A former institutional investor breaks down what cryptocurrencies are and how to frame the pros and cons of an investment in various cryptocurrencies, all in under 10 minutes.
The attention cryptocurrencies are getting in the media – especially Bitcoin – is astronomical. It’s not hard to understand why. The price of a Bitcoin was $300 at the beginning of 2015. The price of a Bitcoin today is close to $14,500. Wouldn’t it have been great to have bought a couple hundred of these puppies two years ago and sail away to a life of largesse on your private island just two years later? There’s even a story that went viral of one of the first Bitcoin transactions seven years ago, when a gentleman paid 10,000 Bitcoins for two Papa John’s pizzas, a sum that would now be worth $145 million (the articles you’ll see show a smaller figure because Bitcoin’s price has jumped significantly in the last few months).
Because of this, I’ve received many emails from readers asking for more information on investing in cryptocurrencies. I’ve honestly dragged my feet about this because I have had the cryptocurrency discussion over a dozen times both back when I was investor evaluating investments in blockchain technology/cryptocurrency and with friends in real life. After getting half a dozen emails about Bitcoin in the same week, though, it’s clear there’s a real interest in exploring the subject, and perhaps the research I’ve done on the topic would be helpful to publish so that others can come to their own decision.
So here we go. Here’s everything you need to know about cryptocurrencies, from the ground up.
Uh, What is A Cryptocurrency Really?
Cryptocurrencies are not the most straightforward thing to understand, especially when all the news articles start with flashy headliners like “Bitcoin to $20,000!”
A cryptocurrency is a form of currency, just like the US Dollar or the Euro. It happens to be digital/virtual in form. The first and most well-known of these cryptocurrencies is Bitcoin. It makes up about 47% of the entire crypto universe in value, probably more given how quickly it’s price is rising. The next largest cryptocurrencies – in order of size – are Ethereum, Litecoin, Ripple, and Dash.
Source: Visual Capitalist
Major Attributes of Cryptocurrencies
Cryptocurrencies’ claim to fame has to do with the fact that they allow for a decentralized money exchange system. With any currency, the biggest issue is making sure that no unit of money is spent more than once. If you had exactly one dollar in your bank account, and you gave it to Sally in exchange for a pizza, you can’t spend that same dollar with Joe for a donut. In order to prevent something like this from happening, you need someone to record and maintain a true list of transactions so you can keep track of where each individual dollar is sitting and by whom it is owned.
So who does this? Currently for every major currency it is a system of banks acting as clearinghouses, whose records all roll up together. This is to say that these currencies require a centralized system for keeping track of who owns what.
What you should know about cryptocurrencies is that it sidesteps the need for centralization by taking a record of every transaction ever made with the cryptocurrency – say, Bitcoin – and duplicating this entire set of transaction records across thousands of machines. It sends this set of records to every peer machine in its network, and in doing so it allows you to cut out the role of a centralizing third party who holds all these authoritative records.This immutable record of transactions, by the way, is called the blockchain.
There are all sorts of security measures in place to prevent bad actors and fraud in the system, and you can read more about them here if you’re interested.
If you think about how every major currency works in the world, you will see that there needs to be a centralized party who records all the transactions.
What’s So Good About Decentralized Currency?
You may be asking yourself what the point of decentralized currency is. Here are the major consequences of a decentralized system:
- It’s Cheaper – A central authority is expensive; they charge high processing fees for being the record-keeper.
- No Single Point of Failure – Because copies of the blockchain are replicated in thousands of places, it is arguably difficult to forge a transaction because there is no single point of failure.
- It’s (Relatively) Anonymous – While the blockchain records the ID of both parties of a transaction, it does so with anonymous, unique IDs. You can see why this might be popular for moving illegal goods around, and indeed criminals have embraced cryptocurrencies. Anonymity has less pernicious uses though.
- Fast Transactions/Available to Anyone – Because there is no central authority, anyone can access the currency, and transactions happen quickly because there is no third central third party. Ever tried to send US dollars to a friend in Thailand? How long did that take? How many hoops did you have to jump through? Yeah, that.
So Are Cryptocurrencies A Good Investment?
Here we reach the whole point of the article. I know this is what is on most readers’ minds. The short answer is that for most people, no, cryptocurrencies are not a good investment. We’ll frame the investment set-up of what you have to believe/understand to want to invest and why, so you can see for yourself.
