by Rachna Bijlani, CFP®
October 18, 2021
Listening to Pink Floyd’s “Money” while driving my daughter to school this morning got me thinking about the latest intangible asset being touted as the new age digital currency- Crypto. There is no denying that Bitcoin has witnessed unfathomable returns in just a few years, eliciting interest and commentary from industry titans and general public alike. But before you give in to the frenzy and activate your “laser eyes” on Twitter or start trading Bitcoin futures, it is important that you thoroughly analyze the asset and make an informed decision. What are cryptocurrencies, what purpose do they serve in your investment portfolio, how do you determine their intrinsic value and what are the limitations and risks surrounding them? I am no Crypto expert, or even remotely tech-savvy, but being an Investment Advisor, I am sharing my opinion and thoughts on Cryptocurrencies. Conduct due diligence and consult your Financial Advisor before implementing any strategy discussed in this article.
What are Cryptocurrencies?
Cryptocurrencies are digital currencies that allow near real-time transactions between authorized parties on a decentralized, permissionless network without involving financial intermediaries, such as banks. Most cryptocurrencies utilize the distributed ledger technology, which essentially is a database shared among its participants, so that each participant has an identical copy of the database. Cryptography is used to ensure that only authorized participants can access the data. Transactions between participants are recorded in this distributed ledger sequentially in blocks, and these blocks of data are linked to previous blocks with a cryptographically secured “hash”. This hash is a sort of consensus mechanism, which validates the new transactions before inserting them into the chain. Some computers on the network, known as miners, must solve cryptographic problems to validate the transactions on the network and generate the hash. The first miner to generate the correct hash gets paid in crypto, which is how cryptocurrencies are “mined”. Most cryptocurrencies set a limit on the amount of currency that might be issued or mined. Cryptocurrencies are not traditionally issued by monetary authorities or backed by the federal government.
Will cryptocurrencies replace fiat currencies?
The process of mining for crypto is time consuming and it utilizes large amounts of computing power and electricity, making it an expensive process; not to mention the environmental impact of using coal-based electricity which generates significant CO2 emissions. If the goal of cryptocurrency is to eventually replace traditional currency, there has to be a greener and more cost-effective way of generating value. Even if cryptocurrencies are accepted as a medium of exchange by the masses, it’ll be difficult for these currencies to maintain stable value without the backing of central governments. The high price volatility seen in cryptocurrencies is caused by the absence of clear fundamentals and the lack of support from sovereign governments. The proliferation of cryptocurrencies will limit the authority of central banks and federal governments to implement monetary policies or tax earnings, which explains the lack of support. Cryptocurrencies might be accepted to settle some transactions, but you cannot currently set the prices of all goods and services relative to crypto in the broader economy. I do believe that most countries will eventually introduce their own digital currency, but it is hard for me to imagine any specific cryptocurrency, such as Bitcoin ever replace the USD.
Will cryptocurrencies replace gold as a hedge against equity market downturns or inflation?
All investors, be it individuals, corporations, or governments, utilize various financial assets to achieve their financial goals and mitigate risks. Capital appreciation, income generation and hedging against financial uncertainties are the most common reasons for investing in financial assets. Where do cryptocurrencies fall in this spectrum of investment vehicles, and more specifically, what purpose do they serve in your investment portfolio? Can they replace traditional commodities such as gold, serving as a store of value and a hedge against equity market declines and inflation?
Historically, commodities such as gold have exhibited low-to-negative correlation with traditional assets such as currency and stocks. Although the same was believed to be true for cryptocurrencies, in recent times, we’ve seen an increased correlation between equity markets and cryptocurrencies, making us question their hedging ability. Also, commodity prices generally increase during inflationary periods, which makes them a strong hedge against inflation. How is it possible for digital currencies, which are cited as an alternative to traditional mediums of exchange, not loose value with rising inflation? By simple logic, a dollar can be exchanged for fewer goods when the prices of those goods rise. So, how will a currency alternative hold it’s value during such times? Some might argue that the cap on the number of Bitcoins that can be mined make it a rare commodity like gold. We need to remember that even though the supply of bitcoins is limited, not all cryptocurrencies have a set limit. If not bitcoin, then Ether coin! So technically, there’s an unlimited supply of digital currencies to be minted. Currently, the value of cryptocurrencies is merely based on supply and demand and it has no fundamental attributes that can help determine its intrinsic value. Inadequate track record on correlations with traditional assets, limitations in correctly analyzing the risk-return characteristics and intrinsic value, high volatility in cryptocurrencies, lack of support and recognition from federal governments and central banks, and confusion over whether it is a currency alternative or a commodity that you purchase with a fiat currency make me a crypto-skeptic for now.
It’s a bird…It’s a plane…It’s Superman! It’s a currency…It’s a hedge…It’s Crypto! I am impressed and intrigued by the potential of Distributed Ledger Technology and I do feel that we will see expanded application of blockchain in banking, insurance, and financial services in the near future. However, I think that cryptocurrencies such as Bitcoin, Ethereum, Tether, and others, in their current stage, are 100% speculative. I’d probably even hesitate to classify crypto as a financial asset. To me, investing in digital currencies, in their current stage and form, is akin to gambling in Vegas. I’d only play the amount that wouldn’t make me flinch if I lost. I wouldn’t bet my retirement savings or my child’s education fund on it.
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