Cryptocurrencies have been dominating headlines and expanding its lineup as the original, Bitcoin, has been joined by new entrants into the field. Businesses are taking notice from the standpoint of both their balance sheets and their payment processes. And even the Federal Reserve is now talking about crypto. Should it be a part of investor portfolios?
Before we can answer that question, let’s spend some time understanding what crypto is, how it works, and what the current thinking is.
Cryptocurrency is a digital currency that can be used to purchase goods and services online. It uses a technology called blockchain that is essentially a database. Instead of storing data in tables, blockchain stores data in blocks, which are then chained together. While blockchain can be used for many things, Bitcoin, the largest cryptocurrency by value, uses blockchain in an interesting way that illuminates some of the basics about crypto. Bitcoin was the first real-world application of blockchain technology.
Bitcoin works by decentralizing the blockchain – blocks aren’t created by one computer, they are created by thousands of computers, all over the world. Every entry created by every computer working on the blockchain is chronological and timestamped. They are irreversible, permanent, and viewable to anyone. It can be thought of as a public check register or transaction ledger. This is what makes the blockchain so secure. Hacking it would mean that the timestamps would no longer match up, and trying to change it would mean you’d have to get collective agreement from everyone.
While the popularity of Bitcoin has been referred to as a “gold rush,” mining Bitcoin looks a little bit different than it did when prospectors headed West during the 1800s.
Bitcoin “mining” is when users validate and monitor transactions made with Bitcoin. As noted above, because there are thousands of miners throughout the world, Bitcoin is decentralized and outside of government influence or control. When someone mines Bitcoin, they are essentially auditing transactions made within the blockchain to ensure no duplicate or fraudulent transactions are being made. This is done by using powerful computing systems that are able to process large amounts of data. As compensation for their efforts, successful miners are rewarded with Bitcoin.
The alternative to mining Bitcoin is purchasing it. You can buy Bitcoin (again using it as a proxy for crypto, but there are thousands of cryptocurrencies) on an exchange, with a traditional form of currency. Bitcoin uses a key pair system to control ownership and spending. Each unit of Bitcoin comes with a unique, public key and a private key that you need if you ever want to sell or spend it. If you lose the private key, it’s not like a password. It’s like destroying paper money — it’s gone. It’s estimated that 20% of all Bitcoin mined is unusable due to lost keys.1
While some investors are buying cryptocurrency for transactional use, other investors are viewing it as an investment. In fact, it’s estimated that roughly just 20% of all Bitcoin mined is frequently traded.2 Bitcoin proponents call themselves “hodlers,” after an investor in a Bitcoin chat room in 2013 who wrote a post on why he as ‘hodling onto his investment despite the price dropping drastically. His misspelling of holding was adopted by the bitcoin community, and hodling describes an act of faith.
If this sounds similar to goldbugs – investors who are perpetually bullish on gold – it is. There’s a lot of discussions comparing Bitcoin to gold, and whether bitcoin is a store-of-value that can be used to hedge against a traditional currency. Both of them share four characteristics that are usually cited as marking an effective store-of-value: durability; fungibility; divisibility and portability. For two of those, divisibility and portability, bitcoin is clearly superior as gold must be smelted and is very heavy. The total number of possible bitcoins is 21 million, which will be reached in 2140.3 Given the limited supply, one could argue that it is more scarce than gold – which augers well for increasing in value.
However, there’s one key differentiator – throughout history, gold has been viewed as a status symbol and rooted in value. Because of this, it is very widely distributed. While gold may drop in price, the likelihood of it becoming worthless is small.
Bitcoin may eventually follow a similar storyline, one that instead of reflecting status is seen as a collective effort in a push towards decentralization. It’s something that people can get behind, participate in, and believe in which only increases its perceived value. However, until it achieves widespread distribution and uptake, it will remain vulnerable.
Cryptocurrencies have seen a rise in value recently, which is both driving and being driven by increased uptake and signs that both investors and users are thinking of it as more mainstream. Institutional investors are increasingly bringing bitcoin into their portfolios, and publicly-held companies (Tesla being the most famous but there are others) are holding it on their balance sheets as a reserve asset. Some of this is related to the perception that crypto can be an effective hedge against inflation, which is projected to increase.
As an accepted currency for online transactions, cryptocurrencies are seeing uptake from several major platforms. Square, Paypal, and Mastercard have announced changes to allow cryptos to be used.
Even with positive signs of adoption and accessibility, there are still risks to consider.
Since the value is not tied to a tangible result, such as a strong performing company, cryptocurrencies could lose their value simply by lack of public interest, or any type of negative publicity event that would shake confidence. In addition, if the hodlers were to open the floodgates and begin selling large quantities, that action would of course result in the price dropping and would create even more volatility in the crypto market.
Also, there’s the potential for government involvement. Governments could step in at any time and shake up the crypto market. There have been early signs of this as Treasury Secretary Janet Yellen has expressed her skepticism towards Bitcoin. Government involvement could introduce new regulations and limitations towards Bitcoin but at this time, it’s unclear how or if this would be implemented.
As with any investment, it has to fit your personal risk profile, fit with your other investments and move you toward your investing goals. Crypto is a speculative investment, and its value as a hedge against inflation is unproven. Unless you have already set aside an allocation to speculative or highly volatile investments, adding crypto could disrupt your existing plan significantly.
Another important factor to consider when investing in cryptocurrency is the tax consequences. Unlike the U.S. dollar, cryptocurrencies are currently classified as property, meaning anytime a cryptocurrency is transacted, it creates a taxable event. Also, the capital gains tax that applies to traditional investments also applies to cryptocurrency. If investing in Bitcoin or other cryptocurrencies, it’s important to keep detailed records of each transaction so they can accurately be reported.
As with any investments, there are factors to consider and there will always be risk involved. While alternative investments and cryptocurrencies are picking up popularity, a financial advisor will help weigh the risks and benefits to see if they’re the right fit for your portfolio.
1. Winck, Ben. There’s Roughly $140 Billion Of Inaccessible Bitcoin Right Now – Or 20% Of The World’s Limited Supply. Here’s What Could Happen To It. Business Insider. January 12, 2021.
2. 60% of Bitcoin is Held Long Term as Digital Gold. What About the Rest? Chainalysis. June 18, 2020.
3. Rosic, Ameer. How Many Bitcoins are There? – 85% Of The World’s Bitcoin Has Been Mined. February 12, 2020.