July 20, 2021

All the Basics You Need to Know About Cryptocurrencies

The advent of cryptocurrencies has changed the worlds of not only finance and technology, but also personal investing.

Written By Patrick Briand

Dominating news media and attracting the attention of a new generation of investors, interest in cryptocurrencies such as Bitcoin and Ethereum has reached a fever pitch in 2021. Dramatic price swings coupled with high-profile endorsements have collided with a risk-on environment to produce a once-in-a-generation moment in the investing world: the birth of a new asset class.

Cryptocurrencies are now being adopted by some of the world’s largest institutional investors and companies and making ambitious high-risk retail traders wealthy. Although many are eager to follow this trend, it is important to understand the constraints and risks behind owning cryptocurrency.

Types of Cryptocurrencies

Making its debut in 2009, Bitcoin was the original cryptocurrency. Many others have followed, but Bitcoin has become the standard against which all other “cryptos” are judged. Early on, cryptocurrencies inspired negative public opinion due to their usage on the ‘Dark Web’, a private internet browser ripe with illegal activity. Over time, this image faded, and Bitcoin came to be appreciated as an investment vehicle and a technological achievement that could fundamentally change the conception of money. 2017 brought the first major spike in Bitcoin prices, which reached $20,000 that year before quickly losing 75% of their value. Bitcoin, like most other assets, struggled during the beginning of the COVID-19 pandemic, reaching a low of roughly $4,000. Prices quickly rebounded, however, and began to take off in the fall. Bitcoin peaked in value at just over $60,000 in early April, and as of early June, was trading around $35,000. Other cryptocurrencies followed suit, with upstart coins seeing even more drastic price moves.

Some of Bitcoin’s contemporaries include Ethereum, Litecoin, and Ripple (XRP.) These are just some coins that have attracted significant attention, as there are now thousands of coins available to trade. Tesla CEO Elon Musk’s preferred coin has been Dogecoin, which was inspired by a popular internet meme. The coin has rocketed in value this year thanks to rampant speculation but leveled off after Musk’s recent SNL appearance where it was jokingly referred to as a “hustle”. Recently, new coins such as SafeMoon and Cardano have been labeled as the “next big thing,” hoping to steal the thunder of industry leaders like Bitcoin. Despite the rising buzz, a big question remains for most of these coins: What practical value will they have? While a few cryptos are touting their potential for financial applications or positioning themselves as a hedge against inflation and rampant money printing, the recent gains in many coins seem to be based on nothing more than internet chatter and a desire for something new on which to speculate.

What is Blockchain Technology?

Bitcoin transactions are stored on a decentralized public ledger underpinned by “Blockchain” technology. Blockchain stores all relevant information about Bitcoin transactions, although the actual owners of the currency remain anonymous. Blockchain’s potential is too often solely linked to cryptocurrency; the technology could have major implications on industries such as finance, health care, and commerce. Blockchain technology is expected to save banks billions by reducing regulatory compliance and making the settlement of financial transactions instantaneous. Other blockchain startups are working on strengthening corporate security, monitoring supply chains, and streamlining the interactions between devices in what is known as Internet of Things (IoT) technology. Even some state governments, such as Illinois, have begun to work on blockchain projects to certify sensitive records for their residents. Non-Fungible Tokens (NFTs) are another development from the world of Blockchain. The Blockchain ledger certifies a non-fungible token as a unique property embedded in a digital asset. This gives digital creations a verified “1 of 1” status. NFTs have sold for exorbitant sums and can include anything from sports clips to art pieces to music videos. A clip of a Lebron James dunk recently sold for over $220,000 on the popular NFT marketplace NBA Top Shot. Expect to hear more about NFTs going forward as celebrities use it to monetize their content, and the blockchain technology behind the fad develops.

How is Cryptocurrency Stored?

Bitcoin is traded via cryptocurrency exchanges such as Coinbase, an online platform which recently went public. Robinhood and other brokerages allow customers to purchase cryptocurrency but do not allow them to store it in a secure cryptocurrency wallet; it appears on users’ accounts just as a stock would. Cryptocurrency is most often stored in a digital wallet with a key that the owner must remember. This has led to widespread loss of Bitcoin, with some estimates stating that up to 20% of Bitcoin may be permanently lost. Most owners of Bitcoin must secure either a ‘Hot Wallet’ (encrypted online storage) or a ‘Cold Wallet’ (an offline device akin to a USB which secures your Bitcoin holdings.) No Bitcoin ETF has been approved for trading in the U.S. yet, but investment firm Grayscale has used closed-end funds to allow investors to get crypto exposure into their portfolios without having to own the actual asset. Grayscale recently added Ripple and Ethereum funds to complement their original Bitcoin offering.

