Cryptocurrency: Speculative Fad or the Future of Finance?
Digital money, known as “cryptocurrency,” has continued to gain acceptance, both among speculative millennials as well as institutions. I used to think cryptocurrency was an over-hyped fad that got too much press. Nevertheless, you cannot avoid it anymore. Many people are blinded by the price volatility and their personal biases, but the reality is cryptocurrency is finding more uses in commerce. Some cryptocurrencies such as Ethereum can be used to create unique digital tokens (AKA: Smart Contracts) which convey certain rights. For example, when digital artist, Beeple, sold his “everyday” collection of work for $69 million through Christie’s auction house, he conveyed the rights to his art using a Non-Fungible Token (NFT), created on the Ethereum cryptocurrency platform. The token automatically gives him a 10% cut of any subsequent sale of these works.
Why Do We Need Cryptocurrencies?
Most people think of money as serving two purposes: shopping and showing off. Just kidding. Money is used by society as a store of value and a medium of exchange. We typically think of money that is printed and backed by the full faith and credit of a government. Some people do not trust governments because they may do something foolish like print too much money. This would cause inflation, which would make it easier to pay off the national debt, but also make your accumulated savings less valuable. People who do not trust the government (or banks for that matter) sometimes invest in gold or precious metals. Gold cannot be printed or created by the government. Instead, it must be dug out of the ground, put in a vault, and then you can pay someone to guard it for you. Cryptocurrencies, such as Bitcoin, solve many of the concerns of those who are skeptical of traditional (fiat) currencies and physical stores of value such as commodities or gold.
What Is Bitcoin?
Bitcoin is the best-known cryptocurrency. It was created in 2009 by an unknown software developer using the alias Satoshi Nakamoto. The software protocols are open source, so anyone can see how it works. Bitcoin’s most important characteristic, and the thing that makes it different from conventional money, is that no single institution controls the Bitcoin network. (See 90-second video: What Is Bitcoin)
Several marketplaces, called “Bitcoin exchanges,” allow people to buy or sell Bitcoins, which are stored in a “digital wallet,” that exists on Internet servers (the “cloud”) or on a user’s computer hard drive. The wallet is a kind of virtual bank account that allows users to send or receive Bitcoins, pay for goods, or save their money. Unlike bank accounts, Bitcoin wallets are not insured by the FDIC. There is a risk if the cloud computers get hacked or your computer with your digital wallet crashes or gets lost/stolen. The Bitcoins would still exist, but you would never be able to access them without the digital encryption key. This is why more and more people store their digital wallet with a company like Coinbase.
Transactions Are Verified Through a Public Ledger: “Blockchain”
Each cryptocurrency transaction is recorded in a public log, which is replicated and stored on Internet servers all over the world. A distributed public ledger that does not rely on a single trusted third party is made possible by a technology known as “Blockchain” (see VIDEO). Many people feel blockchain technology will revolutionize finance and many business practices. The names of buyers and sellers are not revealed—only their digital wallet IDs. This keeps transactions private and enables cryptocurrency users to buy or sell items without an easy way to trace it back to them. That is why Bitcoin has become the currency of choice for people conducting illegal activities such as ransomware attacks.
How Are Bitcoins Created?
Anyone can create Bitcoins by solving complex math problems. Here is a video that explains the process: Bitcoin mining. Many of the smartest computer scientists in the world are working on mining cryptocurrencies as well as developing their platforms and uses.
How Do You Make Money Investing in Cryptocurrencies?
Cryptocurrencies appreciate or decline in value based on good old-fashioned supply and demand. There is a limit of 21 million Bitcoins that will ever be mined. Currently approximately 18.7 million of the 21 million are already in circulation and the supply is growing at about 2% per year. The price will rise if demand for Bitcoins increases faster than the supply. Another coin, called Litecoin is similar to Bitcoin, but the supply of Litecoins is limited to 84 million. Some coins, such as Dogecoin do not have a limit. There are over 129 billion Dogecoins in existence. The fact that many cryptocurrencies guarantee a finite supply has added to FOMO (the fear of missing out).
The value of cryptocurrencies is extremely volatile. In fact, the price of a Bitcoin has fallen by 30% or more 14 times in the past 10 years. (See: The Bitcoin Crash of 2021 Compared to Past Sell-Offs). Unlike traditional (fiat) currencies, there is no central bank working to maintain price stability.
The next big test will be to see if long-term investors and money managers add cryptocurrencies to their portfolio allocations. It seems like many investors want some exposure to this new asset class. However, this has not happened yet in any substantial way for two reasons:
1) Cryptocurrencies are speculative, unregulated, and not widely used in commerce, and,
2) Cryptocurrencies are not securities that can easily be held in brokerage accounts. This situation, however is changing as several companies are in the registration process with the SEC to offer ETFs that mirror the value of one or more cryptocurrencies. Also, more and more financial institutions like PayPal now allow you to buy, sell and hold cryptocurrencies in your account.
The other big driver of demand could come from private companies converting some of the cash on their balance sheet into Cryptocurrencies. This would be more likely if volatility calms down, but a handful of public companies have already done this (e.g. Tesla, MicroStrategy).
- Cryptocurrencies are likely to survive and gain acceptance, although I think there will be some government regulation in the future.
- Cryptocurrency is a speculative investment that is only appropriate for a small portion of most investor’s portfolios. I was not an early adopter, but currently, I have 3.5% of my investible assets in Cryptocurrencies (Bitcoin and Ethereum), and those investments are slightly below my purchase price as I write this.
- In my opinion the risk/reward is favorable. In other words, it is very possible to lose money, but you also have a very real possibility of significant gains.
- Like most investments, it should be held long-term and only invest what you can afford to lose.
What are your thoughts on Cryptocurrencies? Email me.