Cryptocurrencies raise some serious questions about the nature of money and whether it should be entrusted to governments and banks to organise. But cryptos still aren’t especially user friendly or advantageous for most transactions, and they’re purely speculative as investments. Nowadays there are hundreds of cryptocurrencies and the prices of most are rocketing. Is this a genuine boom or just another bubble in the latest technology fad?
Bitcoin, the original cryptocurrency, is currently priced at US$2,251 having rocketed up 10 times from its mid-2015 low. The last bubble and bust was in late 2013, which saw the price peak close to US$1,200 before falling over 80%. A quick look at the price chart suggests that history could be repeating itself.
An OfWealth subscriber, Thomas H., sent me this question: “What do you think about cryptocurrency as a long term investment (a very small scale allocation)?” It’s a complex subject, but today I’ll try to address the main issues.
Some people have strong views on the finer points of money and currencies, and what qualifies to be each. But I’m interested in being practical. Ultimately the words “currency” and “money” can be used interchangeably in most instances. You can define both this way: “a unit of account, a medium of exchange, and a store of value”.
In other words you can measure the value of things using units of money (or currency)…things can be bought or sold in exchange for money (or currency)…and you can keep part of your wealth as money (or currency) in the form of coins, notes or bank deposits.
Are they really “currencies”?
What about things like Bitcoin? Do they fit the definition of “currency”? Or are they mere “digital assets”, as some would have it?
Personally I think there’s no question that they’re currencies, just a new kind. That’s because they can or could be used for those three things: as a unit of account, a medium of exchange and a store of value.
Cryptos also have no intrinsic value beyond their use as a currency. You can’t live in one, you can’t drive one, you can’t wear one, you can’t burn one, you can’t even touch one. Take away crypto’s role as currency and they’re pointless and worthless.
They’re electronic, but then so is most fiat currency which exists as computer entries on a bank’s accounting ledgers. Also cryptos aren’t backed by anything tangible. But then neither is fiat currency that’s regulated by governments and (mostly) issued by commercial banks.
There is one crucial difference between fiat currencies and the crypto kind. Fiat currencies can exist in unlimited amounts. However it’s important to understand that the rate of growth is controlled by bank regulations (principally capital and liquidity requirements), fine tuned with interest rate policy. Together they control the rate of loan growth, which is the same as saying the rate of money creation.
On the other hand cryptocurrencies like Bitcoin tend to have a finite limit on how many units can be created in total. That said there’s no reason they have to, so you need to check in each case.
There’s a maximum of 21 million Bitcoin built into the code, of which 16.3 million have been “mined” so far. That said they can each be subdivided 100 million times, meaning plenty of units to go around. Ripple, a more recent crypto, has a limit of 100 billion coins.
Should you “invest” in cryptocurrencies?
Cryptos are seen as a way to bypass traditional payment systems run by banks and card companies. So they should result in lower costs. The problem so far is that, as far as mass market customers are concerned, there’s been little or no benefit to making the switch. Put simply, the technology hasn’t been user friendly enough for widespread adoption, even if it works well enough at the technical level.
Many crypto advocates – especially early adopters of Bitcoin – also like the idea of cutting the government and banks out of the currency system. Early online chat rooms about Bitcoin greeted sensible questions with rapid accusations of being a “government troll” or “bankster stooge”.
The crypto world has calmed down now, as (ironically) more and more mainstream finance people get involved. It’s less ideological and more practical these days. The area of big excitement isn’t necessarily Bitcoin itself, but instead the clever underlying technology, known as the “blockchain”. The race is on to apply it in new ways.
Bitcoin was launched in October 2008. Next largest is Ethereum, by current value of all coins, which was launched in July 2015. Third placed Ripple has been going since August 2013.
The total crypto market is currently worth US$80.3 billion. That’s impressive in the sense that it didn’t exist at all until a few years ago. On the other hand it’s just 0.05% of global household financial assets of US$157 trillion (using estimates from the Credit Suisse Global Wealth Report 2016).
Here’s how it breaks down:
You can see straight away that Bitcoin is still the biggest, but it’s losing dominance fast, even as its price rises rapidly. It was over 80% of the market as recently as March.
Ripple has come out of nowhere in less than three months, with the value going from US$209 million at the end of February to US$13.2 billion today, up a staggering 63 times. Ethereum was also small before early this year.
