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CRYPTOCURRENCY - FAQ

CRYPTOCURRENCY - FAQ

March 27, 2021
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We have received many questions about cryptocurrency. Here are the most frequently asked questions to help you understand what they are, how they can be used, and the risks involved.

What is cryptocurrency?

A cryptocurrency is a digital token that can be exchanged on a blockchain (see definition of blockchain below). The first example of a cryptocurrency is Bitcoin (BTC), which currently represents the largest share of the cryptocurrency market. Additional examples include Ethereum, Litecoin, XRP (aka Ripple), and Bitcoin Cash. Thousands of different types of cryptocurrency have been created. Exchanges have developed that allow cryptocurrency to be converted to traditional types of government-backed fiat currency (e.g., U.S. dollar, Euro, Yen, etc.).

What is a blockchain?

A blockchain is a software program that may run on a decentralized or centralized network. In the case of Bitcoin, the network is decentralized, meaning that independent parties from around the world are running the software. The software keeps a record of transactions and ownership. All new transactions are recorded in blocks that are linked in a chain all the way back to the original block. Every transaction is sealed and cannot be changed. The result is a publicly distributed ledger. There are thousands of high-powered computers on the blockchain network independently working to verify the transactions and create a new block. In the case of Bitcoin, a new block is created about every 10 minutes. After creation of the new block, the blockchain is approved and computing work begins to solve the next block in the chain. The incentive/reward for performing this work is the issuing of cryptocurrency native to the blockchain.

What is cryptocurrency used for?

At the most basic level, cryptocurrency is used for transactions on the blockchain network. Individuals may also accept a cryptocurrency as a payment for goods and services if they perceive it has value (just like any other currency). If you accept a cryptocurrency as payment, then you have joined the network. To transfer your cryptocurrency to someone else, you must submit that transaction to the blockchain network. One analogy for cryptocurrency is to consider a fairground ticket. You buy tickets so that you can exchange those tickets for rides, games, and food within the fairground network. Unless your tickets are exchanged for dollars, they may not have value outside of the fairgrounds.

What is the value of a cryptocurrency?

The value of cryptocurrency fluctuates with supply and demand. Stakeholders are still trying to determine what the use cases are for the various cryptocurrency blockchains. Examples of use cases include store of value (like precious metals, art, collectibles, etc.), payment network (like banks, PayPal, Venmo, etc.), or programmable contracts (like escrow, trusts, insurance contracts, etc.). Cryptocurrency (or the underlying blockchain technology) may allow peer-to-peer transactions for these use cases without the existing intermediaries reducing costs and complexity for some transactions. As adoption of cryptocurrency for some of these use cases increases, a powerful network effect may emerge (like Facebook, Visa, etc.). Comparisons to those existing goods and services can be made to estimate the value of a cryptocurrency, but those estimates are speculative. Therefore, the price of cryptocurrency has been volatile. It is a nascent market with considerable uncertainty. It is important to understand that cryptocurrency does not have cash flows to evaluate, unlike the equities, fixed income, or alternative assets normally recommended in a diversified portfolio.

What is the investment thesis for cryptocurrency?

Each cryptocurrency blockchain is designed differently based on the intended use case, and its investment thesis may also be different. The thesis for Bitcoin will be examined here to provide an example. The supply of Bitcoin is controlled by the software so that new Bitcoin creation is decreasing. Furthermore, it is decreasing at a faster rate until the final Bitcoin is mined about 100 years from now. The current rate of the increase in supply of Bitcoin is around 1.3%, which is lower than the historical increase in the supply of gold. A limited supply coupled with demand for Bitcoin will drive up the price.

Additionally, supply of fiat currency manipulated by central banks has historically increased, causing a loss in purchasing power (aka inflation). Holding Bitcoin relative to fiat currency allows the holder to maintain or even increase purchasing power. Finally, there is value in the network effect as adoption increases. Once people trust that their transactions on the network are safe and beneficial, they are likely use the network for those transactions. Each person that joins the network brings their own network of potential participants and the network continues to grow until it becomes ubiquitous. The network effect also makes it difficult for a competing network to take market share. Holding Bitcoin provides access to the network and participants who benefit from participating on the network will pay existing holders for access. Consider this: How much would you pay for an account to be on Facebook’s social network? The amount will vary by individual or entity, but some parties would be willing to pay for this access.

What are the investment characteristics of cryptocurrency?

Over the last decade, cryptocurrency has been marked by high returns, high volatility, and low correlations with traditional assets. According to a recent CFA Institute study, a $10,000 investment in Bitcoin on July 17, 2010 would be worth $2.2 billion as of September 30, 2020.1 However, an investor would have had to sit through six declines of more than 70% in order to achieve such a return. Unlike stock prices, which tend to follow the direction of cash flows over long periods of time, cryptocurrency prices are determined by other factors, like store of value and network effects, that are more difficult to quantify.

What are some of the risks associated with investing in cryptocurrency?

Regulatory – Cryptocurrency has been promoted by some as a replacement for government-backed fiat currency. The power to control the supply of currency is not something central governments will freely cede. Additionally, cryptocurrency has been used for illegal activity in the past and the threat of government action to prevent illegal activity remains. Any regulatory action is likely to impact the market price of cryptocurrency.

Security – Cryptocurrency must be stored properly to prevent theft. The private key to access cryptocurrency can easily be stolen or forgotten. One commonly used phrase is, “Your key, your bitcoin; not your key, not your bitcoin.” This sums up the reality that you are now the custodian of your cryptocurrency, acting like a bank (unless you pay someone else to take on that responsibility). When you deposit money with a bank, it becomes responsible for, and takes on the risk of, safely and accurately holding your funds until you demand them back.

