This article outlines the drivers behind the enthusiasm and considers some of the challenges facing cryptocurrencies as an investable asset.
Chips off the block
While the goal of this article is not to canvas the mechanical aspects in depth, we can summarise by saying a cryptocurrency is a decentralised digital form of exchange where cryptographical techniques are used to control the creation of new units of currency and to verify the transfer of funds. With the major examples to date, new coins are created via a “mining” process whereby “miners” are rewarded with coins for solving cryptographical puzzles. Most cryptocurrencies are designed to gradually decrease production of the currency, with some placing an ultimate cap on the total amount that will ever be in circulation, thus mimicking the finite supply of precious metals.
The underlying transaction record for a cryptocurrency is the “blockchain”. The cryptographical puzzle solved by the miners is part of the process of validating transactions. In a conventional digital transaction, you, the counterparty and your banking provider are aware of a transaction. However, in the blockchain, there would typically be thousands of “aware parties” keeping a record of such transactions, and this negates tampering via an attack on an individual copy.
It’s important to distinguish between blockchain technology and cryptocurrency. Blockchain is an infrastructure that has been heavily invested in by major players in the world of digital transactions, and applications are also being developed for non-financial sectors. Blockchain is therefore an exciting development that could have a significant impact on the finance sector and wider economy over the coming decade.
The hope and the hype
The huge interest in cryptocurrencies has been driven by a number of features that distinguish them from government-backed fiat currencies:
Bitcoin price history
Cryptocurrencies face a number of significant challenges in attempting to establish themselves as serious alternatives to fiat currency or gold, thereby countering their suitability as an investment or store of value at this point in time:
What next? Two sides of the coin
“Bitcoin is the beginning of something great: a currency without a government, something necessary and imperative.” - Nassim Taleb (financial author)
“My best guess is that in the long run, the technology will thrive, but that the price of bitcoin will collapse.” - Kenneth Rogoff (economist)
The above quotes highlight that the future success of digital currencies is far from clear. The blockchain technology that underlies their use undoubtedly holds promise in areas such as trade processing and settlement, with many other potential applications under active development. However, in our view cryptocurrencies have yet to prove that they offer much more than the benefit of anonymity and the potential for huge price fluctuations.
Although some argue that cryptocurrencies can be considered a form of digital gold, the key difference with physical gold is that it has played a role in financial systems and been seen as a store of value for thousands of years. With no way of assessing the fair value or longevity of different cryptocurrencies, holders need to contemplate the very real possibility that many, if not all, cryptocoins may be close to worthless at some point in the future. Whilst it is possible that one or more cryptocurrencies might survive and even thrive as the underlying technology and unforeseen applications develop, it is also possible that many will disappear altogether.
Worth a place in portfolios?
In summary, we do not view cryptocurrencies in their current form as a compelling proposition for investment portfolios - either directly, via futures or via hedge funds set up to speculate on price movements. They offer no income to the passive holder of coins (i.e. non-miners) and assessing fair value is close to impossible. In addition, the wave of cryptocurrency launches and the spectacular price rises witnessed in 2017 exhibit many of the hallmarks of a speculative bubble, notwithstanding some deflation seen in recent months. We suggest that investors not partial to “rolling the dice” sit out the action and marvel as more of the story unfolds.
This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.
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