Bitcoin, Ethereum, & Dogecoin - Making Sense of Cryptocurrency
by Lance Gunkel CFP® CFA Managing Director |
October 21, 2021
Is cryptocurrency a good investment? The world of cryptocurrency can seem complicated, so let’s disentangle it.
What is cryptocurrency? In simple terms according to trade-leader.com, cryptocurrency is a type of digital or virtual money. It serves as ordinary money, such as dollars, pounds, euros, yen, etc. However, it has no physical counterparts — banknotes or coins that can be carried around, that is, cryptocurrency exists only in electronic form.
A cryptocurrency (also called crypto) is simply a digital or virtual currency in which a decentralized network is used as a ledger for transactions. As a result,
No central bank controls the supply of the currency (rather, most cryptocurrencies are “mined” by solving complicated math problems and verifying transactions on the ledger)
It eliminates counterfeiting and double spending
It allows for (some) anonymity
Many people interchange crypto and Bitcoin, but in fact many cryptocurrencies exist. Bitcoin may be the leader, but others include Ethereum, Litecoin, Stellar, and Dogecoin. For a full list of cryptocurrencies, click here.
An investor can exchange crypto with anyone online using their phone or computer, and do not need to use an intermediary like a bank. Obtaining crypto can be done through the purchase from an exchange or by mining that cryptocurrency. Once an investor owns crypto, they hold it in a digital wallet, which can be online, on their computer, or on an external hard drive.
According to trade-leader.com, a blockchain is a decentralized database consisting of a blockchain in which all transactions of network members are stored. In simple terms, the blockchain is a combination of computers connected to each other, and not to the central server.
Crypto relies heavily upon blockchain technology because it eliminates the potential for double-spending digital assets. Once a transaction occurs on the blockchain, it is viewable to everyone and cannot be erased. The blockchain is not run by any central operators (which many cite as an advantage), so the system relies upon miners. The miners are high-powered computers competing to solve complicated mathematical problems that verify transactions on the blockchain. This method keeps the cryptosystem running smoothly.
Privacy & Security
Much has been made of the anonymity inherent in crypto, but this is only partially correct. It is true that when looking at the blockchain ledger, we are unable to easily see who owns which crypto. However, it is possible to track transactions through time.
In early 2021, the company Colonial Pipeline was hacked and paid a ransom of 75 bitcoin, then valued at $4.4 million. However, the FBI tracked this bitcoin as it went through numerous transactions and identified the wallet in which it was held. The FBI ultimately recovered 63.7 bitcoin from the hackers.
Security is another important consideration. Cryptocurrency, like cash, is only as secure as the method the person uses to hold it. There is a myriad of stories of individuals holding crypto in a digital wallet that gets hacked and crypto is then stolen. Many have also forgotten their digital wallet passwords, rendering them unable to access their cryptocurrency.
For example, Stefan Thomas, a German-born programmer, may lose $220 billion if he can’t remember his password. His forgotten password is required to unlock the 7,002 bitcoins stored in a secure hard drive. Having tried eight passwords so far, he only has two attempts left. As of June 2021, the password has not been recovered. Read the full story and learn how he feels about it.
Crypto is essentially digital cash, which is not a new concept – think of payments made by credit card, Venmo, and PayPal. Those payment services are tied to “fiat” currencies such as the US dollar that are managed by central banks (such as the Federal Reserve). Cryptocurrencies are managed by technology – and specifically cryptology.
The value of a crypto depends upon the:
Quality of the underlying cryptology.
Number of crypto units created.
Technology that limits the future amount of crypto created.
Widespread acceptance and use.
Any item that is traded – baseball cards, art – has a value reliant upon supply and demand. The fewer units available, the higher the price.
Rising Popularity of Bitcoin and Crypto
Bitcoin was created based on a 2008 white paper written by an anonymous author or group of authors going by the name of Satoshi Nakamoto. Bitcoin gained enthusiasts based on the strength of the underlying technology and perceived lack of government control.
The initial buyers of Bitcoin believed in the coin as the future of currency. As of late, however, traders entered the Bitcoin market, viewing it as just another volatile asset to trade like that of stocks and bonds. The rising volatility led to news stories of crypto winners and losers, which led to greater acceptance and awareness.
Buying or Investing in Crypto
An individual can buy Bitcoin or numerous other cryptocurrencies through a crypto exchange where buyers and sellers meet to exchange dollars for coins. There are many exchanges, but diligence is needed to find an exchange with high security and low fees. Popular exchanges include Coinbase and Gemini, which have a built-in digital wallet to store and transfer the crypto.
There are other methods of purchase that do not include a digital wallet, such as Robinhood, PayPal, and Venmo. An investor can buy and hold crypto using these platforms but they are unable to move their coins to another platform. An individual can only buy and sell the coins on these types of platforms.
Crypto as Payment and Global Currency
It is unlikely that crypto will become the global currency any time soon. A viable currency typically requires that:
It can be used cheaply and reliably to buy goods or services;
It can be a unit of account;
It can be used as a store of value and legal tender honored as a means of payment.
Crypto currently has high transaction fees and is extremely volatile, making it difficult to serve as a store of value and a reliable form of payment. One reason for the dramatic volatility is that 95% of all Bitcoin is held by just 2% of all account holders. This means that a very limited number of Bitcoin is actively traded, which thus creates a volatile market.
Also, crypto currently lacks broad acceptance. It is difficult to convert your crypto into physical cash or goods. Some businesses accept crypto as a form of payment, but it is a small amount of all business conducted. There are crypto ATMs in some major cities but remain inaccessible to most. Crypto still has far to go to emerge as a true form of payment. It is not widely accepted if a person owns a lesser crypto who may be stuck without the ability to use it as a form of payment.
Additionally, broader acceptance is likely to generate greater scrutiny from regulators.
Crypto as an Investment
The idea of investing in a cryptocurrency feels like buying a lottery ticket. There is extreme price volatility in cryptocurrencies, which is another factor that makes it difficult to use as a form of payment: will that pizza you buy today for $20 of Bitcoin end up costing you $100,000 in three years?
Due to the popularity of crypto, there are many coins coming to market, each with nuances. However, this crypto gold rush has brought on many scams. A person is able to search Google for crypto scams and spend all day reading stories of investors losing money on a fake cryptocurrency.
Crypto has much potential in forming a part of our currency system. However, it’s difficult to see which currency will be the emergent winner. It may be one of today’s leading cryptocurrencies, such as Bitcoin or Ethereum. However, a tech company (such as Facebook) and financial institutions (such as JP Morgan) are also trying to develop their own digital coins.
In the existing environment there are too many unknowns, volatility, and risk in the crypto market for it to serve a large role in an investment portfolio. However, an individual with a strong view towards certain cryptocurrencies may want to hold a small amount in a secure, trusted digital wallet.
The SEC has taken a very skeptical view of crypto as a form of investment and has rejected numerous attempts to bring a crypto-based Exchange Traded Fund to market. As a result, the primary way to invest in crypto is through the purchase of a specific coin as detailed earlier.
Another potential investment is in blockchain technology. Beyond serving as the backbone for cryptocurrency, blockchain may be used in many exciting ways, including:
Secure sharing of medical data
Anti-money laundering tracking system
Supply and logistics monitoring
Many companies are incorporating the blockchain into their operations, and there are now ETFs and fund managers investing in companies that draw upon blockchain technology.
Please consult with your financial advisor for more information on cryptocurrency and whether it is worthy of consideration for your portfolio. If you need a financial planner to guide you with your financial planning and/or investments, please contact Syverson Strege at 515-225-6000 for a complimentary, no-obligation, private consultation.