November 8, 2017
What is Cryptocurrency and Should You Own Any?
Please read important disclosures HERE.
November 8, 2017
Please read important disclosures HERE.
Sometime in 2008, an anonymous developer going by the name of Satoshi Nakamoto wrote a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” The paper described a form of electronic cash that would allow online payments to be sent anonymously from one person to another without the need for a financial intermediary. The currency would be entirely digital and it would not be controlled by any government or company; rather, it would be entirely monitored by a network of users around the world. Nearly 10 years later, hundreds of different cryptocurrencies have emerged (e.g. Bitcoin, Etherium, Ripple, etc.) that are valued collectively at over $100 billion.
Since inception, Bitcoin (the largest and most recognized cryptocurrency), has risen from nearly $0 per coin to about $6,900 as of November 6, 2017 , with much of the appreciation occurring in the past few years (see chart). This has led many well-known investors, such as Warren Buffet and Mark Cuban, to declare cryptocurrency the next bubble to pop. Meanwhile, early adopters of cryptocurrency have become “digital” millionaires and many others are now jumping into the fray hoping to profit.
Cryptocurrencies, such as Bitcoin, are administered using Blockchain technology. Blockchain is an online ledger or timestamp that utilizes cryptography to record every transaction publicly via an open network of computers. Each transaction is anonymous so no one’s identity is revealed. Each transaction forms a “block” that is followed by another block and so on, creating an interconnected sequence or timeline that cannot be altered. Sending a bitcoin to another person creates a unique timestamp on a public ledger that is available for everyone to see.
Cryptocurrency is a digital asset. Hence, by nature it is intangible. You can hold digital currency in an online “wallet” at an exchange such as Coinbase. Each user has a unique private key, also known as a bitcoin address. Simply put, a key is a unique string of characters. You must know the private key to send bitcoin to someone else. For example, most bitcoin keys are 34 characters long which consist of random digits and uppercase and lowercase letters.
An example of a private key is: 1CC3X2gu58d6wXUW_MfpuzN9JAfTUWu4Kj
This is your most valuable possession and your ticket to be able to spend the digital money. Hence it must be kept secure at all times.
Cryptocurrencies have value because they are considered scarce resources (e.g. like gold, which is in limited supply). For example, total Bitcoin supply is limited to a maximum of 21 million coins. Unlike with fiat currencies, which are backed by the government that issued the currencies and can be manipulated by governments and central banks, cryptocurrencies are theoretically more difficult to manipulate – a key benefit for those who prefer independence from the traditional financial system. As such, bitcoin has become somewhat of a symbol for social change for many early adopters. For these people, bitcoin represents an idealistic version of a better financial system.
One of the original motivations behind the development of Bitcoin and Blockchain was to allow two parties to transact without involving a third party (e.g. banks or other financial institutions) to verify a transaction. This potentially allows for faster and less expensive transactions with lower possibility for fraud. It also provides for anonymous transactions (which has led to cryptocurrency being one of the preferred means for financing illegal activity). Other possible benefits of cryptocurrencies and Blockchain are emerging as well. For instance, some people believe that cryptocurrency could be a better means for facilitating international transactions because it doesn’t require exchanging one currency for another.
While there is a growing list of merchants who accept bitcoin for payment, including Microsoft, Subway and Expedia, cryptocurrency is still largely illiquid. More troubling for enthusiasts is that the SEC has classified cryptocurrency as a security. This means owners must pay capital gains or losses on every cryptocurrency transaction. Using cryptocurrency to buy goods or services is classified as a bartering transaction that needs to be reported on the individual’s tax return. Does this mean that every Subway sandwich or coffee purchased using bitcoins needs to be reported to the IRS? For now, the answer is yes. Some constituencies are looking to create legislation that would omit small transactions so that cryptocurrency gains wider acceptance but governments are seldom eager to adopt new rules to help consumers evade regulation and capture profits without taxation. Crypto enthusiasts will have to maintain good records.
Another major issue with cryptocurrency is security. If your private key is stolen, your currency becomes worthless and can never be regained due to the irreversible nature of these transactions and the lack of government regulation. There are numerous individuals who have reported that their digital currency has been stolen. They thought that they were worth a lot, only to find that their digital wallets were compromised. How to secure cryptocurrency safely is beyond the scope of this article.
In contrast with most stocks, bonds and real estate, cryptocurrencies produce no cash flow – no earnings, no dividends and no interest. In that regard cryptocurrencies are alternatives to the dollar, the euro and the yen. Much as is the case with the price of gold, cryptocurrency price changes are disconnected from underlying economic activity and are instead a function of the subjective preferences of buyers and sellers. And as with all currencies held at a bank or under the mattress or anywhere else, the expected rate of return, adjusted for inflation, is effectively zero.
That doesn’t necessarily make currencies such as Bitcoin poor investments in and of themselves. It just means that they are primarily speculative on a short-term (trading) basis, and more appropriately thought of as stores of value, or even as a kind of insurance for those who intend to remain committed long-term. Just as buyers of insurance are content to absorb modest premium losses each year rather than risk the financial effects of an untimely death, those eager to protect themselves from poor public finance and depreciating fiat currencies may be content to absorb modest cryptocurrency losses over time. Therein lies a big problem, however: whereas the price of gold can seem high or low relative to some other economic statistic, such as the value of all publicly traded stocks, the price of Bitcoin seems almost plucked out of thin air, and able to rise or fall almost without limit. Take a look again at the price chart above. It does not suggest that potential losses are certain to be modest. For those determined to buy some cryptocurrency, we therefore recommend doing it only in small amounts to learn how it works and not to seek substantial profits.
If you want to learn how to buy cryptocurrency, we recommend using an established exchange like Coinbase. Opening an account is fairly easy. You will need to link your credit card or bank account to the Coinbase account. If you buy $10 worth of bitcoins, your bank account will be charged that amount and you will see the equivalent value of digital currency credited to your Coinbase account. The transaction cost is a fairly onerous 4%.
Some speculate that cryptocurrencies are a bubble ready to burst, and there are many so pessimistic as to believe that they are destined to fail entirely. Governments have a way of regulating otherwise uncaptured profits, and speculative booms usually do come to an end. That said, major cryptocurrencies such as Bitcoin and a few others are likely to persist in some fashion even if the ride is spectacularly bumpy; moreover, our sense is that Blockchain technology, which is already leading to major innovations in law, finance and healthcare, among others, is here to stay. How to use the technology to secure purchasing power is still entirely uncertain, however, with a tax, regulatory and even technology environment reminiscent of the wild-wild west.