Do you have questions about cryptocurrency? Beacon Wealth Consultants’ Chief Investment Officer Hillary Sunderland, CFA, CKA®, answers some of the most frequently asked questions about cryptocurrency, including its history, the problem it was designed to solve, how it works, and considerations for investing in Bitcoin, Ethereum, and Dogecoin.
Full transcript below.
Hi, my name is Hillary Sunderland and I’m the Chief Investment Officer of Beacon Wealth Consultants and this is your May 2021 update. Once per quarter I like to do a segment where I answer our clients most frequently asked questions. In this month. I’m going to spotlight a disruptive technology that has been garnering many headlines as of late and that is cryptocurrencies. The cryptocurrency market is now in its second decade, but few people understand what crypto really is or why it might matter. So some of the questions I get often are is crypto really a currency like the U.S. dollar? Is it a technology? Is it just a speculative bubble? And is it a good investment opportunity? I hope to answer some of these questions for you today. I’m going to start right at the beginning. Where did cryptocurrency even come from? Well, in late 2008, the synonymous computer programmer published a white paper titled “Bitcoin: A peer-to-peer electronic cash system” to a mailing list of cryptographers.
Now a cryptographer is someone who often works in the cybersecurity field and uses their knowledge of math, computer science, and information security to protect data that is stored and sent using technology. So they use codes and ciphers to keep information safe. In this paper, the author described a vision for how individuals could hold, send and receive items of value digitally without any trusted intermediary, such as a bank.
Shortly after the paper was published, Bitcoin was launched with the purpose of solving a problem that we all have. So what is this problem? Well, we suddenly have the world at our fingertips. Technology has made it possible to text or video chat with another person in another part of the world. Instantaneously, we can stream movies and shop online without ever leaving our homes. We can instantly download books without ever going to a library or a store.
And we’re used to taking care of things easily and efficiently. However, in the area of finance, we seem to be stuck in the past. For example, wiring money abroad or paying bills using an online bank account can require two to four days for processing. Consider a simple request to take money out of your investment account. You alert your wealth advisor that you need some money, trades have to be placed to raise the money, to distribute to you. And then trades typically take one to two business days to settle. Then it has to be sent to your bank and that deposit needs to settle before you can use it. So it usually takes two to four business days to be able to use your money. And if the request is made after normal business hours, or if one step in the process falls over a weekend or on a holiday, the process will take even longer.
Do you ever wonder why it takes so long to transfer money? It’s not because banks are lazy. The reason is really because transferring items of value online is much, much more difficult than transferring basic information, such as text messages and emails. For centuries, accounting ledgers have been the bedrock of commerce and as shown on this diagram, mediators such as clearing houses, credit card companies or banks hold private ledgers or records of the history and balances on each account that they maintain. They then use those records to verify that each transaction is true and allow business to take place between strangers for a fee. Because each entity has its own database of accounts, it takes time to make sure that each transaction will actually clear. To speed up the process a different solution is required, and that is where cryptocurrency comes in. The core idea behind Bitcoin was to create a single distributed database that is accessible to everyone.
Anyone anywhere in the world can view the balances and submit transactions on the single database at any time. But the ledger is not controlled by a single corporation, government, person, or entity. So essentially there is one database where people create consensus about what is accurate and true instead of a corporation or a government doing so. And everyone has access to the ledger at all times. So that it’s easy to reconcile all transactions within minutes. So the easiest way to understand this is to work through a sample transaction for Bitcoin. Let’s say that Joe wants to send five Bitcoins to his daughter, Sally, who’s working on the other side of the world. Joe sends a message to all of the computers that are in the Bitcoin network that effectively says, I want to send five Bitcoins to Sally. Now, Joe, like all owners of Bitcoin have a unique password called a private key, and that lets him propose a transaction to all of the computers on the Bitcoin network. Transactions are initially placed into what amounts as a waiting room where they sit waiting for confirmation.
