when they were first introduced. Market capitalization is a key indicator of demand for a cryptocurrency and its likely prospects for the future. In layman’s terms, the higher a cryptocurrency’s market cap, the more it is valued and the more demand there is for it. It indicates the public’s trust in that cryptocurrency as well as prospects for its future. Bitcoin has the advantage of being the first to market and has a market cap of over $10 billion USD. This is quite high in comparison to its competitors and is a good indicator of long-term success with a low risk of depreciation. Ethereum is relatively new and has a smaller market cap of roughly $1 billion USD. While this may seem small in comparison to Bitcoin, it is a relatively high market cap for a new cryptocurrency that has a lot of potential for future growth. This makes it a mid-risk, high-reward investment compared to Bitcoin. High-risk investments are speculative and often include the trading of volatility using volume. This is something that should be considered when comparing market capitalizations and deciding where to invest. High-liquidity cryptocurrencies may want to be on investors’ watch lists. A factor that may be an indicator of future price volatility is the rate at which a cryptocurrency is traded compared to being held. This is also known as the velocity of money. Often, in the case of traded volume being higher than purchase volume, it may mean that the public is using the cryptocurrency as a speculative tool and essentially ‘playing the markets’. While this is not a bad thing for a trader, it may indicate wider price swings in the future. Bitcoin has a relatively high velocity, which represents its high amount of trading and speculative interest. This may be indicative of more stable but gradual price changes in the future, with price bubbles having little to no effect due to strong demand. Ethereum has a considerably higher velocity in comparison to its trading volume and supply. High velocity is often not good for a currency and can mean wide price fluctuations and more dependence on the demand from the public, who may often be lost without a strong use case for that cryptocurrency. Price bubbles may also be an indicator of future interest in Ethereum and Bitcoin as opposed to intrinsic value.

2.1. Market Capitalization

Market capitalization is likely the reason why you are looking at this article. You may be considering an investment in Bitcoin or Ethereum and feel like the comparison between the two is like apples and oranges. The market cap, more than any other factor, represents the sum of all future expectations for a cryptocurrency. The higher the market cap, the more money you will need to pour into a cryptocurrency for its price to go up. As a rule of thumb, you are likely to make more money investing in a coin with a low market cap relative to its circulating supply. This is because the coin has a use case and is likely to see an increase in demand. Step one of this strategy would be to avoid putting money into coins that are more suited for Bitcoin gambling and have only obtained their high market cap due to a pre-mine, instamine, or the fact that the developers kept a large amount of the coin’s supply. Both Bitcoin and Ethereum would fail this first step for different reasons, but it is important to hypothetically consider what it would look like for a coin to achieve in the future what you are expecting it to and how high the future demand for the coin would have to be in order for it to serve its purpose.

2.2. Price Volatility

A common characteristic of a growing investment opportunity is its high price volatility. A significant change in price in a very short period of time can be a very attractive element for an investor, with the possibility of making a substantial return on their original investment. However, the possibility of a greater return also comes with the potential for a greater loss. For a currency that is still in its relative infancy, the volatility of Bitcoin and Ethereum has been remarkably different across the years. Data collected in a study by the Federal Reserve Bank of St. Louis suggests that between 2015 and 2016, the 260-day annualized volatility for Bitcoin was calculated at 75%, compared to just 31% for Ethereum. This reflects the developments in the use of these currencies, with Bitcoin being more established and widely used as a speculative investment in comparison to Ethereum, which faced less exposure from investors at the time. An investor should consider the effect volatility will have on their investment. If an investor is risk-averse and prefers a more stable investment with a lower return, it is clear that the lower volatility of Ethereum is more suitable for this aim. If an investor has a higher risk appetite and would like the potential for a higher return, then the higher volatility and potential for higher losses or gains in a short period of time would make Bitcoin a more attractive platform.

2.3. Use Cases and Applications

Due to Bitcoin’s higher time preference and an increasing proportion of wealth held as a store of value, comparative bearish market conditions could see people move back to spending and investing in attempts to regain lost wealth. This is an irrational but typical reaction to expected higher returns on investment from speculative investments, a demand from which Ethereum stands to benefit.

