Last month, our team of financial advisors wrote about cryptocurrencies and bitcoins. We gave you an overview on the mysterious investment and highlighted some of the dangers. Today, cryptocurrencies are making headlines again. With exponential gains in bitcoins dollar price (currently over $18,000 per unit), coupled by the rollout of a futures market for the currency, many investors are intrigued. Market manias of the past have often centered on new products and niche investments. Without hindsight, its challenging to know whether a new investment is an opportunity, or a fleeting fad.
The Role of Currency
As a starting point, lets remind ourselves of what function a currency fulfills. Currencies are: (1) a medium of exchange, (2) a measurement of value, and (3) a store of value.
To act as a medium of exchange, a currency needs to be based in something of value. Over human history, whats considered of ‘valuable is based on the particular culture and what physical items are readily (but not too readily) available (beads, weapons, animal pelts, food items, metal coins). In short, currency of any kind needs to be valuable to both the buyer and the seller. Currencies must also have the ability to be divided into reasonably-sized lots to allow for smaller transactions, which fulfills the measurement function. Cryptocurrencies tend to offer some of these components, as they can be divided and are being accepted as payment for goods and services on a number of websites.
Currencies must also allow for the storage of value. The durability of metal coins has boosted their popularity, as these can be stored for extraordinary lengths of time without corrosion, spoilage, etc. However, the durability of cryptocurrency is reliant upon current technological limitations for storage of computer data, which can erode over time and requires electricity to archive, retrieve and process. We’ve heard a few suggestions that cryptocurrency may serve a role during a major natural or man-made disaster. If what we know of currency is that it needs to measure and store value, how can you do either with a bitcoin (not to mention, access it at all if this disaster came with a power outage)?
Scarcity, Trust & Competition
Fundamentally, currencies derive their value based on some degree of scarcity. The less of something that exists, the more it is valued. This is true of real assets, which explains the use of certain precious metals as currency, as there is a limited supply. The problem with cryptocurrencies is that its value is based on digital bits that are continually created. The only limitation seems to be the surprisingly large amount of energy resources it takes to create them (enough to power a large city by some estimates). A lack of scarcity results in more difficulty in assessing an items ultimate value.
Trust is another critical element of a modern currency. Think about the U.S. dollar. A part of the reason this is the worlds foremost ‘reserve currency is because it is backed by governmental and economic stability (actual and perceived) of the United States, with a great deal of it held abroad. (The Japanese yen and Swiss franc have similar safe haven reputations.) Consumers trust that the dollar will hold its value over time, and wont be swayed by inconsistent policy or turmoil that could threaten its stability. So far, cryptocurrencies aren’t sponsored by a government entity or backed by physical collateral of any kind.
Another potential risk to upstart currencies is competition. Unlike the dollar, yen, euro or gold bars, which feature a centralized supply and no organized competition, there is no monopoly on cryptocurrencies or restrictions on who is able to create a new one. In fact, other cryptocurrencies are being created seemingly on a continual basis through new initial public offerings in the wake of Bitcoins success. Which will be the winner? Will there be several winners that are interchangeable? Which, if any, will lose some or all of their value? More questions that well only be able to answer with the gift of hindsight.
We encourage you to do your research before making any type of investment, but particularly into an area as volatile and speculative as this. The SEC recently published this note on cryptocurrencies. In it, they provide some facts about just how risky these investments are, as well as some sample questions that should be asked before diving in. Long time clients of our firm wont be surprised to hear that we do not have plans to get involved in the cryptocurrency markets at this time. While we remain open to new and innovative ideas, we always keep the prudent management of your hard-earned nest egg as our top priority. If anything you read here brings up further questions or thoughts for you, please don’t hesitate to reach out to our team of Certified Financial Planners.