And that’s where a special participant in a network enters. And these are known as Bitcoin miners. So miners are computers all over the world that form a critical part of the Bitcoin network. Their job is to aggregate groups of transactions, such as Joe’s and propose them for settlement. So at any given time, more than 60,000 computers around the world are competing with one another for the right to verify the proposed transaction. The competition involves solving a challenging mathematical puzzle and whoever finds a solution first is entitled to rewards such as Bitcoin or a very small transaction fee. Once a miner solves the puzzle, it can post the solution and propose the block of transactions to the network. When a miner posts a solution in a block of transactions, other members of the network check the work.
If the transactions are valid and the puzzle solution is correct, network participants update their copy of the database to reflect the new transactions. These groups of transactions are called blocks and this chaining together of blocks is why this database architecture is called a blockchain. At this point, Joe’s transaction is considered settled and Sally is issued Bitcoin as a payment. Because so many computers are verifying the transactions, it’s a very difficult system to hack. And today this system settles approximately the same value of transactions each year as PayPal does.
So there are a few potential uses of this technology that could prove to be breakthroughs. And that’s why there’s some excitement around crypto assets. The first is rapid, low-cost settlement of money, 24/7. So you can move millions of dollars worth of cryptocurrency in just a few minutes, any time of the day and any day of the week with extremely low fees, meaning pennies on the dollar.
Contrast that with an international money wire for Joe to get Bitcoin to Sally using traditional methods, he would’ve had to send it only during the business day while paying a processing fee for an international money wire of anywhere from one to 8%. And it would take one to two days to settle. With blockchain technology, you get rapid, low-cost settlement of money, 24/7.
Second, because the underlying blockchain database is available to everyone without being controlled by anyone, but still secured by cryptography, there can be digital ownership guarantees that were previously non-existent in the digital world.
And then finally blockchains allow users to effectively program money with certain rules and conditions. For example, smart contracts can be written such that when a company delivers a product, digital smart contract is unlocked and the company is instantaneously paid. So overall there’s a lot of exciting uses for the underlying blockchain technology. And because there are different use cases, there are also different cryptocurrencies. Currently there are about 7,800 different cryptocurrencies in existence today. However, just a few of them account for more than 80% of the industry. And again, there’s different currencies that exist because they each have a different use.
So Bitcoin is programmed to send, receive, or hold Bitcoin. Ethereum, which is another very popular cryptocurrency is programmed to do any type of transaction such as smart contracts. So one might think that the ability for Ethereum to do smart contracts makes it a better blockchain than Bitcoin, but that’s not necessarily the case because the simpler a blockchain is the more secure the technology is. And there’s another popular one as of late called Dogecoin, which has made a lot of headlines due to Elon Musk tweets. This cryptocurrency actually started out as a joke, but it’s one of the larger cryptocurrencies available today. Now I need to tell you here that the vast majority of cryptocurrencies that are available today are likely worthless, close to 2000 cryptocurrencies have already become obsolete. And many of the existing ones are struggling to get a footing in the market.
So as such, most of those currencies are likely worthless and trying to pick which one or few out of 7,800 different cryptocurrencies that are available today, picking which one of those will be a runaway success story is very difficult at best, but these are three of the more popular ones on the market today.
So now that you have a background on cryptocurrency, what does it look like as an investment opportunity? Well, when looking at the performance of some of the most popular cryptocurrencies, you’ll quickly notice that some cryptocurrencies, such as Bitcoin have been able to generate substantial performance. Here’s a chart of the performance of the Bitwise 10 large cap crypto index, and this index tracks the total return of the 10 largest crypto assets. And the beginning date on this chart is July of 2018. And the outsized returns that you’re seeing here is what has been attracting many to the asset class, because there’s usually a fear of missing out on the next big thing.
