Cryptocurrency is back in the news again with more extreme price volatility. For example, after topping $40,000 in early January, the price of one Bitcoin plunged by 25% to near $30,000 by the end of the month, only to soar about $37,000 just a week later.
If you’re like many people, though, you might be wondering: What exactly is cryptocurrency? Following is a primer on the world of cryptocurrency to help you better understand what’s going on behind the headlines.
A Digital Currency
The key to understanding cryptocurrency is first understanding that it’s very different from physical currency like coins, bills and even plastic. Cryptocurrency only exists digitally, not in physical form. This is one reason why it can be hard to grasp the concept of cryptocurrency.
With cryptocurrency, a decentralized system records transactions and issues new units — there’s no centralized issuing or regulating authority (like the federal government, for example). Cryptocurrencies, which take the form of digital tokens or coins, are developed as code and validated via blockchain technology that creates a record of transactions. The system relies on cryptography to secure and verify financial transactions and prevent counterfeiting, fraud and double-spending of cryptocurrencies.
Private keys are used to access and spend cryptocurrency — these keys are sent to digital wallets for storage. Bitcoin, which started circulating over a decade ago in 2009, was the first cryptocurrency and it remains the most well-known. But there are more than 4,000 different cryptocurrencies currently in existence — a few other popular cryptocurrencies are Ethereum, Litecoin, Ripple, Namecoin and Dogecoin.
With their keys, cryptocurrencies have been compared to unregistered bearer bonds that required a certificate for redemption. If a bondholder lost the certificate, he or she had no way to cash the bond. In the same way, holders of cryptocurrencies will lose their currency if they lose their crypto keys. In fact, holders of up to 20 percent of Bitcoin, worth an estimated $140 billion, have lost their keys.
The legal status of cryptocurrency is a little murky in some areas of the world. For example, cryptocurrencies are illegal in at least eight countries. Cryptocurrencies are legal here in the U.S., although they don’t have legal tender tatus. A 2014 IRS ruling declared that cryptocurrencies are considered property for income tax purposes.
Cryptocurrency as an Investment
With all the attention cryptocurrencies have been getting lately, many people are wondering if cryptocurrency is a sound investment? It could be, with some important caveats. First is the high price volatility, as illustrated above. You must be prepared to stomach dizzying ups and downs in the value of your holdings — something not every investor is emotionally prepared to do.
Another caution is the current lack of regulation of cryptocurrencies. Many believe that the U.S. government has been too slow to develop cryptocurrency regulations due to an inability to keep up with blockchain technology. In short, digital currency innovation may have outpaced the government’s regulatory framework, at least so far. Some believe this could change with the nomination of Gary Gensler, who has taught course on blockchain at MIT, as chairman of the Securities and Exchange Commission.
Also, cryptocurrencies aren’t businesses with assets that produce products or deliver services in order to earn a profit. Unlike a business — whose value as an investment typically increases when sales and profits rise — the value of a cryptocurrency only rises when a new investor pays more for a currency than the previous investor did.
Warren Buffett has repeatedly criticized cryptocurrencies as an investment. In an interview on CNBC, for example, he said, “It’s ingenious and blockchain is important but Bitcoin has no unique value at all, it doesn’t produce anything. You can stare at it all day and no little Bitcoins come out or anything like that. It’s a delusion basically.”
One way to invest in cryptocurrency is to purchase shares of a cryptocurrency exchange traded fund (ETF), like the ARK Innovation ETF (ARKK). The Grayscale Bitcoin Investment Trust (GBTC) is another option, though technically it isn’t an ETF. The Bitwise 10 Private Index Fund, meanwhile, is a crypto-based index fund that holds the 10 largest digital currencies.
There are also blockchain EFTs that invest in corporations with business operations in blockchain technology or that profit from it. Amplify Transformational Data Sharing ETF (BLOK), Reality Shares Nasdaq NexGen Economy ETF (BLCN) and First Trust Indxx Innovative Transaction and Process ETF (LEGR) are a few examples.
Is Cryptocurrency Right for You?
We’re still in the early stages of digital currency, which makes it a potentially risky investment. Give us a call if you have any questions about cryptocurrency and its possible role in your investment portfolio.