Currency vs Stocks/Real Estate/Commodities/Other Stuff
It is absolutely critical that you recognize that an investment in a cryptocurrency like Bitcoin or Ethereum is an investment in a currency, not a company’s stock or any other investment asset class you may have more experience with.
When your friend tells you about how they’ve made 50% on Apple stock this year, realize they have bought a sliver of ownership in a company, a company which creates some sort of product and sells them to an end purchaser, pocketing the difference between the price it charged and the costs it took to make the product. You and I can argue about the prospects of the Apple’s sales next year, how efficient their supply chain is to cut costs, and a whole other host of facts to determine ultimately how much profit the company will generate and as such how much a sliver of ownership of that stream of profits will be in the future.
Similarly, if you are buying real estate or a commodity like oil or steel, you own something that a future purchaser might want to buy from you at a later date for more than you paid. You’ve got a whole bunch of factors you can research to determine whether demand for the product will go up in the future (for example, world use of steel has been increasing at X% year on year while there is a reported shortage of steel production, suggesting prices will skyrocket in two years as all the stockpiles dwindle).
So back to currency. Certainly currency pricing is also determined by supply and demand. It appreciates or depreciates against a wall of other currencies for which it can be exchanged, and it appreciates or depreciates at different rates against all those currencies depending on how much demand there is from folks holding US dollars for Bitcoin vs demand from folks holding Euros for Bitcoin. But what determines demand for a currency? What determines supply for a currency?
Generally if there is high demand and low supply of a currency the price will appreciate, in which case you would make lots of of money ‘investing’ in the currency by exchanging your current US Dollars for the other currency. And if there is low demand and high supply, the currency will depreciate against other currencies and you would have done better to stay in a different currency. If you’re planning to invest in a cryptocurrency, you would need to have a perspective on the direction of supply and demand.
Let’s be blunt here: what do you or I really know about the governing forces of currency? And the people around the water cooler who tell you they just bought $30k of Bitcoin, what do they know about it?
I studied economics at Harvard, butt in seat at 9am to learn about how free-floating currencies interact with one another, how depreciation in a currency leads to higher net exports, then corrects as there’s more demand to sign contracts denominated in that currency. I feel about as confident in my currency predicting abilities as you would feel about a monkey piloting your next international flight. There’s just so much there to incorporate.
Forces That Affect Currency Supply and Demand
What are some forces that affect currency supply and demand?
There’s the fact that the interest affects demand for a currency – if you’re sitting in the UK where the interest rate being offered for loaning out your money is 3% but in the US it’s 5%, you’d probably consider converting your money into dollars so you can get a better interest on your investments.
There’s also inflation. If there is high inflation of a currency, you are less likely to want to get into the currency. High inflation means a dollar in a year buys a lot less equivalent stuff than a dollar today. So even if a country has a high interest rate, if it also has a high inflation rate, you’ll find the option unattractive. Even if you never plan to spend in Brazilian reals yourself, the inflation causes the cost of goods production to increase relative to the global economy, generally causing the currency to depreciate. So by the time you want to convert your Brazilian reals back into your home currency, you are doing it at a lower exchange rate.
Finally, there’s also supply of the currency. With the currencies you probably know best, a central government controls the printing and thus overall supply of currency. They’re constantly monitoring inflation, interest rates, etc. for controlled measured movements. No one does that with cryptocurrencies. With Bitcoin for example, when a miner – whose job it is to verify a transaction as legitimate to then be added to the blockchain record – does its job, it is rewarded with a fraction of a Bitcoin for its effort. In this way, more Bitcoins are produced. Bitcoin supply thus increases with the velocity of Bitcoin transactions happening. The more transactions, the more records that need to be verified and the more slivers of Bitcoin that are created every day to increase the supply. The creator of Bitcoin did place a cap on the total number of Bitcoins ever allowed to be created – 21 million. As of August 2017, it appeared 80% of that amount had been mined.
These are only three of hundreds of factors that go into driving currency exchange rates.
Why People Buy Bitcoin and Cryptocurrencies Today
My sense of why most people buy Bitcoin today boils down to the following: “It’s going up and I think I can make money selling to some other guy who will pay me more for it.” In short, it’s the buy high and sell higher strategy.
