Cryptocurrency and Bitcoin: A Quick Primer for Curious Investors

 In early April 2018, The Street, a finance and investing website, ran an article headlined, “Why Cryptocurrency Could Be the Next Frontier in Retirement Investing.” A few days later, an article headlined, “The Scary Truth About Bitcoin and How It Could Ruin Your Retirement,” appeared on The Cheat Sheet, a lifestyle website.

With dozens of conflicting headlines like these floating around, it’s little wonder the subject of cryptocurrency — at its most basic, it’s a form of digital currency, of which Bitcoin is one, enabled by a distributed, peer-to-peer technology known as blockchain — is not only piquing the public’s (and the media’s) curiosity, it’s raising a lot of questions and causing considerable confusion about whether it’s worth paying attention to, not just as the latest “shiny object” to hit financial markets, but as a viable investment option for the masses.

“When people start hearing about investors earning these huge returns [on cryptocurrency investments], they’re going to ask questions about it and they’re going to wonder if they should be getting involved,” says FPA member Amy Hubble, CFA, CFP^®, principal at Radix Financial in Oklahoma City, OK.

For early adopters who already are involved in the fledgling cryptocurrency market, extreme volatility comes with the territory. Along with huge gains in the value of a Bitcoin — from less than $1,000 at the start of 2017 to more than $19,000 at one point in December 2017 — there have been drops of 30 percent in a single day.

If you’re one of the many people who have heard about cryptocurrency and Bitcoin but aren’t clear what they are, how they work and whether they’re worth your time and money, read on for answers to some of the common questions financial professionals are fielding about a concept that appears poised for a breakthrough into the investing mainstream.

1. What is cryptocurrency? Cryptocurrency is a digital-only currency that is bought, sold and traded in a decentralized, peer-to-peer marketplace or exchange that no single entity controls or regulates. Cryptocurrencies have no government backing, nor do they have a physical representation (bills or coins).

First introduced as “Bitcoin” in a 2008 white paper by an anonymous computer hacker writing under the pseudonym Satoshi Nakamoto, digital currencies trade within a secure public database called a blockchain. Each unit of cryptocurrency carries a store of value that fluctuates according to supply of, and demand for, that specific cryptocurrency. These units are bought and sold in the peer-to-peer marketplace. By purchasing a unit of a certain cryptocurrency, a person essentially takes the position that there will be a liquid market for that unit of cryptocurrency in the future — that they eventually will be able to sell that unit to a purchaser.

The blockchain includes cryptographic data records of all user balances associated with a specific cryptocurrency, along with a complete, time-stamped history of all transactions included in each “block” in the blockchain. “The best way I can think of to explain this is to imagine there is one single shared spreadsheet on a cloud drive where everyone in the world has editing privileges,” Hubble writes in a recent blog post about cryptocurrency.  “Blocks made up of hundreds of transactions are reconciled and irreversibly published on the public…blockchain continuously.”

While all transactions are publicly viewable by those who have access to the blockchain, the participants in these transactions remain anonymous. Executing and verifying the transactions, and the data attached to them, requires massive computing power. That power is supplied by computers linked to a particular cryptocurrency. These high-powered computers are known as “miners.”

While Bitcoin, the first cryptocurrency, is still the movement’s standard-bearer, today there are more than 1,500 cryptocurrencies, according to COBINHOOD, a cryptocurrency trading platform. They go by names like Ethereum, Litecoin, Monero, Dash and Ripple.

1. How is cryptocurrency used? Also known as protocol tokens, cryptocurrencies are bought and sold by people connected to the blockchain network of a particular cryptocurrency. They can be used to purchase digital assets or services within that network. “Many protocol utility tokens, such as Ethereum, can be used to trade for digital assets, storage, or work from other network participants; be held and speculatively traded as a store of monetary value; and perhaps will soon be used within a new technology platform owned and capitalized by a ‘real’ investable technology company,” Hubble explains in her blog post.

Ultimately, however, most of today’s investments in cryptocurrency tend to be speculative, where the goal is to make money, she writes. “These are assets generally purchased primarily because you believe there is an opportunity within the current or future market to resell them at a higher price and make a profit.”

1. Why the buzz around cryptocurrency? Besides a general cultural obsession with the next big tech “shiny object,” like the latest iteration of a particular brand of smart phone, people also tend to be drawn to disruptive concepts that have a potential to improve their lives. Cryptocurrency and blockchain certainly fit that description. The idea of a secure, verifiable, readily available and exchangeable, wholly digital and borderless form of currency appeals to many. And the many reports of people reaping huge gains from their cryptocurrency investments certainly have grabbed the public’s attention.
2. Is there a legitimate market for cryptocurrencies? The market for cryptocurrencies is growing fast, driven largely by speculative traders. The overall cryptocurrency market cap— a measure of the value of all circulating cryptocurrencies — fluctuates widely. It stood at about $250 billion in April 2018, down substantially from a high of $820 billion in January of this year, according to Coinmarketcap. That’s still just a fraction of the $30 trillion that the U.S. stock market is estimated to be worth, according to a recent estimate by the Bespoke Investment Group.
3. Are cryptocurrencies worth your attention? Cryptocurrencies hold the potential to emerge as a secure, efficient way for consumers to pay for goods and services. What’s more, they may emerge as another tool investors can use to diversify their investment portfolios with an asset that behaves in a non-correlated way relative to the stock market and other asset classes, notes Adam Nickels, a junior portfolio analyst with Capital Advisors Ltd. in Shaker Heights, OH.

For these reasons, says Hubble, anyone who wants to maximize the value of their assets should keep cryptocurrency on their radar. “I don’t fully understand it all, but what I do understand makes me believe that sticking your head in the sand and ignoring this revolutionary technology is a mistake, if not downright foolish.”

1. Is there a place in a mainstream investor’s portfolio for cryptocurrencies? For the bulk of investors, Hubble suggests a wait-and-see approach: “Unless you have a use for them, or the technical knowledge to know when the demand will be high and when the demand will be low, it’s best to avoid [cryptocurrencies] as an investment for now,” she writes in her blog post. “Much of successful trading is the ability to identify opportunities for value in inefficient or illiquid markets…The ability to identify value and then exploit it by finding a willing buyer is the key to being profitable.” In a still maturing market such as this, it’s difficult to identify those opportunities with any accuracy or consistency, she says.

That’s not to suggest that cryptocurrencies are only for speculators and should be dismissed by mainstream investors altogether. They may hold appeal to people seeking non-correlated assets with which to diversify their investment portfolio, says Nickels. “When assessed within the context of an asset allocation portfolio, crypto-assets may prove beneficial to investors on a risk-adjusted basis…A small allocation to crypto-assets in a portfolio could provide an opportunity to [mitigate the volatility of a portfolio] through decreased overall risk and potentially outsized returns.”

1. Why should people be wary? “Risks to investing in crypto-assets are present everywhere and must be taken into consideration,” cautions Nickels. Those risks include illiquidity, a lack of market oversight/regulation, the potential for market manipulation, theft and fraud.
2. Where’s this heading? What does the future hold for cryptocurrencies? “I still think the future is bright for blockchain protocol technology and digital money,” Hubble writes in her blog post. “Even though it’s currently overly technical, inefficient, and expensive to provide the cryptographic computing power necessary to secure the database, it will get better. Like any new innovation, many players are now entering the market, and there seems to be a new ICO (initial coin offering) to raise capital almost every day. Only time will tell whether Bitcoin or another dominant player will emerge the victor, or whether government intervention will eventually redesign its delivery.”