The dangers of Bitcoin & other cryptocurrencies

The first type of cryptocurrency that got public attention was Bitcoin, of which many thousands of other types of digital coins have spawned – valued at USD 4.67 billion in 2022. If this is true, why is there so much criticism of cryptocurrency?

How did cryptocurrency start?

Cryptocurrencies were established between the 1990s and 2009 with a goal to take the government out of money.

Many people don’t trust central banks, believing these institutions will devalue their wealth by manipulating the value of money to suit the whims of the state. Even worse, the whole “fiat money” setup depends on people maintaining trust in the system as a whole – some would say blind trust – because fiat money isn’t backed by anything that is material or real.

Previously, people of this mind set would be the archetypal gold bug. Now, they turn to the secret world of digital currencies, the anonymity of which has also attracted money launderers, drug dealers and others who wish to undertake transactions under the radar of the authorities.

Many believe that it is the secret nature of cryptocurrency holdings and the accompanying transactions that will ensure their future success. There will always be individuals with a lack of trust in government policymakers and central bankers, and the financial system as a whole drives this view.

Reasons not to invest in cryptocurrencies like Bitcoin

1. There’s too much volatility

In general, asset classes must provide a systematic return over time and/or provide a safe store of value for savings. The volatility of Bitcoin means it does not meet any of these requirements.

Both equities and bonds offer a positive income stream and, in the case of the former, the prospect of long-term capital appreciation as the underlying company matures. Funds containing these assets also pass this test.

The same can also be said for cash deposits. These certainly offer an income stream, albeit extremely low in recent times. Banknotes are also a store of value. They still carry the promise to “pay the bearer on demand”.

Bitcoin does not offer a store of value; it is an entirely digital invention which can be easily replicated. Indeed, the website that tracks prices – coinmarketcap.com – current lists 4,052 different types of digital currency. These include ’joke coins’ such as “Theresa May Coin” and “Dogecoin” which was named after man’s best friend.

Cryptocurrencies have a legitimate purpose, despite the shady reputation in some quarters. But, because they offer no store of value or prospect of systematic return, buying them for any other reason than as a medium of exchange is pure speculation. The timing of transactions is also a risk. Bitcoin can only process 6 transactions a second compared with anywhere between 10,000 and 15,000 a second at Visa and Mastercard.

Warren Buffett, perhaps the world’s most famous investor, has gone further. The chief executive of Berkshire Hathaway thinks that:

“In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending,” Mr Buffett has said. He also said he would not take a short position in bitcoin futures, which have been launched by CME Group in the US. "We don't own any; we're not short any; we'll never have a position in them," he concluded.

2. Bitcoin regulation is limited

One big threat to the value of these coins is regulation. Cryptocurrencies “challenge the ability of governments to levy taxes and to control capital flows more broadly,” according to a recent report from Bank of America. Uncertainty over how the US government will act to limit these uses presents a key risk for cryptocurrency investors. Mounting support for central bank digital currencies (CBDCs) is not “just a form of payments competition,” the report warned. “They are also an effort to replace private digital assets with publicly-controlled ones.”

One big issue that needs to be resolved relates to power. Cryptocurrency is “mined” through a digital process that aims to keep the increase in supply of coins constant. If coins could be created easily then digital currencies would plunge in value as supply soared.

To solve this, the process involves solving an electronic puzzle, the difficulty of which is adjusted to keep the rate of new coin formation constant. If more computer hardware is employed in mining, then the puzzle difficulty will adjust upwards to make mining harder.

3. Bitcoin mining uses ‘shocking’ amounts of electricity

In theory, anyone with knowledge, an internet connection and suitable hardware can participate in mining Bitcoin. However, the power to mine coins is hugely concentrated amongst a few – those clever enough to know what to do that also have sufficient computing power. The computing power needed to solve the increasingly complex puzzles is utterly astonishing and this takes lots and lots of energy – mostly generated from dirty coal and oil.

Because of the complexity of the processes involved in mining, it has been estimated that Bitcoin creation alone uses more power each year than Argentina. If its energy intensively cannot be resolved, then cryptocurrencies will have a major problem in a world that has embraced carbon neutrality with net-zero targets.

How does cryptocurrency work?

The digital currencies are powered by a technology called Blockchain. A Blockchain enables any type of encrypted data – from electronic money to medical records – to be shared between members of a closed network.

Blockchain protects the data from fraud and updates all the members concerned. It is what is known as a distributed ledger technology (DLT), allowing a network of computers to agree at regular intervals on the true state of a ledger’s position. Copies are shared between all participants and a process is established by which users agree on changes to the ledger.

Since anyone can check any proposed transaction against the ledger, this means there is no need for a central authority. There’s simply no need for government inspectors.

This fledgling technology is likely to have many uses. For example, Nasdaq is trialling the use of distributed ledgers for private company share registers.

But, for Charles Stanley, the situation is pretty clear.

Digital coins are not so much an investment as a gamble, informed or otherwise. In fact, it’s easy to argue that they are a classic speculative frenzy. We believe all digital coins should be treated with extreme caution and will not include any digital currency assets in client portfolios.

For risk-adjusted investment ideas, explore our curated list of Preferred Funds.