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Cryptocurrency

Understanding Cryptocurrency

It’s hard to scan the financial headlines these days and not spot at least one call to action related to Bitcoin’s latest moves. Has all the attention given you cryptocurrency fever, or are you at least wondering what it’s all about? Before you start loading up on bitcoin or any other form of cryptocurrency, let’s take a closer look at what you may be getting yourself into, in three parts:

1. Understanding cryptocurrency

2. Spending cryptocurrency

3. Trading in cryptocurrency

Our quick take? Cryptocurrency is an interesting development with a number of promising possibilities. Human ingenuity is always a marvel to behold. But like any relatively new, highly volatile pursuit, it entails considerable risk.

If you’d like to try earning and spending cryptocurrency, be sure you’re familiar with the nature of the beast. If you’re thinking of trading in it for fun or profit, we advise against putting in any more than you could afford to lose entirely. In our estimation, cryptocurrency remains more of a speculative venture than a disciplined investment.

With that, let’s proceed!

Beginning with Bitcoin

Cryptocurrency was introduced in 2009 by a pseudonymous Satoshi Nakamoto. Nakamoto described a new kind of money, or currency, which was meant to exist in a secure, stable, and limited supply strengthened by electronic security, or encryption. Pair “encryption” with “currency,” and you’ve got cryptocurrency.

Bitcoin became the first cryptocurrency, and is still the most familiar kind.1 According to CoinMarketCap, Bitcoin had a market cap of nearly $600 billion as of January 22, 2021, with its closest competitor Ethereum at $140 billion. Market caps drop considerably after that, but there are plenty of others. As of September 30, 2020, a CFA Institute Cryptoassets Guide reported: “More than 6,000 different cryptoassets exist, and many new ones are created each month.”

Unlike a dollar bill, cryptocurrency only exists as computer code. You can’t touch it or feel it. You can’t flip it, heads or tails. But increasingly, holders are spending cryptocurrency in ways that emulate “regular” money (although limitations remain) – and potentially even adding to its uses. There’s also growing interest in trying to build or at least preserve wealth by trading in cryptocurrency, which some describe as being like “digital gold.”

1 You may notice, we sometimes capitalize Bitcoin as a proper noun, and we sometimes leave it as lower case. General practice is to capitalize the entity, “Bitcoin,” but to use lower case for the coins themselves. Think of it like the difference between “the U.S. Dollar,” vs. “a dollar bill.”

Cryptocurrency vs. “Regular” Money

In comparing cryptocurrency to regulated fiat currency – or most countries’ legal tender – there are at least two components to consider: limiting supply and maintaining spending power.

• Limiting Supply: Obviously, if a currency “grew on trees” it would cease to have any value to anyone. That’s why central banks like the U.S. Federal Reserve, Bank of Canada, and Bank of England are tasked with limiting their currency’s supply, without strangling its demand. For Bitcoin, supply is limited to a maximum of 21 million coins. While cryptocurrency proponents offer explanations for how supply and demand will be managed, some systems will undoubtedly be more effective than others at sustaining this delicate balance, especially when exuberance- or panic-driven runs might outpace reason.

• Maintaining Spending Power: Neither fiat currency nor cryptocurrency are still directly connected to the value of an underlying commodity like gold or silver. Thus, both must have another way to maintain their value, or spending power, in the face of inflation. In most countries, the nation’s central bank is in charge of keeping its fiat currency’s spending power relatively stable; only the government can add or subtract from its supply of legal tender. For cryptocurrency, there is no central bank, or any other centralized repository or regulator. Stability is instead backed by its underlying blockchain.

What’s a Blockchain?

Using bitcoin to illustrate, a block is essentially a bitcoin transaction waiting to be settled. Think of it as being like a written, but uncashed check; it’s not real money until the transaction is verified and added to a permanent ledger.

Except there is no bank to complete the transaction. Instead, bitcoin “miners” compete against one another for the role. Each block is secured with a complex mathematical equation. The first miner to solve the equation gets to add the new block to a blockchain. The winning miner is then rewarded handsomely for their effort. They are paid with bitcoin, which can currently be valued at tens of thousands of dollars for settling a single block. [Source]

The CFA Institute’s Cryptoassets Guide describes cryptocurrency security as follows:

“This is the real breakthrough of blockchains: creating timely, bad-actor-proof consensus across all copies of a decentralized and distributed database. … Today, more than 40,000 computers are independently verifying every single bitcoin transaction.”

