One topic that comes up with increasing regularity is the question surrounding cryptocurrencies (sometimes called crypto for short). The success stories of “instant millionaires” seem to be all over the financial press. However, what does not seem to make as much news are the individuals who have lost money in cryptocurrency. It is important to understand what cryptocurrency is and is not as well as what the risks are to investors.
So, what is cryptocurrency?
It is a digital or sometimes called a virtual currency that is secured using something called cryptography. Cryptography is a technique to secure data or communications; the process uses encryption which relies on computer algorithms that are supposed to block out third parties to provide privacy more securely. This process is powered by blockchain technology which basically decentralises authority across a network of computers. Blockchain, in theory, is supposed to reduce risk and eliminate processing and transaction fees for users. However, as we saw with the recent Colonial Pipeline ransomware attack, payment was demanded in Bitcoin which was ultimately traceable and recovered by the Department of Justice because the FBI were able to unlock the bitcoin wallet that had received most of the funds[1].
A common question is whether cryptocurrencies will replace government fiat (i.e., money). To assess this, it is important to understand what money is. Money, or “the good” in economic terms, is a recognised medium of exchange for transactional purposes in an economy which must possess certain qualities. For example, money must be highly liquid in order to facilitate transactions, and fungible, meaning the good is uniform in quality. If money is of different qualities, then its value for use may be inconsistent. The next identifying mark of money is that it must be durable, meaning it must be able to retain its usefulness in future exchanges, and be used many times. Next, the good should be portable, or divisible to understand its original use value enough to be carried or transported. It is also important that the authenticity of the good be reliable and easily ascertainable to users in the marketplace. If only one side of a transaction is clear in the value of the good, the transaction will not occur. Finally, money should be stable. In other words, the good must be constant or slightly increasing over time, though not necessarily in relation to other currencies. It should be noted the money that is used today is considered fiat money. Fiat money does not have intrinsic value nor a use value. However, fiat money’s value is derived by the full backing of the governments that issue the currency regardless of politics. Money at one time was pegged to gold and agreed upon by many countries at the Bretton Woods Conference. The peg stayed intact until President Nixon ended the peg in 1971.
Do cryptocurrencies have these qualities?
In my opinion, generally they do not. It is hard to imagine any government adopting cryptocurrency as their fiat currency, at least based on the current crypto characteristics. The volatility in this ‘asset’ currently cannot provide for stability to facilitate buying goods and services in an economy. At last check, there are more than 4,000 cryptocurrencies in existence. Our best guess is that over time there will be a consolidation in this space, particularly if there is a push to legitimize cryptocurrency as a reliable medium of exchange. The number of crypto options currently available will likely cause issues with stable valuations and liquidity of the more thinly traded coins.
Should I ‘invest’ in cryptocurrency?
Crypto is a novel investment with high volatility and limited historic data available. To get an idea of the volatility of cryptocurrency, below, see a chart that is taken of Bitcoin, the most popular crypto, from January to February 2018:
Bitcoin. (January 1 through February 10, 2018). BTC/USD.
Source: https://finance.yahoo.com/quote/BTC-USD/chart?p=BTC-USD
From January 6 to February 6, 2018, Bitcoin fell by almost 65% from its peak. Only those investors with the strongest constitutions could handle this kind of volatility, and I would suspect this chart may not be the last one that looks like this.
If you wish to invest in this type of asset, you should understand it is a speculative investment. Much like gambling in Las Vegas or Macau, if you wish to dabble in crypto, it should be with funds you are willing to lose; otherwise, you may want to stay away.
[1] https://www.reuters.com/business/energy/us-announce-recovery-millions-colonial-pipeline-ransomware-attack-2021-06-07/
