JOHANNESBURG - With the boom in cryptocurrency values, investors are clamouring to make returns like those experienced by early adopters. As an example, Ethereum ballooned by 5,000% at one point this year.
However, cryptocurrency investing can be confusing. For starters, the term 'cryptocurrency' is misleading as it's not a single currency. There are currently over 900 digital currencies available, including Bitcoin and Ethereum, and 'altcoins' such as Litecoin, Peercoin, Primecoin, Dash, Monero, Ripple and Quark.
It is also questionable whether cryptocurrency can still be considered 'currency'. While technically a transaction medium, the nature of the blockchain – the underlying technology that records chronologically and publicly all cryptocurrency transactions – means their applications have evolved.
The blockchain is also inherently slow, making it a less-than-ideal platform for large volumes of immediate transactions – a fundamental attribute of currency. While the introduction of cryptocurrency bank transfers and credit cards offer a workaround, limitations still exist. As such, cryptocurrencies function more as transaction enablers than a currency or medium of exchange.
Putting aside the classification semantics, investors are trading cryptocurrencies on a growing number of dedicated exchanges such as Kraken, GDAX and Gemini, as they would conventional currencies.
Currency trading and scarcity
Currency trading is inherently volatile as they are influenced by external factors (politics, government policy, inflation, and the balance of global trade, to name a few). Such factors make investing highly speculative, and cryptocurrencies are no different – exemplified by the large fluctuations in values over recent months. This volatility has largely been driven by the artificial demand created when investors piled into cryptocurrencies, creating the potential for a 'bubble'. But, if investors are willing to speculate, they can make returns.
Scarcity was also a factor driving up value… at least initially. Due to the nature of the blockchain, cryptocurrencies have a finite number, which limited supply. This effect was similar to the value that conventional currencies held when linked to the gold standard. However, once abolished, central banks printed more money, which devalued currencies and drove up inflation.
Now, with so many cryptocurrencies on offer, this scarcity has been eroded, which will drive further devaluations.
Increased complexity
Adding a further layer of complexity to this market dynamic has been the introduction of tokens. Used predominantly as a fundraising method through initial coin offerings (ICOs), blockchain startups or projects distribute these units of cryptocurrencies to fund expansion or development.
Another concern pertains to growing calls from governments around the world to regulate cryptocurrencies. This in an effort to limit their use in elicit acts and money laundering, and also bring them into formal taxation frameworks. The consequence is some degree of uncertainty, particularly as the potential exists for cryptocurrency trading to be declared illegal in certain countries.
From an institutional investor perspective, it is therefore too early to include cryptocurrencies as a dominant asset class in a portfolio. That is because the fundamental elements necessary for value investing, such as the ability to conduct due diligence on listed companies before investing in equities, are currently lacking.
Valid options
That's not to say cryptocurrencies cannot serve a purpose in the financial services sector, however. For instance, the blockchain offers the ability to transact in a transparent, non-reversible manner, and cryptocurrencies utilise this underlying tech to store value. This makes applications like transparent legal document processing, exchanges, or its use as a ledger, all valid options. Certain cryptocurrencies are also well-suited to applications such as ensuring privacy in smart contracting and payment scaling.
The industry has not yet settled on where cryptocurrencies fit in. Until there is wider market acceptance and use, real-world applications will remain limited, resulting in muted adoption. This may change as the millennial and digital natives of Generation Z become more financially active. For the immediate and mid-term, however, the chance remains low that a cryptocurrency will dethrone sovereign currencies or replace the dollar as the standardised global currency.
Should this point be reached, cryptocurrencies may face other challenges. For instance, if a digital currency becomes the global currency of choice, a case of 'too big to fail' may develop. The risk of hacking also remains high, making accumulated cryptocurrency wealth prone to theft. While security is improving, there also exists a risk that the development of quantum computing could break the blockchain and lead to a global collapse.
Accordingly, the future of cryptocurrencies would most likely be one where it is kept outside of government hands, and offer a valid hedge against risk. It does require greater stability and refinement, and the entire ecosystem must be simplified if it is to become a pervasive transaction medium.
Currently, most people do not understand how it all works, particularly as the focus remains on the technology. Unless this changes, cryptocurrencies will fail to meet basic human needs. The underlying technology will need to work in the background without the need for a fundamental understanding to use it.
Until that point is reached, sound investing principles that pertain to volatile asset classes should prevail, namely: never invest more than you can afford to lose.