In other words, blockchains create a strong, yet globally decentralized check-and-balance system. The competition among thousands of miners keeps everyone relatively honest, as any attempted “cheating” by cryptocurrency holders or miners should be promptly detected.

Next Up: Spending Cryptocurrency

We’ve now provided a general introduction to cryptocurrency. In our next piece, we’ll cover some of the ways people are using it, along with some of the challenges involved in doing so. In the meantime, don’t hesitate to be in touch if we can answer additional questions.

Challenges and Opportunities

Next, let’s explore the challenges and opportunities that exist for those hoping to earn, store, and spend their bitcoin or similar cryptoassets. 

The Crypto-Possibilities

Cryptocurrency is typically driven “by and for the people” in peer-to-peer exchanges. At least in theory, this permits it to flow more quickly and cheaply, with fewer fees and administrative hurdles. Ideally, cryptocurrency offers the potential to: 

  • Push Past Boundaries: Successful cryptocurrencies and the blockchain technologies behind them could offer a faster, cheaper, or at least additional way to conduct domestic and international commerce alike. 
  • Democratize Currency Exchange: Cryptocurrency as a means of exchange may particularly appeal to those who are not big fans of government oversight, or who live in a country that lacks dependable currency of its own. 
  • Make Money More “Programmable”: By optimizing different blockchains for different purposes, it may be possible to “program” a cryptocurrency to adhere to certain rules or conditions during an exchange. For example, this in-depth report describes how a cryptocurrency could potentially be programmed to act as a digital trust, contract, or escrow reserve, which could only be unlocked when certain conditions were met. 

The Crypto-Challenges

On the flip side of the coin, many of the same qualities that appeal to cryptocurrency holders can also create challenges, even for established currencies like Bitcoin. 

  • Competition: What if a competitor invents a better mousetrap, and the cryptocurrency you’re using falls out of favor? With no central authority in charge of safeguarding your ownership or preserving the worth of your cryptocurrency, its purchasing power may or may not endure. As one chief investment officer observed in a January 2021 Financial Advisor piece, “There is little in our view to stop a cryptocurrency’s price from going to zero when a better designed version is launched or if regulatory changes stifle sentiment.”
  • Theft: Recent evidence suggests bitcoin theft decreased dramatically in 2020 … or at least became harder to detect. Either way, cryptocurrency remains an appealing target for cyberthieves with long histories of finding new nefarious strategies, even as older ones are shut down. Granted, the same thing can happen to your legal tender, but there is typically more government protection and insurance coverage in place for more regulated accounts. 
  • Loss: Your cryptocurrency “wallet” is typically secured through a password that you – and only you – know; consequences are dire if you lose that password (or if a thief does get ahold of it). Best case, you may be able to pay a professional 10%–20% to recover your coins. Worst case, your coins may be gone for good. A January 2021 BBC piece reported, “Currently, about $140bn worth of Bitcoin is lost or left in wallets that cannot be accessed.” 
  • Supply and Demand: A government can seek to stabilize its currency’s spending power by adding to or pulling back on supply as demand rises or falls. In contrast, Bitcoin’s supply is fixed and finite. With a maximum set at 21 million bitcoin, approximately 18.6 million are already in circulation as of January 2021, with no mechanism for reducing that supply when demand declines. Time will tell whether this model remains a sustainable way to store value. 
  • Government Regulation: Speaking of governments, since cryptocurrency was uncharted (unregulated) territory until quite recently, the rules of engagement are still largely under construction. As such, your cryptocurrency could suddenly become more or less appealing to hold, trade, or exchange, depending on countries’ rapidly evolving reporting requirements, taxable ramifications, judicial findings, and other regulatory acts.
  • Energy Consumption: Last but not least, cryptocurrency mining centers around the globe are using enormous amounts of electricity. In December 2020, MarketWatch reported bitcoin production alone was annually “gobbling up the energy of a country of more than 200 million people.” The same report notes that most production is coming out of coal-fueled China, where “bitcoin production is likely to be particularly dirty.” Iran recently shut down most of its bitcoin processing centers as the country faced rolling blackouts and toxic smog in Tehran. In short, many cryptocurrencies aren’t exactly “green” money. 

Given the challenges, no wonder one tweet from a celebrity can still send a bitcoin’s spending power sinking or skyrocketing overnight. You don’t generally see that from a dollar bill! 

Still there are many who believe cryptocurrency is here to stay. Are they right? Will cryptocurrency prevail, and ultimately become a widely accepted means of exchange? If so, which ones will sink? Which will swim? Under what circumstances? 

