Understanding Cryptocurrencies: Speculation or Investment?
You’ve probably seen plenty of headlines touting bitcoin and other cryptocurrencies as incredibly lucrative investment opportunities. What was once an esoteric concept has evidently gone mainstream. But what exactly is cryptocurrency? Cryptocurrency is a digital or virtual means of exchange. But because cryptocurrencies aren’t physical objects, like the dollar or the euro, they can only be stored in a “digital wallet”—a virtual bank account that enables account holders to pay for goods and services via online transactions. While bitcoin may be the best known and largest by market capitalization, there are more than 7,000 cryptocurrencies for sale today.
When it comes to understanding cryptocurrencies, they do offer some compelling characteristics. The accounts cryptocurrencies are stored in have lower fees than a traditional bank account. Since transactions are anonymous, there is greater security compared to other on-line payment methods because you are not sharing credit card or personal information over the internet. And, due to a lack of intermediary institutions and government regulation, cryptocurrencies provide increased flexibility compared to traditional currencies, including little to no costs for wire transfers, international payments and no need for ATMs or brick and mortar banks. For these reasons, supporters see cryptocurrencies as the way of the future and are eagerly buying them up, believing that they will only increase in value over time.
Of course, the prospect of getting in on the ground floor of a cutting-edge investment opportunity is exciting. However, when you’re considering an investment, it’s important to separate fact from fiction and deliberate analysis from irrational exuberance. And when you analyze cryptocurrencies in this light, considerable risks quickly become apparent and it is easier to see why the rise of cryptocurrency is based on speculation and is not a sound investment opportunity for long-term investors.
The many risks of cryptocurrencies
Unlike traditional, fiat currencies, cryptocurrencies are not regulated or backed by any central authority, like the Federal Reserve or Securities and Exchange Commission (SEC). With that comes little, if any regulation, lots of dizzying volatility, and a considerable amount of unquantifiable risk.
They are an incredibly volatile asset. Although you hear a lot about massive increases in cryptocurrencies’ valuation, you hear less about their declines. In its short existence, bitcoin has been extraordinarily volatile, rising or falling by more than 40% in price in just one month and crashing 69% over the course of 2018—a steeper fall than the dot-com bubble—making the S&P 500 look like it has the stability of a bond.
What’s more, only a fraction of the bitcoin supply actually trades on exchanges. Most of it is kept off the market by individual account holders in “cold wallets” for secure storage. This means that, because of the limited supply of coins available to trade, bitcoin behaves like a thinly traded stock, which adds even more volatility. This kind of see-saw market may be enticing for speculators, but it makes cryptocurrencies a poor replacement for assets that offer long-term growth—like stocks—or for those that can provide stability—like bonds.
You may end up unable to sell easily or at all: Unlike traditional currency, no one is required to accept cryptocurrency as payment, and a company or individual can suddenly decide to stop using a particular cryptocurrency at any moment. In addition, even when a merchant accepts cryptocurrencies, it can place considerable restrictions on their use—with little or no warning. This means that you could end up with a cryptocurrency that is difficult, if not impossible, to sell—another aspect of cryptocurrencies’ liquidity problem. We believe it is necessary to invest in liquid assets that are easy to value and trade. This way, if you ever need to sell your investments for cash, you can.
There may be no recourse if you’re defrauded or forgetful. Because there’s no oversight over cryptocurrency markets, investors have few protections. If you unwittingly enter a transaction with an unethical or misleading trading partner, there is very little recourse for recovering your funds. Cryptocurrency intermediaries can—and do—simply close up shop at any time. In 2014, a once-dominant bitcoin intermediary, Mt. Gox, suspended trading and filed for bankruptcy, and hundreds of thousands of bitcoins were lost and likely stolen. There was not much account holders could do. Finally, with many cryptocurrencies, you automatically lose access to your account if you log in with the incorrect password too many times. This is no small problem. Some users have lost millions of dollars’ worth of cryptocurrency. In fact, a cryptocurrency watchdog group estimates that 20% of all outstanding bitcoin is currently stranded in inaccessible accounts.
No one completely agrees on what cryptocurrency is. When considering an investment for your portfolio, it should be clear about what purpose the investment serves. Is it intended to protect you from inflation, serve as income during retirement, or provide asset growth? A fundamental problem when understanding cryptocurrencies, is that it is unclear how to classify them. The U.S. Comptroller of the Currency sees them at least somewhat as currencies because it recently allowed U.S. banks to conduct banking in stablecoins (a type of cryptocurrency whose value is tied to an outside asset, like the U.S. dollar) and participate in blockchain networks. Yet cryptocurrencies are different from other currencies because merchants don’t have to accept them, and they aren’t widely used as a unit of value. The IRS classifies cryptocurrencies as property and subjects them to capital-gains tax, while the Commodities Futures Trading Commission has convincingly argued that cryptocurrencies should be considered commodities. This makes sense because they can be bought and sold in cash markets and via derivatives. But they are not physical raw materials, like most traditional commodities. The classification for cryptocurrencies is still up for debate, but they clearly do not yet fit into an established asset class like stocks, bonds, or cash.
We believe you need to be able to identify the purpose of an investment, and at this early and uncertain stage with cryptocurrencies, there isn’t a clear answer to this question. You will probably keep hearing about the potential for unlimited upside and the rush of excitement from participating in the next or newest thing. However, these aren’t the qualities of sound investment policies, but of speculations. That’s not to say that cryptocurrencies are inherently dangerous or that they can never be part of our clients’ portfolios. Rather, it’s an early, uncertain market with a lot of players and a lot of volatility. As with all opportunities, we will continue to monitor the metrics of cryptocurrencies and how they can fit into a long-term, diversified portfolio.