But who is the end holder of that Bitcoin? Is there a sustained demand/uses for transactions denominated specifically in Bitcoin (driving continued demand and appreciation of the currency) as opposed to other currencies? If you want to get US-level interest rates, you have to buy US Dollars so you can buy treasury notes issued by the US government. If you want to work with a Chinese export company, you are probably going to have to convert your cash to renminbi or one of several widely accepted global currencies like the US Dollar, chosen for stability. What transactions will consistently be done with Bitcoin, creating steady demand for exchanging cash into that currency?
Marginal Pricing: A Note on Bitcoin’s Skyrocketing Price
One interesting thing to take note of is that Bitcoin has a fairly low daily trade volume. While $5 billion of Bitcoins is reported to be traded each day, the way that figure is calculated is to take the last cleared trading price between Bitcoin and the US Dollar, and multiple that by the number of units traded. At an $14,500 exchange rate, that means only about 344k Bitcoins are changing hands every day. When there is low trading volume, it’s easy for pricing to be extremely volatile, because the actions of just a few folks set the price for the market. You can understand this better by looking at stocks. Every stock you see on a publicly traded marketplace is cleared by matching buyers and sellers. An exchange will create an order book, taking all the orders to buy a share of Apple and what they’re willing to pay for it, and then comparing it against a list of all the parties wanting to sell a share of Apple and what they’re willing to share it for. They sort the list by price and clear all the matches where there is overlap. Cool.
When you think about how price is set for Bitcoins against the US Dollar, there’s far less volume and far less order to the market because the transactions happen across many small brokers rather than a few major exchanges like the NYSE or NASDAQ where the bulk of supply and demand can go to meet one another. Imagine an example of just one buyer of Bitcoin showing up each day. If it’s crazy Uncle Harry and he offers $25,000 to buy a fraction of a Bitcoin, he’ll find a seller and every newspaper will report that ‘Bitcoin has gone to $25k!’ Larger daily trading volume leads to more stable pricing. So one caution in observing the historical pricing data on Bitcoin is that the volume traded which is setting the pricing each day is still very low. That’s why Bitcoin can go down by 10% in a single day. Compare the last month’s bitcoin exchange rate into the US Dollar against that of Euros into the US Dollar. The biggest one-day move in the Bitcoin exchange rate is 10%, while the biggest one-day move in the Euro’s exchange rate was less than 0.4%. Because so few buyers and sellers show up at the table to make trades each day in Bitcoin, the clearing price changes significantly based on who shows up at the table that day. When there’s a lot of volume, the fact that Crazy Uncle Harry showed up with a record-setting price gets blended out quickly amongst the multitude of other transactions who influence price movement with their transactions as well.
Have a look at the charts below – you want to be looking at the y-axis labels, where one is moving by pennies and the other is moving by hundreds of dollars.
Bitcoin Price Chart vs Dollar
Dollar Price Chart vs Euro
Your Appetite For This Kind of Investment
So why did I say at the beginning of this section that cryptocurrencies are not a good investment for most people? I say this because when you look at the factors above, I believe most people would say they do not want to develop an expertise and perspective on currency as an asset class. And I don’t blame them. I don’t either.
If you’re not interested in the fundamental analysis above to develop a view on the investment, that leaves one other real reason people might want to invest in cryptocurrencies. They want to be part of the ‘buy high and sell higher’ club. The answer to what makes them think their investment will do well maybe just be some version of “I don’t know, it’s gone up very quickly the last two years and so I think it will at least take a little while to slow down.”
If that’s of interest to you, it’s perfectly fine to make an investment in Bitcoin or another cryptocurrency. But it’s important to be realistic about your investment thesis being ‘I don’t know, it’s being going up quickly so I hope it continues to go up quickly.’ If you see your thesis clearly for what it is, you will see that your risk is that you don’t know exactly when the top or bottom will be. If you can evaluate that with clear eyes and tell yourself that you are willing to take that exposure, then investing in cryptocurrency may be a legitimate avenue for you.
For me, it’s an absolute no. This is not to say Bitcoin and others won’t continue to go to the moon. There’s a very important distinction between what makes a good investment decision as a steward of my money and what the outcome of a particular investments turns out to be (even if it ends up being a home run). As a steward of money, I realize that I will miss plenty of opportunities where I might have made 3x, 5x, 10x my money. We all have to be okay with that, because the challenge of money management is that you don’t have perfect information on the outcome when making a decision. My personal approach to investing is that I need to devise a system where the combination of my strategies makes me right at least 60% of the time and thus yields my X% target over the 30, 40, 50+ years I need.
What are your thoughts on cryptocurrencies? Do you have friends and family that have invested?
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