Investing In Cryptocurrency

Cryptocurrencies are digital assets or “tokens” – akin to the idea of money – specifically designed to take advantage of the architecture of the Internet. Unlike traditional currency they have value not because of the guarantee of a financial institution or government. Instead, they have value for three reasons: their ability to be accurately “confirmed” by the computers on a particular network, the value that is placed (or misplaced) on them by the market, and as a consistent way to measure the price of goods within a blockchain network.

Cryptocurrency versus traditional currency

In some ways, cryptocurrency works very similarly to a traditional currency or a precious metal like gold. The worth of the US dollar, for example, as a means of exchange, is valued not only in term of what a dollar can buy in real terms, but also by its relative worth against other currencies.

A key difference, however, between traditional currency and cryptocurrency, despite Bitcoin’s recognition as an “asset” by the IRS and as an accepted currency by the EU, is that the supply of cryptocurrency is not controlled by a central bank, but rather reflects the actions and perceptions of many independent individuals across a large number of jurisdictions. This has the potential to upend basic models of political economy of the last century (if not the last several hundred years of Western history).

Bitcoins, for example, are mined at a predetermined rate each time a user of the network discovers a new block (currently 12.5 bitcoins are created approximately every ten minutes) and the number of bitcoins generated per block decreases over time. Ultimately, the total number of bitcoins in existence is never supposed to exceed 21 million.

The real impact of Bitcoin beyond the hype is that it has the potential to diminish the need for central banks. It also has the potential to reduce the role of financial intermediaries like retail banks. Cryptocurrency was designed as a form of electronic cash to allow individuals to transact without going through a financial institution. This is likely to have a profound impact on the global financial system, financial markets, and the banking industry.

When it comes to buying other kinds of cryptocurrency, such as Ether, which was not created as a traditional “currency” but rather to pay for computations along the Ethereum network, the investment analysis becomes more complicated. In a very real sense, the “value” of Ether is more like the cost of a barrel of oil, a watt of electricity or any other mineral that must be “mined” or processed in some way, and then used to make a piece of machinery function – in this case a computer.

Cryptocurrencies are not immune from market forces or monetary policy, starting with the fact that you still need traditional currency to buy them. Ultimately, the buying power and inherent value of a cryptocurrency will be affected by the real economy including by things like inflation, exchange rates, global electricity prices, and the speed of the computing networks through which the cryptocurrency is created, traded and transferred. In the case of Bitcoin, for example, a market price is created against traditional currencies like the US dollar and renminbi because the main buyers of Bitcoin do so in dollars and yuan. To the extent that the value of these traditional currencies continue to fall with inflation, the price of Bitcoin will continue to rise over time.

Investment risks

The value of cryptocurrencies are not controlled the same way that fiat currencies are, for example by a decision of a central bank to increase the money supply. However, the cost of the resources that are used to create, price and transfer cryptocurrency may still be controlled on a national basis.

Potential investors should carefully consider the risks of cryptocurrency investing, some of which are listed below:

  1. Lack of Adoption: There are many cryptocurrencies in existence. The more people that use a particular cryptocurrency, the more likely it is that other people will be willing to use it also. In short, this means that cryptocurrencies benefit from “network effects”. Investors need to be aware that if a cryptocurrency fails to gain critical mass, or if it is superseded by a technically superior or more popular cryptocurrency, then its value may decline rapidly.
  2. Market Volatility: Potential investors in bitcoin would be wise to tread cautiously given the high levels of volatility in bitcoin’s market price over the last few years. This means that even if you are correct about the long term direction of bitcoin’s market price, you could still lose money in the short run. As John Maynard Keynes noted “the market can remain irrational longer than you can remain solvent.” Potential investors should keep in mind that purchasing bitcoin with the hope of achieving short term capital gains is a form of high risk speculation, similar to gambling. Professional traders manage this kind of market risk by following the “2% rule”; a trading practice which suggests that an investor should never commit more than 2% of her total capital to any one trade. Further, manipulations of the price and supply of bitcoin have occurred regularly.
  3. Security Risk: Cryptocurrency is digital, and so there are risks posed by hackers, malware, or system failures. For example, anyone who has the private key to a bitcoin account can transfer bitcoins in that account to any other account. This poses a significant risk since all bitcoin transactions are permanent and irreversible. Many experts recommend storing bitcoin in a digital wallet that is not connected to the Internet.
  4. Increased Regulation: Cryptocurrency could be a competitor to traditional currency, and may be used for black market transactions, capital flight or tax evasion. There is also no reason why a government could not move to control the supply of a cryptocurrency in the future either by passing legislating, buying up enough of it to change the rules, or by incentivising programmers to change them.
  5. Lack of Liquidity: Liquidity refers to how easy it is to quickly convert an asset into cash without a significant drop in the market price. The more difficult it is to buy and sell a cryptocurrency, the greater the risk for an investor if they need to sell in a hurry. Bitcoin can be traded on various bitcoin exchanges, which makes it easier to buy and sell, however it has still not achieved mainstream adoption.