We’ve received numerous questions about whether or not we plan to incorporate crypto into our portfolios, given this meteoric rise that we’ve had in the markets, especially over the last few years. So, you know, just to address that question first, in finance, we use valuation frameworks to ascertain whether a stock is over or undervalued. And unfortunately because cryptocurrencies are more similar to currencies than stocks or bonds, the valuation framework is extremely challenging. The question of how to appropriately value crypto assets is one of the most complex, challenging and disagreed on aspects of the crypto market. And the reality is that none of the ways that people have come up with to place a value on cryptocurrencies is academically defensible. There are holes in all of them. So when you don’t know what something is actually worth, it’s difficult to know when to buy or to sell it.
Additionally, buying crypto also comes with a lot of volatility. Here’s a look at the price declines at Bitcoin from all time highs. And this chart goes back to 2010. Uh, Bitcoin hit an all time high of more than $63,000 per coin on April 15th, 2021 before falling nearly 45% to a level of around 35,000, just last month. So I’ve shown on this chart Bitcoin has had extreme bouts of volatility over time. And in some cases it took years to recover those losses. So while Bitcoin has been a very high returning asset, it also courted very high risk. And with investing across all asset classes, there is the always a temptation to chase runaway returns or to sell against falling prices. So if you are thinking about investing in crypto, consider that it may be particularly difficult for you to stick with it. It given it’s exceptionally high volatility, you really need to have a stomach for it and not invest more than you are willing to lose.
There are some additional considerations as well when considering cryptocurrency as an investment. First, the IRS has ruled that crypto assets are taxed as the same way as property when you’re trading it. So in general, that means that crypto asset investments are taxed with traditional short and long term capital gains tax rates, depending on the length of the holding period. So those will generate tax issues for you if it goes up in value. Also crypto is largely unregulated and this poses probably by far the biggest risk to investors, one of the reasons why we don’t hold crypto in client accounts is because the Securities Exchange Commission, the SEC who’s our regulator, has repeatedly rejected applications to list a crypto asset ETF citing concerns about market manipulation, custodial risks, audit risks, and other factors.
Additionally, with respect to security, the landscape of brokerage apps is large and varies widely. Safekeeping can be an issue. So while some custodial solutions, which is, you know, where you’re holding your money are robust, others are negligent and have lost client funds or denied clients access to their funds. So if you choose to invest in crypto, you should be discerning about which particular service that you use.
Other challenges include an inability to invest via trust and tax advantaged accounts. And also there is the risk of getting hacked. So even if the brokerage that is holding your crypto asset, doesn’t get hacked, your phone or email where you’re storing your passcode could get hacked. Remember that the ownership of a given crypto asset is established by controlling a password or private key. If that password is lost or stolen or not provided to heirs in estate planning and you pass away and nobody has your passcode, the related crypto asset is lost forever. This finality is necessary to permit some of crypto’s key advantages such as rapid settlement, but it presents a significant risk if not handled appropriately.
So if you currently do own cryptocurrencies like Bitcoin or Ethereum for estate planning purposes, you need to make sure that your heirs can retrieve your passcode. Also, there are environmental concerns which I’ve talked about in previous blogs. There is a massive amount of energy that is required worldwide in order to keep these networks active. And a lot of those, a lot of that energy usage is actually in China and coal is used to mine a lot of the cryptocurrencies. So there are significant environmental concerns as well. Overall, the emergence of a new asset class is a rare event. And so regardless of your personal view, digital assets and cryptocurrencies are becoming an increasingly large part of the global financial system.
After learning more about where cryptocurrencies came from and how the underlying technology works. I hope that you can see the tremendous value in the underlying technology and how this could shape the world for years to come. However, as I outlined, there are also some big hurdles to overcome such as regulation, taxation, and safe keeping. Additionally, the volatility of Bitcoin makes it difficult to view as a store of value in a traditional sense. So your decision as to whether or not to allocate the cryptocurrencies will depend on your risk tolerance and it may be appropriate for some however, proceeding with caution is warranted, given those numerous hurdles that I spoke about earlier. We thank you for your continued confidence, and please reach out to us with any questions that you may have.
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