An oversaturation of speculative valuations can also lead to a bearish climate of liquidation. But in contrast to Bitcoin, Ethereum’s continuous chain will see higher speculative demand as an investment vehicle, given the clarity on how to buy the more valuable chain in events of large market fluctuations. High speculative demand as an investment vehicle is not necessarily an intended goal for Ethereum. However, the security offered by speculative demand and the profitable market for people attempting to assess price trends and holding long or short positions have led to various comparisons between Ethereum and Bitcoin, and it has become increasingly seen as an emerging competitor. This has positive implications for the speculative value of Ethereum and those holding it.

Building on the lack of a supply cap, demand for block rewards in Ethereum will remain for the near future as returns on POW mining can still be lucrative. This is in stark contrast to Bitcoin’s recent halving RampD event that has developed BIP 176, which seeks to reduce Bitcoin issuance and increase fee market sustainability. Overall, the clarity and prospect of continual change have an effect on the future speculative value of both. Bitcoin’s recent and ongoing political struggle has led to a detrimental number of scenarios of uncertainty and chain speculation with an array of potential Bitcoin futures. Japan’s acceptance of Bitcoin as a legal payment method and other countries following suit have caused an increase in speculative demand, often as an investment vehicle. It is unclear whether Ethereum or even Bitcoin’s current split chain with Bitcoin Cash will see any of these events as potential laws that could affect the current states of the various cryptocurrencies.

The situation is further complicated by the recent Bitcoin hard fork that resulted in a chain split and the formation of a new altcoin called Bitcoin Cash. This has created an uncertain environment with users and businesses having to decide which chain they will support, furthering the lack of real-world application of Bitcoin in comparison to the current established fiat system.”Although one of the most successful digital currencies to date, Bitcoin has a definite lack of governance, which has led to numerous situations of indecision and stagnation. This contrasts greatly with Ethereum’s well-defined upgrade process and its absence of a supply cap. This has vital implications for investors, as the long-term supply inflation for Ethereum is over twice that of Bitcoin and has been a contentious issue.

There is a stark contrast in the degree of usefulness and value of Bitcoin and Ethereum. Bitcoin being ‘digital gold’ has a debatable meaning. It can mean that it is highly valuable and thus an excellent store of wealth, similar to gold. On the other hand, it can mean that it has no real-world application or value against traditional fiat currencies, bonds, or stocks. This is the interpretation that Ethereum founder Vitalik Buterin states in his comparison between Bitcoin and Ethereum: “The Bitcoin community is often derided for not making any actual decisions, for it has the Bitcoin Improvement Proposals (BIPs) process. Yet if you ask someone in the community what each of these BIPs actually does, you will often get a stuttering response.

3. Investment Considerations

A good place to start when talking about investment considerations is risk and return potential. In terms of constitutive value, Ethereum admits in some facets to be riskier, granting higher possible returns; current investors cannot shirk the feeling that ERC20 ICO tokens and the massive number of projects migrating from the Bitcoin blockchain could have a negative impact on the price of Ether. The hard fork executed to restore the DAO investor’s funds also impacted the risk of Ethereum, resulting in varied opinions from different people on what the correct action should have been, contributing to the current split between Ethereum and Ethereum Classic. Conversely, more risk-averse investors may decide that the 2-3-year history of Bitcoin’s price being somewhat more stable is a compelling reason to forecast that it is less risky with more predictable returns. When compared directly to Ethereum, Bitcoin has a higher risk-adjusted return, which provides a more compelling opportunity for adding volatility as a separate asset class or investment strategy. An instrumental variable in assessing investment risk and comparing both Bitcoin and Ethereum is the establishment of the inflation rate for each respective blockchain. The coming Proof of Stake ‘Casper’ and ‘Ice Age’ are attempts for Ethereum to control an inflation rate that currently varies between 13 and 14% per annum, gradually decreasing to 0.5–2% over the next five years. This contrasts starkly with Bitcoin, which in July 2016 went through its second halving’, dropping the inflation rate of Bitcoin from 8% to 4% per annum and capping the total number of bitcoins in circulation at 21 million. A long-term risk-inflation risk comparison between the two may be weighted in Bitcoin’s favour, but this is a complex issue with many moving parts.

