Introduction
Cryptocurrencies are digital assets, based on multi-user computer networks, which employ new ‘blockchain’ technology. These are unique from the physical assets we commonly think of and invest in, such as real estate, oil, metals, or shares of company stock. Unlike those physical assets, crypto is held in digital form, similar to how one would store computer files. That by itself is not unusual, with much of modern banking and brokerage activities done electronically, as opposed to using physical instruments. However, their entire existence is non-tangible, and importantly, decentralized from world governments, which makes them unusual in the world of money. The concept was first laid out in a 2008 paper, authored under the pseudonym Satoshi Nakamoto, with the identity of the actual inventor(s) remaining a mystery to this day. In recent years, cryptocurrencies have been increasingly adopted as an alternative method of making payments or being speculated on for potential profit, if the value of a currency rises. Some of these new cryptocurrencies (referred to as just ‘crypto’ from here forward) include Bitcoin, Ethereum, Tether, and USD Coin, although there are literally thousands of others.
Cryptocurrency and Blockchain Technology
With crypto technology being so new, it’s been sometimes difficult for buyers to understand what they are actually getting. This complicates the assessment of potential return and risk. Firstly, it’s important to break the asset down into its component parts—separating the ‘currency’ part from the ‘blockchain’ technology upon which it’s based.
Blockchain technology. This is the backbone that crypto currencies and transactions are based on. It is best thought of as an encrypted electronic ledger that records and embeds information in pieces, which can then be reassembled in such a way that individual data cannot be later changed or deleted. This ledger is distributed to all users electronically on an ongoing basis so it remains current.
Although there are practicalities to be worked out, blockchain technology appears to have separate commercial promise in its own right and could be feasible for adoption as modernized digital ledgers to replace outdated recordkeeping systems (like paper) for contracts or property deeds, for example. That doesn’t mean the technology itself will necessarily end up being hugely profitable. Historically, many new technologies have created efficiencies and lowered costs for consumers, without resulting in investment windfalls for the providers.
Cryptocurrencies. These represent digital units traded via blockchain, which allows for the tracking of ownership changes, and are assumed to prevent duplication.
Crypto and Standard Definitions of Money
Firstly, what makes something a ‘currency’? Over the course of human history, countless items have been used as money—including sea shells, animal pelts, and metal coins—before more modern paper, coin, and accounting versions were created by banks over the last few centuries. Money has been increasingly concentrated and standardized by national central banks to improve acceptance, reduce counterfeiting risk, and control economic policies and inflation. According to traditional economics, there are three primary functions of money.
Medium of exchange. This is the ability to easily exchange money for goods and services. Some of the larger crypto might meet that hurdle to some extent, since they’re being increasingly accepted in money transfer systems and as online payment options (akin to PayPal). However, this only applies to a small handful of the most popular crypto (such as Bitcoin), but not the majority. A key test of a currency as an effective medium of exchange: Is it liquid and easy to convert to other assets? Perhaps this is true of the very largest, but not nearly as obvious for the other few thousand crypto with lower name recognition and usage. Prices for all crypto have been volatile, which could require frequent repricing of underlying assets in keeping with the changing currency conversion rate. So, it’s debatable as to whether these pass the test as effective mediums of exchange. Larger crypto appear to have some network effects, helped by first mover advantages. The volatility of crypto prices has caused problems as a payment medium, not unlike the constant repricing of goods required during periods of historical currency debasement, notably Weimar Germany in the 1920s (with images of near-worthless paper money being rolled around in wheelbarrows).
Liquidity is also related to the medium of exchange role, as transactions need willing buyers and sellers. Moving away from the most recognized crypto, where name recognition and network user effect has created a more liquid market, the next tier of options is more opaque. If a new crypto is that easy to create and introduce to the world, with so little information about its backing and creation process, risk rises tremendously. This is not only price risk, but risks of operational problems and fraud. In a sense, some crypto appear more like rewards programs, to the same degree that airline miles, gaming tokens, or grocery coupon points are ‘currencies’. As in many emerging industries, dilution between all of these crypto products could ultimately create a handful of winners but many losers. The fact that only 180 national/regional physical currencies exist today (according to the United Nations), some with fairly little liquidity, shows that the global demand for currencies is not unlimited. In one example, it’s our understanding that at least one well-known crypto was set up as a joke by its founders, and has since taken off due to the novelty, with free advertising help from online message boards. Another risk is technological. If new processes are invented, which reduce transaction times, fraud/theft risk, electricity use, or other hurdles, it’s easy to see new winners emerging over time that could leave current products in the dust.
Unit of account. This refers to being able to easily measure a currency’s value for accounting or transaction purposes. As crypto tends to be divisible and have a numerical quote, it mathematically fits the bill. Then again, other than the rough parameters around some crypto’s capped number of creation units, there might be less transparency about issuance limitations for others. (An investor is better off owning 1 unit out of 100 units ever to be issued, as opposed to 1 unit out of 100 million.)
