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.
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:
- 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.
- 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.
- 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.
- 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.
- 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.