Cryptocurrency Security and Environmental Effects

Cryptocurrencies have been the subject of major controversy, especially regarding their security and environmental effects. There have been multiple major cryptocurrency hacks, resulting in the losses of hundreds of millions in value. In the early 2010s, Mt. Gox was a popular Bitcoin trading platform. Over the years, thieves infiltrated company software and customer accounts to steal over $400 million worth of Bitcoin. Bitfinex, which took Mt. Gox’s place as the premier Bitcoin exchange in the following years, was also subject to a $72 million hack in 2016. Today’s major trading platforms are more secure, but with a product so valuable, the risk of theft is always present. Numerous internet scams have targeted those seeking to invest in Bitcoin; it is thus important to be diligent when purchasing these currencies as many investors have let their guard down in pursuit of high returns. A famous Bitcoin scam in 2020 targeted the Twitter accounts of celebrities and politicians such as Barack Obama and Joe Biden; encouraging their followers to buy Bitcoin. Tens of millions in losses to crypto scams have been reported in recent months, often through pyramid schemes and fake websites, which is why it is essential to buy through a secure platform such as Robinhood or Coinbase.

Bitcoin mining is a rigorous process that requires huge quantities of electricity and produces annual cardon dioxide emissions on par with a mid-sized country. It was for this reason that Elon Musk recently backed away from his commitment to accept Bitcoin as a form of payment for Tesla. The process of using coding machines to mine Bitcoin works best in areas with cool climates and low energy costs, which has turned parts of Iceland, Canada, and Upstate New York into Bitcoin mining havens. Bitcoin miners solve complex, time-consuming mathematical puzzles in order to verify transactions and strengthen Bitcoin’s network. The miners are rewarded for their efforts with small amounts of Bitcoin.

Major Investors and Companies Thoughts

Some major investors and companies have endorsed cryptocurrencies, if only as an alternative to holding cash in a portfolio. Payment company Square, headed by Twitter’s Jack Dorsey, invested $50 million into crypto, while Mass Mutual poured in $100 million. Top investment professionals have advocated for making small positions in the speculative coins, and legendary investor Carl Icahn recently said he plans to get into cryptocurrency “in a big way.” Others, including titans of the business world such as Bill Gates and Warren Buffett, have argued against cryptocurrency and reminded investors that the coins produce nothing tangible. Central bankers, including Janet Yellen and Andrew Bailey, have also come across as negative in their public comments on the technology. PayPal and Mastercard have begun to support crypto transactions on their networks, which has improved the usability of the speculative assets. Expect wider corporate adoption in cryptocurrency in the coming years, as well as targeted purchasing serving as a form of currency hedge or growth investment.

So given these concerns, why is there so much demand for cryptocurrency? A lack of trust in fiat currency like the U.S. dollar is one reason. Excessive money-printing in recent years has led to many people being concerned the days of “King Dollar” could come to an end; similar fears have abounded in Europe. Another reason is the constant desire for something new by investors, especially younger investors entering the market. Tech-savvy Generation Z is not adhering to the same asset allocation principles as generations before them; and their strong affinity for crypto has caused older investors to take a second look. That this latest crypto boom took place in a time where young people were stuck inside with limited entertainment options is no coincidence, as cryptocurrency’s rise went together with a boom in retail trading of speculative stocks during the pandemic. This should trigger investor fears of an asset bubble, similar to what happened with technology stocks in 2000.

The Future of Cryptocurrency

The future for cryptocurrencies is cloudy as regulation looms and individuals ponder whether an investment that may not produce anything of value belongs in their portfolio. Prices have already fallen from their recent peaks, influenced by a slowdown in trading amongst retail investors and China’s regulatory crackdown, which essentially banned cryptocurrency trading from the country. Currently, 18 million Bitcoins have been mined, and the total supply that will ever be minted is 21 million, although this will take another century as the founders of Bitcoin have sought to reduce the velocity at which Bitcoin is being mined. There has also been talk of different countries and companies building their own cryptocurrencies-maybe one day we will see a Federal Reserve coin or an IMF coin, considering those organizations have begun to research how potential digital currencies would fare against private offerings and affect the economy. China has begun testing out a digital version of the Yuan, allowing it to circulate in major cities such as Shenzhen as the government seeks to promote a cashless society. Facebook has been working on a cryptocurrency called Diem for years, and many other companies have joined their efforts. Other factors to consider in Bitcoin’s future include environmental regulation related to Bitcoin’s massive energy consumption, whether a U.S. ETF is ever approved, and if Bitcoin will ever be accepted by businesses en masse.

It is an exciting time to follow cryptocurrency as it shakes up what we thought we knew about currency and keeps investors glued to their phones and computers with volatile price changes. The dangers surrounding this new horizon of speculation are concerning. The challenges of using crypto as a transactional “currency” are obvious when the value of these coins can fluctuate so rapidly. As a portfolio holding, the fundamentals are difficult to value so would be appropriate for only a small percentage of assets for investors with the highest risk tolerance for losses.

Plimoth Investment Advisors focuses on providing clients with the very best investment management services.

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