Store of value. This refers to how consistently a currency holds its value relative to other currencies, goods, and services over time. Again, it’s helpful to take a step back. Well-accepted currencies like the U.S. dollar (arguably the world’s primary ‘reserve currency’) are backed by immense asset holdings (land holdings, mineral rights, etc.), as well as the economic, taxing, and military powers of the central government. Also important but less tangible backing comes from accepted cultural conventions, such as political stability and rule of law, which have created an environment of trust surrounding the dollar globally. The U.K. pound, euro, Japanese yen, and Swiss franc are also well-accepted as globally-desired currencies, due to the similar underlying trust holders have in the assets and policies of these nations. Those tangible and intangible factors have resulted in the stability of these currencies over time, relative to currencies from less stable nation-states.
Crypto, on the other hand, have experienced the type of volatility more in line with what one sees in the stock market or in other speculative assets. This instability tends to run counter to the desired predictability for a major currency, especially one used as a primary medium of exchange. (For example, since the price of one well-known crypto fluctuated wildly between $10,000 and $60,000 per coin over the course of a few months, would a buyer feel comfortable seeing the price of a new car priced in that currency double in one month and then fall by half again the next?) One argument against crypto is that there often isn’t an underlying asset base or historical legacy that give the currencies any fundamental value—we really don’t know if the true worth of a given unit should be $1,000,000 or zero—the current and future value is entirely based on popularity.
The concept of ‘scarcity’ is also related to the store of value definition. Under the guidelines of some crypto sponsors, there has been a cap on the number of total units to be ever created (such as 21 million Bitcoin). How caps can be properly verified and free from manipulation and fraud remains an open and highly-technical question. As noted earlier, that also assumes new digital currencies don’t emerge that are superior in technology or gain popularity for other reasons. This is a historical attribute and Achilles heel common of all currencies: if there is unlimited money printing, each unit will lose proportionate value. Traditional currencies tend to have an advantage here, since individual nations (or blocs) tend to only issue a single currency, which results in a limited universe of possible options, rather than thousands. That said, critics will remind us that recent massive spending and money creation by the U.S., Europe, and other regions in response to the financial crisis in 2008 and Covid in 2020-21 has caused many to contemplate the eventual impacts on these currencies as well.
An advertised advantage of crypto is that they aren’t reliant on any single government or economic bloc for support, nor can they be subject to central bank monetary policies. This has been seen as a benefit, with the opinion of some that major governments are spending too much money, leading to inflation, and debasing long-term currency values. However, if something catastrophic occurs, it also means there is no authority with deep pockets to step in and provide support, either. (A variety of governments operate in foreign exchange markets on a regular basis, often to help sustain the values of their own currencies in the open market.) In fact, there have been crypto created as a joke (really), as publicity stunts, or fraudulently, to dupe enthusiastic investors hoping to jump on the latest bandwagon.
Speaking of long-term value, it is important to separate any fundamental value crypto might offer, relative to the short-term level of general excitement, the component of FOMO (fear of missing out, fueled by expensive TV commercials), and lack of discussion about downside risks. Related unique digital assets, such as non-fungible tokens (NFTs), also use blockchain technology and have seen a recent spike in popularity. Some NFT pieces in the entertainment world like digital photos, videos, and other original art, have sold for astronomical prices. It remains to be seen whether this is the beginning of a new futuristic trend or an odd footnote in a future history book.
Anonymity
One benefit noted by many early crypto buyers is the anonymous nature of ownership. This specifically means the ability to transact privately, akin in some ways to exchanging briefcases of untraceable cash. Unsurprisingly, demand came originally via illicit transactions, tax avoidance, but also presumably from those just wanting high levels of secrecy. According to several recent case reports, though, the U.S. government has apparently been able to locate and retrieve stolen and ransomed crypto, so these transactions may not be as ‘private’ as once believed.
Crypto has also appealed to those seeking to avoid the traditional financial system and government-based channels. This would be similar to the hoarding of gold or silver coins, for example. In fact, some crypto has been referred to as the ‘digital gold’. While crypto doesn’t have the physical attributes of precious metals, the similarity is that prices have been extremely volatile, as discussed above. That may erode some of the safe-haven appeal.
Regulatory, Legal, and Practical Risks
As crypto investment and taxation have been in the crosshairs of increasing political discussion globally, governments are feeling the heat. China and several other countries have imposed an outright ban on crypto ownership and trading. This policy is assumed to be due to concerns over evasion of transaction tracking and capital controls, which govern movement of funds into or out of a country. Will other nations elect that same route? Or, as in the case of the United States and Europe, central banks have been investigating the idea of issuing their own digital versions of standard currencies, to compete with crypto. The benefits are automatic credibility, while privacy fans lament the government involvement and sponsorship.
