Bitcoin, the most widely followed cryptocurrency, had a winning year with a year-to-date return surpassing 1,590 percent! But can those great numbers be sustained? And is the value of cryptocurrencies, in general, headed in a positive direction? Here’s a look at the basic facts.
Is It Viable?
You could spend several days trying to understand the technology and process behind cryptocurrencies such as Bitcoin. Cryptocurrency is a virtual or digital currency. You can’t carry it around in your wallet. It isn’t issued by a central bank or government. And instead of a bank vault, it uses cryptography for security. So is cryptocurrency a viable currency?
To be sustainable a currency must pass two tests. First, you shouldn’t be able to "double spend" it. Once you use the virtual $20 bill to pay for a purchase, it goes into someone else’s virtual wallet. You no longer have access to it and the transaction cannot be undone. There’s no way you can “double spend” with cryptocurrency.
Second, to be viable, the currency must be viewed as safe, liquid and secure. For someone to willingly accept your cryptocurrency he or she has to believe it won’t vanish overnight and its value won’t drop significantly.
Cryptocurrencies passed the first test by using math (algorithms) to ensure transactions can’t be "double spent." However it’s debatable whether cryptocurrencies passed the second test. Why? In any given day their value can swing back and forth – a lot! Given that, it seems unlikely that merchants will get excited about accepting it right now.
What’s it Worth?
Cryptocurrency advocates and investors may get angry when I say this: There’s no way to realistically value any of the cryptocurrencies. This doesn’t mean they aren’t valuable, but there are no assets, income streams or taxing authority backing them. And that can be problematic.
But what about Bitcoin’s year-to-date return of more than 1,590 percent? Bitcoin has gone up in value this year because more people want it and supply is limited. But you must understand that Bitcoin didn’t increase in value through anything it did. Its value increased based purely on increased demand for it. But people are fickle, and Bitcoin is vulnerable to falling out of favor as quickly as it reached its "in" status. That leads us to the next question…
What Are The Risks?
The biggest risk seems to be the proliferation of cryptocurrencies hitting the markets. CNBC.com reports more than 1,300 cryptocurrencies exist now, and the top five have amassed more than $400 billion of outstanding cash. Combined, the top five cryptocurrencies are now worth more than JPMorgan, the largest bank in the United States!
One of the positive features of a cryptocurrency is its finite supply. Owners don’t have to worry about their Bitcoins becoming less valuable because more are being made and flooding the market. However, nothing is stopping others from creating their own limited supply of cryptocurrencies. That makes the supply of cryptocurrencies, as a whole, limitless.
Cryptocurrencies were created, in part, to avoid a centralized government from controlling the supply of a currency. This means no one entity can manipulate or regulate them. However this also creates a void of natural demand. For instance, if you live in the United States you have to use U.S. dollars for many transactions such as paying taxes, etc., ensuring there will always be demand for dollars. This isn’t true for cryptocurrencies. Users could lose interest in a particular cryptocurrency for a number of reasons such as lack of trust or difficulty using it, when that happens, they have no reason to continue using the cryptocurrency. Demand will drop since there are no “natural buyers” being forced to use it.
Investor beware: owning a cryptocurrency isn’t like owning a technology stock. With a technology stock, if the company fails you own the patents, software and other assets. With Bitcoin and other cryptocurrencies, you don’t own a piece of the technologies behind the scenes. So when you hear people talk about the technology behind these cryptocurrencies being the future, it is important to note that a cryptocurrency owner has no ownership of that technology.
If this article sounds negative, it wasn’t meant to be. But, with all the focus on Bitcoin, it’s important that you understand there are risks with any investment – even one that’s up more than 1,500 percent this year! If you’re interested in cryptocurrencies it’s best to think of them as a highly speculative investment rather than a currency. Invest with the understanding that you could lose it all.
Ryan Collier is the Director of Investment Management with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Ryan.