Demystifying Cryptocurrency

May 13, 2021

There are few investments that are as little understood and as over-hyped as cryptocurrency. The April 14 initial public offering (IPO) of Coinbase, a cryptocurrency exchange, generated tremendous buzz on Wall Street. For “crypto-evangelists,” the IPO was viewed as a watershed moment and a signal that cryptocurrency investing had achieved mainstream status. For that reason, we thought it might be helpful to explore the cryptocurrency space and provide some food for thought before one considers whether cryptocurrency is a good investment. This is by no means intended to be a deep dive but rather scratching the surface of an area of the market that both mystifies and excites investors.

What is Cryptocurrency?

Although some forms of electronic currency date back to the early-1980s, the first decentralized cryptocurrency, Bitcoin, was created in 2009, following the global financial crisis. The intent was to develop a form of exchange that could not be regulated by governments or central banks. Bitcoin, like other cryptocurrencies, uses blockchain technology, which allows it to be transferred from one person to another both privately and without the need to go through a bank or payment processor. That privacy makes cryptocurrency tough to trace and, therefore, attractive to those who want to transact anonymously. And, because cryptocurrency is not tied to a national government like US Dollars, Euros, Yen, etc., it can be used worldwide without the need to convert from one currency to another.

Pros and Cons

The attractiveness of cryptocurrency is that it is decentralized. That means no involvement or interference from governments or financial institutions. However, upon further examination, the exciting benefits of decentralization begin to erode. For one, with cryptocurrencies, you cannot reverse a transaction once completed. Credit card payments can be stopped and reversed. And, having a third-party intermediary, like a bank, can be helpful when it comes to protection from fraud. While cryptocurrency is intended to be more secure than a bank account or credit card, cryptocurrency fraud and identity theft still exist. And, if someone steals your Bitcoin, it is gone. Also, it is important to note that you can easily lose your entire store of Bitcoin if you forget the PIN for your Bitcoin wallet.

The privacy of cryptocurrency is more a story of potential than current reality. Nearly all transactions in cryptocurrency are performed through centralized exchanges, which means they are subject to the same regulation as transactions performed through the traditional banking system.

And, then there is the convenience argument that transactions using cryptocurrency are easier to make than those with credit cards or cash. However, because cryptocurrency is not a widely accepted means of exchange, if one owns a lot of Bitcoin and hopes to use its purchasing power, that Bitcoin would first have to be converted into hard currency (at a taxable gain) – not very convenient. So, until there is that ability to transact more broadly in cryptocurrency, it will remain more a store of value than a means of exchange.

Investing Merits

In some ways, cryptocurrency as a potential investment reminds one of gold. It produces no cash flow, its value is highly speculative, and its performance is driven by hype. It is also a scarce resource like gold. Just as there is a finite amount of gold in the world, there is a finite amount of cryptocurrency, even though that amount will not likely be fully tapped for an estimated hundred years. And, unlike a stock or bond, whose price and return can be explained by fundamentals such as earnings, interest rates, etc., there is no explaining the wild ride of cryptocurrency. When the entire value of an investment is driven by speculation, that should give any investor pause. And, at its core, the lure of cryptocurrency has always been that it exists outside the purview of governments or central banks. However, given the incredible power of these institutions, is it unrealistic to believe that those institutions would allow another means of exchange to exist unregulated and unchecked?

Conclusion

That said, investing in cryptocurrency today has been equated by many as gambling in Las Vegas. Never play with more than you can afford to lose. And keep in mind that cryptocurrency is still in its infancy. Bitcoin has been around since 2009, but thousands of other cryptocurrencies have popped up in the years since (you can even create your own). One helpful analogy to consider is the internet boom of the 1990s. Think of all the internet companies whose stock prices skyrocketed during that time. How many of those companies are still around today? Remember Netscape? CompuServe? Myspace? AOL? Google did not exist, Facebook was not created until 2004, and Amazon was only selling books online. So, when you think about investing a few dollars in one of the many cryptocurrencies out there or buying stock in a company like Coinbase, realize that many of those players may not be around even though the technology of blockchain itself may prove to be a gamechanger.

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