Of course, there are other legal risks. What happens in the event of widespread hack and crypto theft? (These have already occurred.) What authority is really in charge to help restore confidence and asset values? Secure storage is an important issue for all digital assets, as online sources haven’t always been foolproof.
On an even more basic level, what if there’s a widespread power outage? This is a problem for all digital assets, with digital money being adversely affected at an inopportune time. Speaking of energy, crypto that requires ‘mining’ (with crypto units being given as a reward for solving computer math puzzles and add to the blockchain) require immense amounts of electricity. This process hasn’t been earth-friendly, and has drawn criticism from environmentalists.
Correlation to Other Assets and Inflation
Inflation can potentially erode any currency’s value over long periods, but that’s the rationale for investing in other assets such as stocks, bonds, real assets, etc., with historically positive long-term real returns. Due to its limited history, and much of it under a low inflation regime, the durability of crypto values is far from certain. In fact, during recent market volatility of the past several years, some crypto returns have correlated far more closely to technology stocks than to either ‘inflation’ hedges or ‘safe’ assets, such as treasury bonds or precious metals. Looking at the last eight years (ending 1/31/2022), ETF-based crypto holdings showed around a zero correlation on average to other major asset classes of U.S. stocks and bonds, energy, gold, real estate, as well as inflation.
In all fairness, traditional currencies and cash-like instruments haven’t always fared well on an inflation-adjusted basis over longer time frames, either. Better traditional hedges against inflation include equities (unless inflation becomes extreme), real assets like commodities and real estate, TIPs to a limited degree, and foreign assets (if the dollar weakens relative to history or other currencies).
Investability and Suitability
With any new and complicated financial product, it’s important to take a 30,000-foot view. From that vantage point, a buyer of any potentially ‘investable’ asset should ensure it makes basic economic sense, is durable to some degree, and/or fulfills a unique need. In the worst case scenario, what is under the hood? For crypto, the jury might still be out. It goes without saying that when speculation in hard-to-value assets are involved, any invested funds should be considered within an investor’s overall risk budget.
The larger, well-known crypto may score better on some metrics than others, including a larger network effect at this point in time. Although, there are still questions about what a person physically owns (electronic bits). For the remainder of crypto, it’s becomes harder to extract value from a real asset standpoint. What makes the 1001st currency unique from the 1000th? If anyone can create a crypto, and without a market for it, does it have any value?
Methods of Investment
If an investor desires crypto exposure, it can be approached directly or indirectly.
Directly. From a longer-term standpoint, buying crypto directly is the purest method. But this is not the end of it. As with any asset not under traditional custody, one needs to be cognizant of operational risks involved with online storage (risks of hacking or theft). Some experts have noted the best and most private method is ‘cold storage’, which is essentially downloading one’s crypto off of the cloud and onto a physical computer drive for secure physical storage (safe, safe deposit box, etc.), just as one would treat collectable coins, computer files, or important documents. An investor still needs to worry about lost passwords or access problems, since that’s often the only way to retrieve the crypto.
Indirectly. This would be through financial futures contracts or one of the new exchange-traded funds (ETFs). (These ETFs own crypto futures contracts, but not the actual coins at this time, with several applications for direct crypto-based funds having not met the approval of the U.S. Securities and Exchange Commission, as of early 2022.) As with commodities, owning futures contracts provides exposure to an asset, but the price of the futures can drift from the actual spot price of the asset. (This can occur to a second degree with ETFs based on contracts, due to their own market price vs. net asset value dynamics.) Futures are also prone to conditions of ‘contango’ or ‘backwardation’, where prices of near-term contracts can diverge significantly from later contracts, and the need to continually replace them (this is referred to as ‘roll risk’). This may get less noticeable as ETF products become more popular or spread out the operational risk of ETF position limits, or it may not. There are also management fees to consider, which look to be in the 1-2% range so far. Given that list of caveats, if someone wants liquidity, ease of use, or just a way to speculate in crypto without needing much precision in the short-term, owning an ETF is more convenient than going through the crypto exchange and cold storage process to buy directly.
Summary
Crypto, and the blockchain technology on which they’re based, represent significant technological innovations. No doubt, these may have potential uses far beyond what we’re currently able to envision. But are they valid replacements for our current system of currencies, backed by governments with legal power and resources? Today, the story features significant risks.
Cryptocurrencies are speculative assets that offer the potential for high returns but also carry a high degree of risk, including the risk of losing the entire amount invested. Actual returns will fluctuate. The information provided is not a recommendation nor an offer to buy or sell cryptocurrencies. Exchange-traded funds (ETFs) are sold by prospectus. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, or summary prospectus if available, provides a balanced analysis of the investment risks and benefits. It can be obtained by contacting the fund advisor. Read it carefully before you invest.
Sources: FocusPoint Solutions, Bitcoin.org, Euromoney, Forbes, Goldman Sachs Investment Research, JPMorgan, Morningstar, The New Yorker, U.S. Federal Reserve.