We wouldn’t bet your life’s savings on any particular outcome – which brings us to our next topic of conversation: Does cryptocurrency belong in your evidence-based investment portfolio? Our short answer is no – at the very least, not yet.

Trading in Cryptocurrency

You may or may not be interested in using cryptocurrency as a means of exchange. But what about trading in it, directly or in fund form? If you are considering that possibility, know that, at this point:

  • Cryptocurrency is a highly risky holding: For every cryptocurrency success story you read, there are plenty of other tales of woe.
  • Cryptocurrency is not an investment; it’s a speculative venture: Bottom line, cryptocurrency doesn’t fit into our principles of evidence-based investing … at least not yet.

Remember the Risks 

All the transactional risks we covered in part 2 can also impact cryptocurrency traders. To recap, these include:

  • Potential loss or theft of an underlying cryptocurrency you’re holding
  • Loss of equilibrium between a cryptocurrency’s supply and demand
  • Governmental regulation hobbling a cryptocurrency’s growth potential
  • The massive energy consumption required to mine cryptocurrency

That’s a lot of potential buzzkill for your happily-ever-after holdings. These and other risks have translated into an extremely volatile ride for cryptocurrency traders, and one reason you might want to think twice before piling your life’s savings into them.

Then again, every investment carries some risk. Without risk, there’d be no expected return. That’s why we also need to address an important difference between evidence-based investing vs. speculative ventures. It has to do with how we evaluate future expected returns.

 Setting Expectations

What’s a bitcoin worth? A dollar? $100? $1 million? The answer to that has been one of the most volatile bouncing balls the market has seen since tulip mania in the 1600s. As described in this Wall Street Journal piece, bitcoin was trading for around $7,000 per coin in early 2020; as of February 20, 2021, the price topped $55,000. By the time you’re reading this piece, there’s not much stopping it from being worth far more than that … or far less.

The problem is, there’s really no way to establish meaningful expectations either way. In his ETF.com column, “Bitcoin & Its Risks,” financial author Larry Swedroe summarized how market valuations typically occur:

“With stocks, we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending, for which there are decades of data, we have historical evidence to make the appropriate estimates. With bitcoin, none of the preceding analysis is possible. Bitcoin is purely speculation.”

Here are several others weighing in on the matter:

“Bitcoin’s fundamental value is zero. … It’s almost all speculative.”

  • Steve Hanke, Professor of Applied Economics, Johns Hopkins University

 “[Bitcoin] is not a vehicle for investment, not a store of value, and not an inflation hedge. BTC is not a capital asset: it does not generate cash flows derived from economic returns on capital. Its extreme volatility invalidates claims of a reliable store of value and calls into question any inflation-hedging properties.”

— Alex Pickard, Vice President of Research, Research Affiliates

“Bitcoin depends on the faith of investors and nothing more. It could equally well go to zero tomorrow if 10% of investors sold.”

— Eswar Prasad, Trade Policy Professor, Cornell University

“You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”

— Alan Greenspan, former Federal Reserve Chair

Investing vs. Speculating

In other words, we’re not saying it’s impossible to profit from trading in cryptocurrencies. But the attempt more closely resembles a game of chance than an investment. In contrast, evidence-based investing enables us to create a unified portfolio we can manage according to YOUR individual goals and risk tolerances. Evidence-based investing calls for the ability to: 

  • Estimate an asset’s expected return, based on relatively well-established fundamentals
  • Factor in how different asset classes interact with one another within your total portfolio
  • Provide a sensible structure for embracing a long-term, buy, hold, and rebalance strategy  

 Cryptocurrency simply doesn’t yet synch well with these parameters. It does have a price, but it can’t be effectively valued for planning purposes.

 Venturing Forward 

All this said, what if you are still interested in trading in cryptocurrency, for fun or potential profit? If so, here are key tips to consider: 

  1. Treat it like an entertaining trip to the casino. Don’t venture any more than you can readily afford to lose!
  2. Use only “fun money,” outside the investments you need to fund your essential lifestyle.
  3. If you do strike it rich, regularly remove a good chunk of the gains off the table to invest in your managed portfolio. That way, if a bubble bursts, you won’t lose everything you’ve “won.” (Also set aside enough to pay any taxes you may have incurred.) 

Making Sense of Cryptocurrency

We hope it’s helped you put this headline-grabbing subject in proper context. What other questions can we answer for you? Whether cryptocurrencies mature into mainstream transactional tools or they eventually wither on the vine, we remain available to assist you in managing your total wealth, in whatever form it takes.

If you have any questions or comments, feel free to reach out to us.