What Are Cryptocurrencies?
No, seriously, what are they? I can’t find a definition that does a great job of describing them. Aside from being a digital asset, it’s more instructional to look at what cryptos are not:
Cryptos are not a currency.
Since a limited number of businesses will accept crypto as payment for goods and services, they fail at being a medium of exchange. Most businesses wouldn’t accept cryptocurrencies as payment, knowing they could fall by 40% in value overnight and wipe out all profits.
Also, unlike cryptos, you don’t have to worry about taxes when you buy something with any true currency.
Cryptos are not a store of value.
Assets normally thought to be a store of value don’t normally have massive price fluctuations as we’ve seen with cryptos over the last month. Additionally, if a government can unilaterally decide to outlaw them (as China and India are signaling), the risk of having their value disappear is unusually high.
Cryptos are not digital gold.
While neither gold nor cryptos generate dividends, gold does have a track record that extends for millennia. Gold also has plenty of practical uses stemming from being – you know – a tangible thing. It also doesn’t drop in value in a “risk-off” scenario as Bitcoin did during March of 2020 when it fell by 50%.
While it’s difficult to define cryptocurrencies in relation to other investments, they do potentially have promise as a standalone asset class once a few issues have been settled.
There’s been plenty written about how cryptocurrencies work, so I’ll leave that to someone better:
There are quite a few positives for cryptos, like Bitcoin, which explain their popularity. The first is as a potential medium of exchange. Cutting out the middle man (commercial banks) can save on transaction charges and account fees. Simply put, should Bitcoin ever be widely adopted, people and businesses would save tons on bank fees.
Certain cryptos, most notably Bitcoin, have been designed with an upper limit of how many “coins” can be mined. This is an interesting and unique feature that differentiates it from fiat currencies, which don’t appear to have any upper bound at the moment.
Why is this feature important? Should Bitcoin (or another similar crypto) be widely adopted as a means of exchange, then it would be insulated from being debased as fiat currency often is. It’s standard practice for central bankers to print money in an attempt to inflate away liabilities on their balance sheet.
Unfortunately, money printing erodes the purchasing power of the fiat money that’s used by people in the system, slowly making them poorer over time. The Bitcoin supply issue could potentially side-step this issue. We’ll come back to this point a little later.
Once cryptos become more established, they could potentially become another inflation hedge — as a complement to gold, rather than a replacement. As such, investors may eventually harness them as a non-correlated asset class in constructing a portfolio. This could be a terrific reason to view cryptocurrencies are a good investment.
Finally, privacy is an important feature of Bitcoin and other cryptocurrencies, assuming that it’s still achievable in this day and age. Of course, privacy can be a double-edged sword, as we will discuss momentarily.
Accessing and using your cryptocurrencies is done by using an encrypted digital wallet. Unfortunately, if you lose your wallet or forget your password, you’re out of luck! In fact, one man in California famously lost the password to his thumb-drive wallet containing $220 million worth of Bitcoin.
Taxes dramatically hamper the ability of cryptocurrencies to become a medium of exchange. The IRS considers cryptos as property, so if you sell crypto assets, normal capital gains taxes would apply. You could even use losses to offset capital gains.
Unfortunately, taxes don’t just come into play when you sell. If you exchange for another cryptocurrency or purchase goods or services using cryptos, that also triggers a taxable event.
Finally, in what could ultimately decide the fate of cryptocurrencies, they could potentially face regulatory scrutiny in the future.
As I mentioned earlier, having a means of exchange that is not controlled by a central bank would threaten the power of those entities. During times when nations are running huge deficits (like today), having the ability to inflate away the debt is a huge advantage for any government. If they no longer control the money supply, that goes away.
I would expect that, at some point, the government steps in to regulate cryptocurrencies in order to protect the dollar as the world’s reserve currency. This is something to watch closely before we can say cryptocurrencies are a good investment or not.
We mentioned privacy earlier as a “good” feature of cryptocurrencies. With this privacy, there’s often the incentive for the unscrupulous to use cryptos for nefarious purposes. Bitcoin and other cryptos can be used in criminal activities due to the anonymous nature of the asset.
Of course, this facilitates criminals and creates an impediment to law enforcement’s effort to fight them. However, it’s not completely clear how much criminal activity is actually laundered through cryptocurrencies.
What is clear is that the central banks will be happy to use this as leverage to step in and regulate the crypto markets to maintain the hegemony of the dollar.
And while we’re talking ugly, let’s not forget that nobody really knows the true identity of Satoshi Nakamoto, the mysterious inventor of Bitcoin.
This brings us to Dogecoin.
Created by two Adobe software engineers in 2013 as a joke mocking cryptocurrency speculation, Dogecoin is literally a meme investment. Who knew that the joke would be on them? After a few tweets from Elon Musk, Mark Cuban, and Snoop Dogg, Dogecoin started its journey to the moon.
However, unlike Bitcoin, there is potentially an unlimited supply of Dogecoin. So much for the feature that prevents debasement!
At this point, Dogecoin is completely speculative, leaving buyers with the greater fool problem. But it does have a cute Shiba Inu on it and everyone loves dog memes.
Are Cryptocurrencies A Good Investment?
Serious cryptocurrencies such as Bitcoin, Ethereum, and Litecoin stand a good chance of eventually becoming part of a diversified asset class that would be useful in building a long-term investment portfolio.
Unfortunately, at this time, there are two serious concerns that should give investors pause. First, the potential for regulation (or an outright ban) is a massive risk. If the government did it with physical gold, don’t think they wouldn’t do it with cryptocurrencies. Controlling the money supply is an extremely powerful feature that the Federal Reserve will not happily cede.
The second risk for cryptocurrencies is the current market environment. If Dogecoin and NFTs aren’t a sign of irrational exuberance, then I don’t know what is. Cryptocurrencies like Bitcoin are not immune to the forces of speculation. Like the tech stocks of 1999, there is a future for these assets, but in a more rational context.
Once these questions are answered, we can start viewing Bitcoin and other cryptocurrencies as investments rather than what they are today: speculative assets.
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