So, where should you invest?

The question of what cryptocurrency to invest in is a loaded one. It depends what one’s goals are. If the aim in buying cryptocurrency is to use it to buy specific goods and services, or to transfer money from one place to another, then the purpose is very different from someone who is merely trying to make money by speculating in the short term volatility of a cryptocurrency’s market price.

As the above discussion indicates, there are many issues to consider. For that reason, investing in a cryptocurrency is a far more complicated decision than investing in other kinds of assets – and the risks of the same are also not yet fully and widely understood. Tread cautiously.

Marguerite Arnold is an entrepreneur, author and third semester EMBA candidate at the Frankfurt School of Finance and Management.

Image: Pexel

What Is Cryptocurrency?

While “Bitcoin” has become a household word over the past several years, the concept of what cryptocurrency actually is goes far beyond traditional concepts of “money”.

First invented by the individual or group of people known as Satoshi Nakamoto in 2009, the original concept was to create a decentralized automated cash machine (in very simplified form) that would allow anyone to send assets of value to any other person whereby those assets would not need to pass through or be controlled by any financial intermediary. In other words, it was an attempt to build another kind of currency uncontrolled by any central bank or government. Further, such transactions would be recorded by the computers connected to the network so that they could be verified by anyone who had access to it.

When seen as “money” cryptocurrencies pose a very real challenge to the role of central banks in that they essentially establish a new way for value to be created and transferred – globally.

How many cryptocurrencies are there?

At this point, there are too many to count.

Cryptocurrency is given value both by its creation (or mining) and by the other tools that are used to store, access, transfer, trade and transact with it. For example, Bitcoin, which is the oldest form of digital currency, is now traded on exchanges. Its reflected value is usually calculated either against the dollar or the yuan (which most people use to “buy” Bitcoins).

However, it is also not quite that simple. The inherent monetary value of Bitcoin as expressed in traditional currency terms is also impacted by how many people want to hold Bitcoins at a certain point in time (for whatever reason) and further by how many people are using Bitcoin for some other purpose (for example, transferring Bitcoin to another place or using it to buy another asset).

That said, the way that institutional entities (such as the IRS in the United States or the European Union) recognize Bitcoin as a form of “asset” is very much reflected in their understanding of cryptocurrencies as a form of “cash” or monetary asset, valued by reference to local currency. In other words, the inherent value of Bitcoin as understood from the perspective of agencies and governments who recognize and use fiat currency is to treat Bitcoin’s value as an asset understood in terms of local fiat currency – as if Bitcoin’s entire “value” was like dollars, gold or oil.

The two most widely recognized forms of cryptocurrency that are commoditized currently are Bitcoin, which is the oldest and most recognized form of cryptocurrency, and Ether – the “gas” as it were that makes the Ethereum network tick.

What is the inherent “asset value” of Cryptocurrency?

The short answer is that there isn’t one. It can be the value assigned to the currency by what is paid to acquire it, what kind of other asset worth it can be used to buy, how much it costs to create or “mine” such currency, or the perception of its worth based on its scarcity or expected future value.

Ether, as much as it is beginning to be traded, was not envisioned as a “currency” but rather a way to pay for computer processing power to effect another transaction along the Ethereum network. “Digital tokens”, of which Ether is an example, can be priced by the amount of electricity and computing time necessary to either create them or to perform a specific function along the network (such as recording a transaction). In other words, “cryptocurrency” is the juice which allows connected devices to do what they were programmed to do.

It remains to be seen how cryptocurrencies will affect national economies – in fact, the concept of what a traditional economy is could easily be upended (which is the fear of the central banks). Regulation of cryptocurrencies is still beyond the reach, if not ability, of traditional economic controls. This is part of the allure of cryptocurrency. What its ultimate asset value will be, however, is still very much an unknown and incalculable concept.

Marguerite Arnold is an entrepreneur, author and third semester EMBA candidate at the Frankfurt School of Finance and Management.