3.1. Risk and Return Potential

There are two general investment criteria that are of paramount importance in evaluating investment alternatives. These criteria determine the expected risk and return of an investment. The investor compares the expected return to be generated by an investment with the risk that the expected return will not be achieved. The investor will only accept a risky investment if the expected rate of return is high enough to warrant the risk. Conversely, the investor will not accept a low rate of return on an investment that is highly risky. This evaluation is based on the fact that investor’s preference for the higher rate of return over the lower rate and their preference for lower risk as opposed to higher risk if two rates of return are expected. The investor will take the investment with the lowest level of return as a reference point, and a line above this point is drawn to differentiate between risk levels; the steeper the line, the greater the rate of substitution of risk for return. This decision can be made using indifference curves between rate of return and risk, where there will be an optimal investment point tangential to one of the investment possibilities provided. With these two points of reference, it is relatively easy to compare two different investment opportunities, with the latter step comparing two different levels of the same type of investment. The comparison between two investment possibilities can be determined using the slope of the line at the optimal point, with the investment that has the steeper line being the one with higher risk, and the comparison between the two same investments being that the higher rate of return alternative has a higher risk level. Bitcoin and Ethereum are the current predominant digital coinage brands and can be seen as alternative speculative investment opportunities to forex trading.

3.2. Regulatory Environment

Bitcoin has an adverse record with legislative changes, particularly those set by the US. These changes have been known to yield negative effects, but they can often pave the way for future interest and an increase in Bitcoin’s value. An example of such an event occurred in late 2017 when CME Group Inc. and CBOE Global Markets launched Bitcoin futures contracts. This in itself resulted in a short-term increase in Bitcoin’s value, reaching a price of 19640 USD on December 16, 2017. It also represented an inflated sense of approval, legitimization, and acceptance of Bitcoin from the financial sector. This can only be seen as positive for Bitcoin’s future as a fungible and store-value asset.

An important event surrounding Bitcoin occurred in early September 2017, when Chinese regulatory authorities announced a ban on Initial Coin Offerings (ICOs). This resulted in a massive outflow of Bitcoin and the migration of its value to other cryptocurrencies, notably Ethereum. By the end of the month, the market capitalization of Ethereum had reached 80% of that of Bitcoin. A sustained period of inflation followed, and by the 14th of January, its market cap had peaked at 74 billion USD, which was around 95% of Bitcoin’s market cap at the time.

A string of negative and positive legislative changes have, directly and indirectly, affected the market capitalization of both Bitcoin and Ethereum. A stark contrast between the two comes in the form of the Chinese government’s stance towards both cryptocurrencies. Whereas the government has clamped down on Bitcoin in recent years, imposing strict regulations, it has fostered an environment conducive to the development of Ethereum. Evidence of this can be found from a well-informed source, a Chinese Bitcoin trader, who asserts that “the two cultures between the Bitcoin and Ethereum communities are fundamentally different, in the way in which developers and the community interact and the mindset to what the future holds.”

3.3. Future Outlook and Potential

This is possibly the most important variable in determining the long-term price of both Bitcoin and Ethereum. Bitcoin was the original cryptocurrency and has a first-mover advantage. If it can continue growing as a safe-haven asset and its layer 2 technologies can scale, the future looks bright. It has been fairly established that the stock-to-flow model is a valid one for predicting its price. Assuming this is still valid, the model predicts the price of Bitcoin reaching $1–2 million per coin, which would be a 20–40x return from today’s price. Successful scaling into layer 2 technologies can only add to this. If Bitcoin fails to become a safe-haven asset or its brand is damaged, the future prediction would not be promising. Ethereum is looking to transition into a deflationary asset with Ethereum 2.0. Some argue that as a general-purpose platform, it cannot achieve a high enough level of demand for Ether in its transaction fees, particularly if most applications are built in layer 2 for scalability. However, in a simple supply-and-demand model, it is quite clear that lowering the rate of inflation is likely to increase prices. If Ethereum succeeds in becoming the world’s leading computing platform, its price is likely to be much higher than it is even today. This is a big if, however, as the transition into proof-of-stake and various technology scaling upgrades have had and will continue to have their obstacles. The prediction is still very much 50/50 for Ethereum’s future success.

Bitcoin vs. Ethereum – Investment Comparison FAQ

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