Cryptocurrency is the hot new thing. It seems that everyone these days is catching the crypto-bug. Whether Bitcoin or Ether, or any of the hundreds of other digital currency offshoots, here is the rundown of what you need to know from a professional investor’s perspective.
In my job of managing money for a living I have gotten asked on a couple of occasions “When are you going to start buying bitcoin or other cryptocurrencies?” The short answer is: not anytime in the foreseeable future. I’ll say why, but first, let’s look at what cryptocurrency is.
Cryptocurrency is basically a digital form of cash. It gets its ‘crypto’ tag because it is generated and transferred using encryption technology which makes each unit unique and verifiable. What makes this possible is a technology called blockchain, which is essentially just the digital transaction ledger.
The actual units are called coins or tokens and are ‘mined’ by the keepers of the blockchain network. Think of it as the miners with pick axes getting paid with small nuggets of gold. These ‘miners’ can then exchange their tokens to anyone in the market and ‘viola’ you have a currency in circulation.
On this point, let’s look at a quote from Blockgeeks.com:
“If you take away all the noise around cryptocurrencies and reduce it to a simple definition, you find it to be just limited entries in a database no one can change without fulfilling specific conditions. This may seem ordinary, but, believe it or not: this is exactly how you can define a currency.”
This quote is pretty good and makes a great case for cryptocurrencies as currency. However, whether or not it is a currency is not the question. That does not really matter. I can put a picture of my face on a limited set of blue subway tokens and call it a currency. In fact, when I was in middle-school, Pogs were a form of currency. You would win them in the morning with a battle, and use the rare ones at lunch to buy french-fries from friends.
The real question about cryptocurrencies is whether or not any of them can become a legitimate part of our monetary system. For that to happen – for them to be widely accepted as a medium of exchange – it needs to satisfy two major functions.
1) Trust – that the rules of exchange are as expected
2) Consistency – expectations that the value of exchange will not deviate
And here we have a problem. Bitcoin, Litecoin, Ether, and all the other cryptocurrencies can’t yet fulfill either of these promises.
With a tag like ‘crypto’, cryptocurrency will always have the aura of a black-market currency and have trust issues. It sounds a little too ‘cryptic’. Even if cryptocurrencies went by another blander name (like an early predecessor, Digi-cash) it would still take a very long time to earn the kind of trust that would make it any kind of meaningful part of our monetary system. This industry, whatever it eventually becomes, is currently in it’s infancy. It is being plagued by market hacks, flash crashes, and lots of fraud.
Trust is the essential tenant of our monetary system, and our U.S. dollar, (despite the cries of some conspiracy theorist, cryptocurrency fans) has earned that trust over many decades. Our entire financial system is based on the idea that I can trust that a dollar given to me will be accepted by anyone else for an expected value.
It is impossible to treat any cryptocurrency as a legitimate currency when the price fluctuations are as dramatic as they are. Is it possible that price movements level out and bitcoin, ether, and the others become more stable? Sure, but right now, cryptocurrencies would lose 80% of their clientele if it were to do that.
I don’t understand why the path to becoming a stable currency alternative seems to mean that the price must escalate by 1000%. If the holders of cryptocurrency are being honest, this is the real reason they have them. The vast majority of purchasers are really just hoping to buy a little bitcoin now, and cash that bitcoin in later
Privacy – “I use cryptocurrency because it is untraceable and I don’t trust central governments”
Sorry but this is only an excuse for the debilitatingly paranoid, and those operating in the black market. Bitcoin is great for those dealing in the drug-trade, and human trafficking. Digital cash which is not traceable and fully anonymous? Who else benefits more in such an environment?
Learning Experience – “I’m buying to learn more about it.”
What I find interesting is the number of well known investors, (many of whom I have tremendous respect for) who are buying these cryptocurrencies “to learn more about it.” I personally think the real reason is that they recognize this is a bubble and are hoping that they are early enough to make some money on the thing. If these things appreciate by 10,000% then they get to say they were in on it, and if it crashes and goes to $0, they can chalk it up to the cost of “education”.
I wish they would just come out and say “look, I’m speculating that these things are going to appreciate in price by a ton. So, I am going to buy my lottery ticket and see what happens.”
Speculation – “This thing is going to $1 million!”
At least you’re being honest! If you want to buy a few bitcoin because you think it may go up by 1,000 or 10,000%, then go right ahead. Just be real about it and keep it in the speculation bucket. Do not use your retirement bucket or your kids’ college bucket to gamble on the craps table of cryptocurrency. I have seen ads for a bitcoin IRA, and that makes my stomach drop. There is no way this stuff should be anywhere near your retirement bucket (bucket mindset explained here). Just remember that no matter what anyone says this stuff is speculative and could go to zero just as easily (more so in my opinion) than to $1 million.
Goldman Sachs analysts made a statement recently (h/t @davidschawel) that said “real dollars are at work here and it deserves watching”. That statement sums up my entire opinion on the space. No one is buying bitcoin because someday it will make buying groceries super easy – they are buying it in hopes that it makes them more DOLLARS.
The bottom line is that buyers of cryptocurrency fall into 2 camps: Speculators and Blackmarket participants. You are either subscribing to the ‘greater fool theory’ or you need to transact in back-alley channels.
Finally, there is this graph from Liz Ann Sonders (@LizAnnSonders) of Charles Schwab.
While I normally regard a chart with 2 different scaled y-axes as a cardinal sin, the trends in this chart are revealing. As the popularity increases, the price increases. As the price increases, the popularity increases. This is the very definition of a bubble.
I’m not trying to say that this particular bubble will pop now, or even soon. We could still be very early in its expansion and it could continue expanding for a long time. All forecasts on where the price could go are completely wild guesses. I do not know how any analyst maintains their intellectual credibility and tries to offer a specific price forecast. What in the world would you base it on? A surge in Google search trends?
That isn’t to say that this bubble in cryptocurrency is a totally bad thing. Just like the tulip mania in Holland back in the 1630’s garnered the rise of the first financial derivatives, and the tech bubble of the late ‘90’s accelerated our transition to the internet age, the rise of cryptocurrency could help usher in new financial innovations based on the underlying blockchain technology. The potential for progress is there; however, if history teaches us anything, it’s that innovation does not proceed up in a straight line.
I’m still ok sitting on the sidelines for this one.
Until next time…
“When you see reference to a new paradigm you should always, under all circumstances, take cover. Because ever since the great tulipmania in 1637, speculation has always been covered by a new paradigm.” – John Kenneth Galbraith
photo credit: Chris Martin via flickr.com