Cryptocurrencies: What are they, how do you buy them and what are the investment risks?
By Alek Sawchuk, CFA 5 March 2021 9 min read
Cryptocurrencies have quickly become a global phenomenon, creating hype that has led to a speculative investment trend. Due to the complexities of cryptocurrencies, many people have limited knowledge about them, including the use case for the blockchain technology behind each cryptocurrency. Ultimately, this can lead to investors acting on incomplete information without understanding the risks with buying a cryptocurrency.
It’s human nature to start feeling a strong sense of “fear of missing out” when the price of Bitcoin is rising astronomically. While recognizing the benefits of blockchain technology, it poses the question if the price of Bitcoin has separated itself from its underlying technological benefits. To highlight the degree of investment speculation and price volatility consider this: a purported true story of an individual who paid 10,000 Bitcoin back in 2010 for two pizzas ($30 dollars worth of pizza), would today be worth over $400 million dollars! This article strives to expand on blockchain technology benefits while also discussing the risks inherent in cryptocurrency investments. Let’s get started.
What are Cryptocurrencies?
“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”
Satoshi Nakamoto—commonly referred to as the “creator of Bitcoin''
A cryptocurrency is a digital asset that exists mainly on distributed, decentralized networks, that uses blockchain technology. It is considered a form of digital money designed to be secure and, in many cases, anonymous.
Bitcoin is arguably the most known of all cryptocurrencies and currently holds the largest market share. Created in 2008, Bitcoin was the first successful iteration of a cryptocurrency. It was made public in 2009, when it was released as open-source software.
As recent as 2018, there were slightly more than 1,000 different cryptocurrencies. Now, in 2021, there has been exponential growth with over 4,000 in existence. As such, more and more market participants will continue to express interest in cryptocurrencies such as Bitcoin, which markets itself as “digital gold”.
How does cryptocurrency work?
A cryptocurrency’s underlying technology is called blockchain. Blockchain is a publically-shared ledger or database that utilizes cryptography (the art of writing or solving codes) to make the information contained within it secure and extremely difficult or even impossible to alter. Once a transaction is made, it cannot be changed and lives forever on a shared ledger which can be referenced by anyone. This is important because financial transactions currently depend on mutual human trust.
Guaranteed digital security and accuracy due to publicly distributed ledgers can increase the trustworthiness of a crypto transaction and are the primary reasons why blockchain has sparked people’s interest.
Let’s say your friend, Bob, is collecting $25 from the four of you for a joint birthday present for a mutual friend, Jill. There is an implied trust that what is collected will be put towards the joint gift. When the big day arrives, Bob presents Jill with a $75 gift card rather than a $100 one. Without a publicly shared ledger showing who contributed what ($25 each) and the cost of the transaction ($100), it’s your word against Bob’s.
Within blockchain, this form of human trust is irrelevant, since a copy of the ledger is distributed to everyone. The ledger is anonymous and only shows account numbers, and verifying all transactions for any account number is extremely simple for anyone who has access to the public ledger.
Another example is if the bank accepts a cheque for $1,000. The bank puts a hold on those funds until the $1,000 can be verified with the other financial institution to avoid the potential for loss due to insufficient funds in the account. With the use of blockchain, there is no need for the delay because the $1,000 can be verified quickly using the public ledger.
Is Bitcoin the only cryptocurrency?
Another well-recognized cryptocurrency, Ethereum, has the second largest market share value behind Bitcoin at the time of writing. Ethereum was proposed in 2013 by programmer Vitalik Buterin. Subsequent Ethereum development was crowdfunded in 2014, and the network went officially live in July of 2015. In addition to Ethereum, there are thousands of “alternative cryptocurrencies” with varying distinguishing features.
How is Ethereum different from Bitcoin?
Both Bitcoin and Ethereum are decentralized and utilize the aforementioned ledger blockchain technology. Ethereum partially distinguishes itself in its ability to settle “smart contracts''.
For example, if you are looking to purchase a house with your Ethereum holdings, your digital asset will only be received by the seller after satisfying contractual requirements stipulated in your digital “smart contract”. It should be noted that “smart contract” technology is still in its early stages of development and whether or not the technology will be adopted is still to be determined.
Outside of “smart contracts'', Ethereum is already recognized as a programming language; developers use the cryptocurrency on the Ethereum platforms as “gas”. In other words, it powers a platform, and users interested in purchasing platform-offered cryptos must first exchange through Ethereum, for a fee.
Cryptocurrency investing and storage
Investors can gain exposure to cryptocurrency indirectly through a fund traded on stock exchanges. More cryptocurrency funds have been popping up, providing investors publicly traded funds to indirectly own cryptocurrencies. Prior to this, investors “physically” purchased cryptocurrencies utilizing exchanges such as Coinbase or Binance. However, “physical” cryptocurrency exchange purchases expose the investor to potential storage risks. Investors of crypto funds would have far less concerns as the fund itself would mitigate such risks on the investors’ behalf.
Investors looking to purchase cryptocurrencies directly should understand how to safely store physical cryptocurrency. Cryptocurrency theft and hacking have occurred, and will likely persist, as security breaches present opportunities for those to nefariously profit.
