Chances are you’ve heard of Bitcoin and other cryptocurrencies at this point. But what exactly are they and what things are most important to understand as you’re talking to your friends about these options?
Cryptocurrency is as hot as it gets these days, in terms of pop-culture and investing. But what exactly is cryptocurrency and what things are most important to understand before considering buying something like Bitcoin for yourself?
An alternative currency?
Let’s start by talking about currency in general. Currency is really anything that can be considered a useful and trustworthy medium of exchange. And in order for something to truly be dependable as a medium of exchange for goods and services, it also should be considered a reliable store of value.
Cryptocurrency is intended to be an alternative to traditional “fiat” currency, which is used and trusted in everyday life around the world, to purchase goods and services. What makes the concept of crypto unique is that it offers users access to a decentralized payment network, which can reduce or eliminate transaction costs, improve speed of transactions, and provide even higher levels of access, trust, and security than the traditional, somewhat antiquated global banking system. At least, in theory…
A medium of exchange?
As cryptocurrencies like Bitcoin become increasingly more mainstream, its use cases as a true medium of exchange may become more widespread, but it remains hard to argue that something like Bitcoin is truly a currency at this point in its very brief existence, in terms of its ability to actually be used to buy much of anything.
Many will argue that there are several ways individuals can make purchases with Bitcoin, but the reality is that as long as goods and services are priced in terms of dollars or any other local currency, using Bitcoin to buy just about anything most often still requires converting Bitcoin into the actual fiat currency first, like the US Dollar or the Euro. Selling your Bitcoin in order to convert it to another currency before using it is not using Bitcoin as a true and direct medium of exchange. It is simply liquidating an asset in order to extract it’s purchasing power in terms of the US dollar or another local currency.
In 2020, Russell Okung, an NFL player for the Carolina Panthers, made headlines for demanding that his salary be paid in Bitcoin instead of dollars. A third party payroll service offered a solution to make that happen…sort of. The Bitcoin community latched onto this story as an example of a revolutionary development in the evolution of Bitcoin as a true currency. But the reality is that this player’s contract is still valued in terms of dollars. While his paycheck will be converted into Bitcoin each pay period, based on the price of Bitcoin at that time, this is not the same thing as being paid in Bitcoin.
Truly being paid in Bitcoin would mean a salary would need to be stated in terms of Bitcoin, not US dollars that would be converted to Bitcoin at a constantly fluctuating, highly volatile price over time.
For example, a salary of 1 Bitcoin (1BTC = approx. $50,000 at the time of writing this piece) per year is very different from stating a salary of $50k per year. If Bitcoin’s value drops by 50% within the year, which it is prone to do, that 1 Bitcoin would be worth just $25k, cutting the Bitcoin salary in this example, in half. At least in terms of its actual purchasing power, which we of course have to state in US Dollars. It’s worth noting that paying an actual Bitcoin salary would also require the employer to hold Bitcoin itself for its own payroll purposes.
Truth be told, there is really nothing revolutionary about this story, as pretty much anybody can turn around and buy Bitcoin with their paycheck whenever they want to. Bitcoin’s history is flooded with somewhat misleading stories like this, which can unfortunately take away from some of the more compelling arguments about its legitimacy as an alternative currency, whether today, or in the near or distant future.
A store of value?
The example above of being paid in Bitcoin highlights another challenge for Bitcoin as it fights to legitimize itself as an actual alternative currency. Bitcoin is notorious for periods of extreme volatility, where price swings in the thousands of percentages are often followed by the price falling off a cliff. This pattern has been a recurring one throughout its existence. And price swings do not instill confidence in its ability to be used as either a medium of exchange or a store of value.
In order for a currency to truly be reliable, it must be relatively stable in terms of its value. This may ultimately happen over time, if Bitcoin and other cryptocurrencies become more widely adopted, but as of today, it’s hard to make a case for Bitcoin as anything close to a reliable store of value.
Globally, cryptocurrency remains a largely unregulated asset class. This poses risks that potential traders, investors, users, adopters, etc., should be aware of. Just like many in the Bitcoin community itself often struggle to tell a consistent story as to what type of security Bitcoin actually is (commodity, currency, derivative, etc.), regulators around the world are also struggling with that same question.
Here in the US, the SEC has stated that, due primarily to their decentralized nature, Bitcoin and many of the other top cryptocurrencies are not considered securities. What this means is that the world of crypto remains a bit of a “wild west” for investors.
The idea of regulation both frightens and excites proponents of Bitcoin in particular, as it gains in popularity and fights for legitimacy. On one hand, the idea of regulating these assets defeats the very purpose of their existence in the first place. But on the other hand, regulation that doesn’t result in an all-out ban means far more access to both individuals and institutions. And more access means the network grows bigger and the assets’ values could climb even higher.
Because of the SEC’s stance, there are very few ways for investors to get exposure to Bitcoin and other crypto assets in their investment portfolios, without holding it through a third party crypto exchange or their own personal crypto wallet. But exchanges and wallets are not protected by FDIC or SIPC insurance, adding significantly more risk to holding these assets, especially as they are often linked to fraudulent and criminal activity.
That said, there is a big push within the ETF (exchange-traded fund) community to get a Bitcoin/crypto ETF into the market. The SEC remains relatively quiet on the idea, but as popularity grows and institutional adoption becomes more common, many speculate that an ETF product could be coming very soon.
The bottom line…
While crypto assets like Bitcoin are often referred to as currencies and the “future of money”, that currency label can imply a misleading characteristic of these instruments – stability and/or relative safety. It’s very important for investors to understand that money invested in crypto is still seen as extremely risky in today’s environment, even if you do feel strongly about its future.
In time, the thesis for cryptocurrencies as reliable alternative currencies may come to fruition. And as more individuals and institutions get on board, the case for crypto assets likely becomes much stronger. But volatile assets like Bitcoin must continue to be handled with abundant caution for now.
As advisors, it’s our job at blooom to lay out the risks of investing in speculative assets like this. While speculation can certainly have its (relatively small) place in a financial plan, we generally recommend only putting money into these instruments, if you would be perfectly fine losing every penny of it.
That’s not to say we are predicting cryptocurrencies will fade and become worthless at some point. But as an unregulated instrument, potential investors need to be aware that placing bets on the future of an asset that is unregulated, has no earnings, pays no dividends, has no real intrinsic value, and (as of yet) cannot truly be considered a currency, is really nothing more than gambling.
The information is provided for discussion purposes only and should not be considered as advice for your investments. The information does not represent a recommendation to buy or sell securities. Investing involves risk. Your investments are subject to loss of principal and are not guaranteed. Investors should consider their ability to continue investing through periods of fluctuating market conditions. Please consult an investment advisor before you invest.
Published on March 3, 2021