Insurance – FDIC and SIPC insurance is available for most bank and brokerage accounts to insure against a loss of dollars. No similar protection exists for cryptocurrency.

Replacement – It is possible that developers of another cryptocurrency blockchain may develop a better technology to power a blockchain that is cheaper, faster, and/or more secure. This may cause trust to decline in one or more of the existing cryptocurrencies. Bitcoin has amassed a significant network effect and market value based on trust in the underlying technology and growing adoption. However, it is possible that a loss of trust in the technology relative to future innovation may have a negative impact on the market value. Similarly, it is possible to “fork” a blockchain and create an entirely new cryptocurrency that has different characteristics. For example, Bitcoin Cash is a fork from Bitcoin. Developers of Bitcoin Cash desired to see a better payment use case application that could process more transactions than the existing Bitcoin blockchain. Both have remained valuable to date, but that may not always be the case.

Is cryptocurrency like digital gold?

One of the proposed use cases for cryptocurrency is as a store of value. Especially in the case of Bitcoin, comparisons are often made to gold. The blockchain that powers Bitcoin is structured so that only 21 million Bitcoins will ever be mined. In other words, Bitcoin is theoretically a more scarce resource than gold. Throughout the history of money, scarcity is one of the most important characteristics of effective stores of value. Trust in the scarcity and authenticity is ultimately what give both gold and Bitcoin a value beyond the cost of production. It is important to note that there is no pricing model to determine a value for gold like there is with other assets. The amount of gold in existence exceeds the amount needed for industrial use (jewelry, dentistry, electronics, etc.). Historically, some of the excess supply would have been used as currency. Today, most of the excess supply of gold is simply bought, sold, and stored. The result is that investor sentiment can move the price up or down in addition to the supply and demand fundamentals. Similarly, sentiment is likely to move the price of Bitcoin and possibly other cryptocurrencies.

How can individual investors access cryptocurrency?

Individual investors can purchase cryptocurrency on several different exchanges. Setting up an account with an exchange is like setting up an account with a traditional brokerage firm. A bank account can be linked to fund the exchange account and purchasing cryptocurrency is like buying a stock or ETF. The exchanges charge a fee for each transaction. After cryptocurrency is purchased, it is common to move the cryptocurrency to another digital wallet provider for secure storage.

Over the last few years, several cryptocurrency-centric investment vehicles have launched. However, most of these investments are only available for private placement for accredited investors or to the public via OTC exchanges. These offerings are not subject to the same level of scrutiny and regulation as typical mutual funds and ETFs available to the public. The investment offering landscape continues to evolve and it is possible that mutual fund and ETF offerings will be available in the coming years.

What are the costs associated with investing in cryptocurrency?

The costs of investing in cryptocurrency are currently high relative to traditional investments. The exchanges charge transaction fees, which come in addition to spreads between the buyer and seller. Additional fees are also required to pay for varying levels of secure storage with custodians. Fund expense ratios are currently in the 0.5%-2% range. The funds that are traded on OTC exchanges have historically traded at large premiums to the net-asset-value (NAV) of their underlying holdings. If those spreads were to tighten (which would be expected as the market develops), then any premium paid over NAV would be a significant drag on returns.

Is cryptocurrency investing consistent with an evidenced-based approach to investing?

Cryptocurrency is a newcomer to financial markets and therefore the historical evidence is very limited. Currently, there is not a passively managed and broadly diversified low-cost investment vehicle for investors to purchase. Based simply on back-testing, a portfolio with a small allocation to cryptocurrency looks terrific because of the staggering returns provided by cryptocurrency. However, even a decade of high returns may be nothing more than noise for any particular risk asset. Currently, Personal Wealth Strategies is monitoring the product development space and investment research on cryptocurrencies but has no near-term plans to add an allocation to cryptocurrency to any of our client portfolios.

In terms of asset allocation, how should cryptocurrency be categorized?

In its relatively brief history, cryptocurrency has exhibited low correlations with traditional asset classes. The risks associated with cryptocurrency are unique compared to equities and fixed income, which make up the largest allocation of most investor portfolios. From this standpoint, cryptocurrency should be classified as an alternative asset. As the use cases for cryptocurrency become clear, correlations with traditional asset classes are likely to change and the role of cryptocurrency in a portfolio will be easier to define.

How much should I consider allocating to cryptocurrency?

Personal Wealth Strategies does not currently recommend an allocation to any cryptocurrency. For clients that insist on an allocation, we would treat this like any other client preference and keep the allocation below 5% of net worth with the client recognizing the chance of total loss.

What is the tax treatment of cryptocurrency?

Cryptocurrency is subject to capital gains tax treatment just like other capital assets such as stocks. For cryptocurrency held less than one year, it is taxable as a short-term capital gain. For cryptocurrency held longer than one year, it is taxable as a long-term capital gain. One notable difference is that cryptocurrency is not subject to the wash sale rule.

Have I missed it?

Regret with investing is pervasive. Envy toward the early adopters who became fabulously wealthy (whether by genius or dumb luck) is a powerful emotion. There have been many times where investors could have thought they missed it (Nifty Fifty stocks in the 70s, technology stocks in the 90s, real estate in the 2000s, etc.) If cryptocurrency is a real game-changer with a unique source of risk and expected return, then there will be a market to participate in going forward. It is important to remember that the primary objective of a well-thought-out financial plan and investment policy statement is to create a high probability of accomplishing goals while controlling risk. Achieving high returns is not the primary objective, and missing high returns in certain areas of the market does not mean failure. At present time, the prudent investor is probably wise to wait or to buy cryptocurrency with money for which a total loss is acceptable.

1. “Cryptoassets: The Guide to Bitcoin, Blockchain, and Cryptocurrency for Investment Professionals” https://www.cfainstitute.org/en/research/foundation/2021/cryptoassets