Ripple is a hot new thing that’s meant to help bypass the SWIFT / correspondent bank networks used for international payments. That’s assuming the banks don’t build their own system to do it for themselves. A while back I read about a group of large banks planning to use “blockchain” technology, the secret sauce underpinning Bitcoin, to create a new payments system. It’s too early to know what will end up dominating.
Aside from that, look at the “other” segment, which is 13% of the market. It seems there are an impressive 831 cryptocurrencies, including the top five that are shown separately on the chart.
Almost all of them are rocketing in price at the moment, when measured in US dollar terms. For example I spotted one called Reddcoin which has shot up 15 times in the past seven days alone! (Bubble anyone?)
The ‘flations…and other matters
The sheer number of cryptos leads us to an interesting question concerning an unresolved dynamic. Are cryptocurrencies inherently deflationary, inflationary, or even hyperinflationary?
The maximum number of Bitcoins is limited, which is inherently deflationary. If the money supply can’t grow but the volume of “stuff” (goods and services) keeps expanding, then prices will fall in relation to the currency unit. It’s the opposite of the fiat currency system we have most of the time, where prices rise. (It also discourages economic activity and encourages hoarding, since people are more inclined to cling onto their appreciating currency.)
But, even if all cryptocurrencies have limited numbers of units, there’s no limit on the number of cryptocurrencies. Anyone with the right technical ability can create one.
Put it this way, there are 180 traditional fiat currencies in the world but already 831 cryptos, and the sky’s the limit. The vast majority will probably fail, but it still means unlimited potential volume of crypto units, which is inflationary, or possibly hyperinflationary.
What’s more, unlike fiat currencies, there’s no banking regulation, or limited number of issuing countries, to stem the growth. Put another way, measured in US dollars there’s a chance that crypto prices completely collapse in future.
And here’s another thing. Ongoing price appreciation of cryptocurrencies literally requires similar conditions to a classic ponzi scheme.
I’m not saying cryptos are fraudulent, although some may be. But their ongoing price appreciation – the only source of profit for people that own them – does require more and more people to pump money into the crypto system. That’s the only way that the prices will get bid up to higher and higher levels.
Of course this is what a lot of people are banking on. Namely a switch of more funds out of fiat currency deposits and into cryptos.
Bank deposits are just under 20% of household wealth in the US and a little over 40% in Europe, so 30% if we split the difference. Most of the rest of the world is poorer, meaning a higher portion of financial assets held as cash or deposits.
If we assume 40% of global financial assets are deposits it would amount to US$63 trillion. All cryptos are currently worth just 0.13% of that amount. If that changed to just 5% then today’s cryptos would be worth US$3.1 trillion, or 39 times as much.
Thus the prices of Bitcoin and other cryptos must skyrocket. Or so the theory goes. Never mind that Bitcoin is losing dominance and there are already many hundreds of competitors. And don’t forget that governments and banks may use the underlying technology to improve the way they transact in existing fiat currencies, thus preserving their dominant role.
There’s another fundamental problem with cryptocurrencies that rarely gets mentioned, at least those with limited maximum volumes. There’s no room for credit, at least not without squeezing more and more people out of the system.
How does interest get paid and collected in a system with finite currency units such as Bitcoin? Someone has to be selling down their units and moving out of the system in order that someone else can accumulate more of them.
Anyway, I have no idea whether any cryptocurrency prices are going up, down or sideways or when they’re going to do it, or not. And I don’t think that anyone else has a clue either, despite reading many confident claims.
There’s a reasonable case for major price gains for a select group of long term winners. But there are a great many headwinds and unknowns. I haven’t even got into the risk of a coordinated government crackdown at some point. (And yes folks, it is possible. They can get you at the interface with other currencies or the real economy.)
The bottom line is that cryptos are not what I’d call “investments”. They’re just too speculative. They sit in a similar risk bucket as cash burning dotcoms in the late 90s…or very junior mining stocks…or buying a lottery ticket. There are huge potential payouts but a with low probability of winning.
Of course you could make a small fortune from Bitcoin and other successful cryptocurrencies. And that’s surely going to be better than losing a large one. Always remember the late 90s dot com bubble and bust if in doubt.
This is a viciously volatile area with no sensible way to value anything and plenty of uncertainty ahead. Few people have the stomach to see their savings fall 80% in a short time, as happened to Bitcoin during 2014. A repeat crash is entirely possible after the latest price spike.
Buy some Bitcoin by all means. Enjoy the ride. Just be prepared for a wild one. In the meantime, I’d be interested to hear your views or experiences when it comes to Bitcoin and other cryptocurrencies.
Stay tuned OfWealthers,
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