Cryptocurrency: Fad or Future?

By Jason Flores, CFA, CAIA – Senior Vice President & Senior Portfolio Manager

There has been a lot of discussion over the past several years regarding cryptocurrency. Pundits, speculators, investors, and everyone else seem to have opinions on whether cryptocurrencies are indeed valuable, or not. If you feel like the whole idea of cryptocurrency is hard to understand, you are not alone. First, there is the technology aspect to understand – blockchain, hash, mining, digital wallet, cold storage and more. Then, there is the seemingly endless number of different cryptocurrencies themselves. Some of the common questions are:

• Why are there so many cryptocurrencies?
• What makes them valuable?
• Which one should I invest in?

I’m not going to focus on the infrastructure and technology that supports cryptocurrency; I’ll leave that topic for another day. Let’s dive into the questions noted above.

To better understand why there are so many different cryptocurrencies, it is important to understand the different uses. In the parlance of cryptocurrency this is referred to as the “use case”. There are three main use cases for cryptocurrency:

1. Store of value or currency;
2. transacting between fiat currency and cryptocurrency;
3. and to facilitate transactions on a particular blockchain.

Each of these use cases could be further subdivided, but the use is essentially the same.

The cryptocurrency everyone is familiar with, Bitcoin, is a great example of the “store of value” or “currency” use cases. Bitcoin, in essence, is digital money. You can save it, like gold or silver, hoping it will be of more value in the future (store of value), or you can spend it at the local Starbucks on a cup of coffee (currency). To be used widely as currency, Bitcoin needs to be more stable. It is hard for merchants to price goods and services in Bitcoin, as the value of Bitcoin fluctuates wildly from day-to-day. Due to this, widespread adoption from merchants remains relatively low, with estimates ranging from 19% to 33% of businesses accepting cryptocurrency. The limited adoption and frequent changes in the price of Bitcoin have led to most people holding Bitcoin as a “store of value,” anticipating future price increases. The stability in value will most likely come from widespread adoption and usage as a type of money to transact, but widespread adoption will most likely come from stability. A real “chicken or egg” conundrum. A recent crack in the store of value case emerged when Russia invaded Ukraine. Safe haven assets like gold and silver rose in value, while the price of cryptocurrencies declined.

Stable coins are designed to be stable. Tether is the cryptocurrency most associated with stable coins. Tether has various versions, one version “tethered” to the US Dollar, and another version “tethered” to the price of gold. The main use case for these cryptocurrencies is to purchase other cryptocurrencies. Typically, an investor in cryptocurrency will buy a stable coin, then hold the stable coin to purchase one of the more volatile currencies, like Bitcoin. This cuts the time from depositing cash in an account and then buying Bitcoin. Due to the stable nature of these coins, there is a belief that these coins could potentially be used instead of fiat currency.

There is currently no widespread adoption from merchants, which limits their use. Stable coins are also being looked at very carefully from regulators in the US. There is concern that stable coins could lead to a financial crisis if there is a run on the coins. Regulators are checking to make sure that the coins are indeed backed by the amount of gold, or fiat currency they claim to be backed by. An interesting point here is that if a cryptocurrency is simply backed by fiat currency, why have the cryptocurrency at all? Users will point to the ease of transferring cryptocurrency quickly with minimal fees.

The final use case is use on a particular blockchain. Ethereum is the cryptocurrency most associated with this use case. The most non-technical way to explain this is to think about a casino. In a casino, you exchange your cash for chips. You then use the chips to play the games in the casino. This is very similar to Ethereum. You convert your cash to Ethereum (the chips) to use on the Ethereum network (the casino). The popularity of these cryptocurrencies depends largely on the popularity of the blockchain or network underpinning it. If no one does transactions using smart contracts on Ethereum’s network, the cryptocurrency has no value.

So back to the original questions.

Why are there so many?

One answer is that there are specific cryptocurrencies created for different uses. Another answer is that cryptocurrencies are relatively easy to create, meaning that anyone that wants to learn how to create a cryptocurrency can create one. These extremely low barriers to creating a cryptocurrency all but ensures that there will be many, many cryptocurrencies (currently there are over 10,000 different cryptocurrencies according to Investopedia).

What makes them valuable?

Originally, the value of Bitcoin was the anonymity it provided. The ability to transact across borders with no government regulation, and with the user’s identity unknown. Increasingly this is going away. Governments worldwide are enacting regulations, or outright bans of cryptocurrencies. Each passing day the ability to remain anonymous and out of the purview of governments while using cryptocurrency is fleeting. A recent example is the freezing of cryptocurrency transactions for the protesting truck drivers in Canada.

I believe we are in a period where the value of many cryptocurrencies is simply the hope that someone will pay more for it than you did, known as the “Greater Fool” theory. This isn’t to say that a reason for their value will not emerge, but it is hard to see a value case across the entirety of all cryptocurrencies. There are specific cases of limited amounts of certain coins which makes them scarce, better adoption for some coins, or highly used coins on specific blockchains; ultimately, cryptocurrencies are worth something because people are willing to pay for them.

Which one should I invest in?

With so many different options to choose from combined with the low barriers to creating new cryptocurrencies, it is hard to keep up with all the new cryptocurrencies available. Add to that trying to handicap which use case will be the most predominant adds an extra layer of complexity. If, for example, you believe that cryptocurrency will replace fiat currency in day-to-day transactions, then Bitcoin (or similar coins) are appealing. However, if you think that the future is smart contracts, you may want to investigate the most popular blockchains and the coins that are used, such as Ethereum on the Ethereum blockchain.

There is a certain feeling of safety in numbers, which will lead most investors towards the older, more established cryptocurrencies noted in this article. The more speculatively inclined will look for the next Polka Dot, Dogecoin, or Shiba Inu to purchase hoping for dramatic price appreciation. What goes up can come down, and as Dutch Tulip Mania of the 1630s proved, not all speculation has a happy ending. In the end, cryptocurrencies may be regulated and/or banned to the point that they have little value at all. Many countries have plans to introduce a government backed digital currency following China and India. The US Federal Reserve is also looking into creating digital dollars. This will continue to be a highly fluid space with several moving parts, and sharp moves in price from day to day should be expected. A good rule of thumb is to not invest more than you can afford to lose, no matter which cryptocurrency may peak your interest.