Cases have arisen where investors holding cryptocurrencies in cold storage (discussed shortly) have misplaced their passwords, not being able to access funds in excess of $100 million. This differs extremely from a bank where you can contact them to prove your identity and therefore prove your ownership; in the deregulated crypto space, there is no one to do this validation.
When an investor takes a self-directed approach to cryptocurrency investing by utilizing an exchange such as Coinbase, they need to understand the storage risks associated with keeping their “physically” purchased digital currency on the exchange and how to effectively transfer it to a safe cryptocurrency wallet.
A cryptocurrency wallet is a software program that essentially stores your cryptocurrency holdings securely. There are three main types of wallets: hardware (cold storage), software and paper. Hardware wallets are cold storage devices similar to a USB stick that holds the user’s private keys offline, and deemed to be the most secure. Software wallets can be downloaded, are quite user friendly and easy to install. Lastly, web-based online wallets run on cloud servers but are oftentimes criticized for being the most susceptible to hacking since—depending on the wallet, your private key is held by a third-party. Finding the right cryptocurrency wallet is important and the reader is encouraged to perform adequate research in weighing the costs, pros and cons, of wallet types.
Why is Bitcoin not a replacement for gold?
Avid Bitcoin advocates have suggested the cryptocurrency could be a substitute for an investment in gold—quoting astronomical future Bitcoin price predictions, on the basis Bitcoin could slowly replace gold’s market share. In fact, Bitcoin’s marketed online value proposition is labeled as “digital gold”. However, Bitcoin fails to meet conventional investment criteria sought after by investors of physical gold and it’s important to highlight the different characteristics.
Some characteristics of gold include:
- Scarcity of supply.
- Conventionally uncorrelated with broader markets and equities (acting as a recession hedge in times of market crashes and sell-offs).
- Consistently stable volatility over a long period of time (store of value).
Comparatively, Bitcoin only meets two of these criteria. Bitcoin was designed to have a limited supply (scarcity) by the original man-made construction of 21 million coins. Additionally, Bitcoin could arguably be considered its own asset class, which may exhibit returns that contrast the broader market in a recessionary market condition. This did not hold entirely true for the March 2020, COVID-19 crash—but to be fair, gold also behaved unconventionally during this period.
The third point, however, is where Bitcoin and gold diverge. Investors need to recognize just how large price swings can be for cryptocurrencies.
By the end of 2017, Bitcoin traded near USD$20,000, only to fall close to USD$10,000 and oscillate from there, until a rise in 2020 and further 2021 price rally. In early 2021 Tesla CEO Elon Musk sparked a dramatic increase well above USD$40,000 with a purchase of $1.5 billion and sought approval to use Bitcoin as a payment method for Tesla vehicles, eliciting further fervor on what this would mean if other corporations followed suit.
The degree of riskiness of Bitcoin and Ethereum to conventional asset classes can be seen in the chart below. For example, the annual volatility of Bitcoin was three times that of gold during the historical reference period. In other words, Bitcoin has higher annual investment return risk and the investor should recognize how this could impact their long-term financial plan and goals.
260 day comparison of average annualized volatility
(1-5 year history as of Sep 30, 2020)
At the end of the day, it will be up to investors to decide whether or not Bitcoin can replace gold. However, at this point in time, we do not believe Bitcoin is a replacement for gold on the basis of its currently high levels of volatility, which may not be well understood by many investors, and likely exceeds many investors' risk tolerance thresholds. If investors are unsure if cryptocurrency exceeds their risk thresholds, they are recommended to discuss with their financial advisor or wealth expert.
The regulatory and legal risks of cryptocurrencies
Last year, when cryptocurrency Ripple (XRP) faced a lawsuit and SEC charges, a sharp price drop ensued. The lawsuit argued that the digital currency Ripple, “is a security, like a share of stock—which must be registered with the agency—or is instead a currency”. Without getting too deep into the intricacies of how a currency is defined, recognize that investment regulators have bestowed lawsuits against cryptocurrencies, creating ambiguity for future crypto product approvals. This risk should be understood by investors and could adversely impact the price of denied cryptocurrencies and associated investment products.
Another “word of caution” pertains to Anti Money Laundering (AML guidelines). Many cryptocurrencies are founded on the basis of an anonymous transaction. This has been a criticism of Bitcoin, citing it as a way to launder money and hide criminal activities by organized crime groups. It goes without saying that not all of those who are engaged in cryptocurrency investments are criminals, but we wouldn’t be aware if we were transacting with criminals either.
If greater transparency and personal information are required for cryptocurrency transactions, it could put many at risk, upending the foundational “anonymous” transaction. We do not view ourselves as experts on legal and regulatory topics, but this is an area to contemplate and further research when making an informed decision to invest in a given cryptocurrency.
What’s the future of cryptocurrencies?
We can’t overlook the fact cryptocurrencies are changing the way we envision future payments and the ease at which this “peer-to-peer” blockchain technology can streamline seemingly archaic centralized processes. That said, we don’t know if they will all succeed in attaining global adoption. With thousands of cryptos out there, analogous to thousands of companies, many will fail, too.
There is no definitive answer as to whether or not Bitcoin and others will succeed in jumping over these hurdles, but if history is any guide, it could be a long and bumpy road ahead for the broader cryptocurrency market and investors should perform due diligence and seek guidance from financial experts before making an investment decision.
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