To many seasoned investors, and to many financial professionals, cryptocurrencies are an enigma. Few imagined a nascent asset class could spring out of nowhere and capture the public’s imagination in such a dramatic way. Yet many early adopters and ‘hodlers’ of decentralised digital money such as Bitcoin are sitting on returns (in many cases unrealised) that have far outstripped the traditional asset classes so diligently researched by the investment community. Most investment professionals have scoffed at crypto, dismissed it as a fad or focused on the shortcomings, but they have all been essentially wrong – at least in terms of the price action so far.
Crypto hits the mainstream
Crypto awareness is spreading, and acceptance is becoming more mainstream. It has been estimated that as much as 14% of the US population now invests in cryptocurrency, with two thirds of those that don’t labelled ‘crypto curious’. Like any popular investment area, a lot of the recent upward momentum is likely to be have been driven by ‘FOMO’, or Fear of Missing Out, with people inspired by the giant gains made by those who bought in early. It’s very easy to be tempted to buy an asset that has performed incredibly strongly – that’s just how the human brain is wired.
It has also become progressively easier to buy crypto through various exchanges, which has made it more accessible for non-geeks. The process is made to feel a bit like buying shares, even if the underlying assets are entirely different, and it's possible to move between Bitcoin and many other coins such as Ether, Binance Coin and Ripple. Hundreds of other ‘altcoins’ also exist, many of which have genuine uses in the real world. Others are almost certainly ‘pump and dump’ scams designed to sucker investors in so that early buyers can make money before the price crashes. It is, after all, a completely unregulated space, so a fertile hunting ground for snake oil salesmen and criminals.
What’s good about crypto?
Cryptocurrencies are built on blockchain technology, a decentralised ledger that protects data from fraud and updates all parties. A network of computers agree the ledger’s position at regular intervals and a process is established by which users agree to any changes – in the case of crypto, when any transactions take place. Since anyone can check a proposed change against the ledger, it means there is no need for a central authority. There is no ultimate ‘owner’ commanding the blockchain.
The technology offers some interesting and useful applications. With cryptocurrency it creates a bearer ‘asset’ that can be securely moved anywhere in the world, whenever required. No customs, foreign exchange fees or government intervention. That has notable attractions for criminals, but there are certainly all sorts of legitimate uses too.
More broadly, blockchain enables any type of encrypted data – be it personal or company data, medical records or financial transactions – to be shared between members of a network. The potential to cut out paperwork and counterparties for this fledgling technology is huge. Many developers are building "decentralised finance" apps on the Ethereum blockchain, which is also used to produce digital art – so called Non-Fungible Tokens or NFTs.
What are the drawbacks?
There are several reasons why Bitcoin and other cryptocurrencies should be treated with extreme caution.
- Who wins?
It is hard to gauge which digital currencies will be most dominant and enjoy widespread use. For instance, Bitcoin is currently considered the foremost digital currency. It is the most accepted and it is an intermediary asset for buying other digital coins and tokens, but its status may fade. This has implications for its perceived value. The barriers to entry in cryptocurrency space are pretty low. It takes some time and blockchain coding knowledge to establish a digital token tethered to a network, but there's usually nothing unique about an underlying network that can’t be replicated by somebody else given sufficient time and effort. Out of hundreds of coins, this means only a few might survive over time.
- No intrinsic value
OK, there is arguably no intrinsic value to a pound sterling or a gold bar either, but how do you value a Bitcoin or another crypto asset? There is no sensible way to do so, and therefore no ‘anchor’ for price as there is with assets that produce cashflow such as shares or property. Some coins have no upper limit in terms of how many can be produced, so there is not really any scarcity as there would be with gold or precious metals. In the case of Bitcoin, the energy and effort that goes into the ‘mining’ process to produce new coins can be quantified – but that leads to another problem...
- Energy intensity
Mining Bitcoin is energy intensive as it involves computers solving highly complex problems. That’s by design. The effort and power that goes into the mining process is what gives the coin value, and many other cryptocurrencies use similar ‘proof of work’ mining processes. However, consuming as much energy as a medium-sized country each year is a big issue in a world that has embraced carbon neutrality, and it begs some serious questions. Can Bitcoin overcome this paradox, or can another cryptocurrency solve it? What other credible ways are there of ascribing value to a cryptocurrency? In which case who will the winners be?
- Easy money
Most bubbles are built on economic booms or otherwise lax monetary conditions. It’s hard to prove, but increased savings, US stimulus cheques and lockdown boredom seem like a good explanation for more and more people pouring into various crypto coins. What happens when the hot money dries up?
- Meme culture
The popularity of many altcoins seems dependent on their promotion on social media. There seems no end to the shameless ramping, which in regulated markets would be market abuse and against the law. A digital currency can be ramped, mis-sold and manipulated with little or no consequences for those with vested interests that do it. I hesitate to state the obvious, but investing on the strength of a “to the moon” meme is beyond foolish.
Cryptocurrencies are going to be increasingly in the crosshairs of regulators the bigger they get. Regulators aren’t interested if something is marginalised and underground, but you can bet they will be if it becomes a threat to governments (read: tax take). Historically, ‘unofficial’ currencies have a tendency of getting closed down if they gain traction. Bitcoin and others are designed in such a way that it’s not possible to shut them off – but that doesn’t mean to say that life will always be easy for those that use them.
Do crypto assets deserve a place in your portfolio?
The hype and noise surrounding crypto assets has become a cacophony. The market is chaotic, still in its infancy and full of traps for the unwary. Wild price swings are the norm. They are not so much an investment as a gamble, informed or otherwise. In fact, it’s easy to argue they are a speculative frenzy that could end in tears – eventually.
Yet just as Amazon emerged from the ashes of the 1990s dotcom boom and bust, there could be some big winners from harnessing decentralised money through blockchain technology. This could be a story that plays out just as much in regulated markets as the alternative world of crypto and the coins themselves. If you buy these then you will either need remarkable insight, or a leap of faith and a good deal of luck. Either way be on your guard to avoid fraud and theft – there is no protection in unregulated markets.
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