A Perspective on Cryptocurrency
More questions are coming up about cryptocurrencies, especially after an election in which they became a hot topic at times. What are cryptocurrencies? How do they work? And maybe most important, should they be part of my portfolio?
First and foremost, I’m not a cryptocurrency expert. I’ve always been interested in technology and started learning about Bitcoin in 2011. However, I am a Financial Advisor: bound to the best interests of my clients, bound to comply with industry regulations, with a desire to provide as much information as possible to help support clients’ financial decisions.
What are cryptocurrencies, and how are they different from traditional currencies?
To borrow a definition from Coinbase, a leading cryptocurrency exchange, cryptocurrency is a decentralized digital money designed to be used over the internet. Throughout history, trade has been facilitated through different types of exchange. Long ago, people would trade shells, or salt for the goods they needed. Money evolved to be represented by coins, many of which were made of a valuable metal such that the coin itself had value. The concept of money evolved to paper currencies, such as the dollar. Originally, those paper dollars were backed by assets, including gold, so that the money was viewed as having value – but it was easier to carry than gold.
Over time, a currency backed by hard assets did not scale well, so it decoupled and became a floating rate of exchange vs. metals and other currencies. The process of exchanging money, like a dollar, evolved from giving a piece of paper which represented an amount of value, to writing a check, and ultimately to digital transfers. These include options like ACH transfers, wire transfers, and use of credit and debit cards to make transactions easier. Now, platforms like PayPal and Venmo are being used by people to exchange money directly. Once banks are involved, there are different forms of exchange – but the commonality is that the transaction is cleared by the bank, which credits and debits the parties involved. If a transaction cannot be completed, the bank declines it – hopefully before the exchange of goods or services is complete.
A cryptocurrency is another form of digital exchange. One key difference, however, is that transaction processing is not done at a bank. Instead, transactions are processed on a ledger called a blockchain that is publicly available to anyone in the world, and the decision of approving or declining a transaction and moving balances between exchange participants is done by a network of computers solving difficult math problems. The processing of those transactions helps ensure the accuracy of the exchange because it costs power to confirm a transaction, and at least 51% of computers validating the transaction must agree. The computers that use energy and time to validate transactions are rewarded with a small amount of that transaction – similar to the way a bank or credit card company keeps a small fee on traditional transactions. So – transactions are processed by a global network of computers on a transparent ledger that facilitates the exchange of the currency for other currencies, goods, or services. That processing is decentralized – meaning there’s no one bank or credit card processor, no one “bank account”, and no set of governmental regulations on the processing of these digital currencies. In addition, participants in the exchange of cryptocurrencies can remain anonymous. Their “wallet” is a highly encrypted address that can send or receive cryptocurrencies over the internet.
https://www.coinbase.com/learn/crypto-basics/what-is-cryptocurrency
How are cryptocurrencies used?
To state the obvious, cryptocurrencies have been used to exchange digital money between people, companies, and likely nations. It has helped to facilitate moving value between traditional currencies under different regulations and exchange rates. It has served as a basis for anonymous transactions (for better or worse). It has also been used as a trading tool, where supply and demand for these digital currencies drives prices higher and lower. The exchange rate of cryptocurrencies to traditional currencies like the dollar has fluctuated wildly at times, with volatility far exceeding what would normally be recognized as a stable store of value or means of exchange for a relatively stable amount of goods or services. That volatility creates some challenges for consideration as a competitor to traditional currencies. But it also creates opportunities for speculative traders and those who see cryptocurrencies as a foundation for the future economy.
There have been broad questions about regulation around cryptocurrencies, the tax impacts of exchange using cryptocurrency, and the long-term prospects around the value of these assets. On that front, it’s important to remember that ownership of a cryptocurrency does not have any intrinsic value. It is not backed by any government, hard assets, guarantees, or insurance. The value of each coin is assigned by what participants are willing to exchange it for, again driven by supply & demand, confidence, and momentum. One of the original cryptocurrencies, Bitcoin, has been used to represent more than $7 trillion of value exchange since 2009.
https://www.coinbase.com/learn/crypto-basics/what-is-bitcoin
Should cryptocurrencies be part of my portfolio?
Maybe? Many cryptocurrencies have appreciated significantly in value, gathering a lot of attention as demand has exceeded supply recently. It is possible that this trend will continue, especially if more nations hold cryptocurrencies and demand continues to escalate. This has been discussed, but the reality remains to be seen as the use of cryptocurrencies muddies the water with traditional currencies and regulations. What could go wrong?
A loss of confidence in the ability to securely store or exchange value. The framework has been very resilient against hacking and decryption – but it wouldn’t take much of an issue to have a dramatic impact on confidence and the balance of supply and demand.
Changes in governmental regulations
Excess volatility could drive casual investors to exacerbate a selloff
The evolution of computing power, including quantum computing, could impact security of the framework.
A high risk of not understanding what you’re investing in, how it works, and what could go wrong (beyond this very basic list)
Complexity of investing. This has recently gotten easier through the issuance of funds that hold cryptocurrency assets. However, fees may be high because the fund helps alleviate the complications involved with direct purchase of currencies.
Again – there is no backing of the value of a cryptocurrency by a government or tangible assets. This contributes to the price volatility when exchanging cryptocurrencies for traditional currencies.
Holding cryptocurrencies, either directly or through a fund, may lead to price appreciation and gains. It could easily lead to losses as well. For some perspective from Schwab, I would encourage you to read https://www.schwab.com/cryptocurrency.
If you want to speculate and try to profit from cryptocurrencies, I’d encourage you to think about how to hold them. The type of account matters for tax purposes as you remember:
After tax (individual, joint, trust) accounts invest using after-tax dollars and each profitable sale of a security may incur a capital gains tax, and distributions may be taxable as well. A sale of a security at a loss can offset other capital gains, or a portion of income tax.
Qualified (IRA) accounts invest using pre-tax dollars. There is no capital gains tax on the sale of a security for a profit – income tax is incurred when assets are distributed from the account.
Roth IRA accounts invest using after-tax dollars and earnings are tax free, provided that distributions meet specific qualifications.
https://www.coinbase.com/learn/crypto-basics/understanding-crypto-taxes
In summary
Cryptocurrencies can be complex to understand, and recent speculation has pushed prices to record highs in some high-profile currencies. It’s possible that prices will continue to go higher, but there is risk involved with buying a rapidly evolving asset in a rapidly evolving economic and regulatory context while at all-time high prices. For investors that want to participate but are not experts in the field, it is more prudent to invest through a Mutual Fund or ETF with a portion of your portfolio that you can afford to lose.
Freestate Advisors will not make qualified recommendations on whether to invest in cryptocurrency nor which type of currency to invest in. We will help you gain access to information or execute your special requests in accounts that you grant us access to.