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The World of Bitcoins and Other Cryptocurrencies

Thus far in 2017, cryptocurrencies have become the hot, new investment. At last count, there are 1,205 known cryptocurrencies in existence with a total market cap of approximately $172,000,000,000 – slightly larger than PepsiCo and slightly smaller than General Electric. The five most popular currencies – Bitcoin, Ethereum, Bitcoin Cash, Ripple, and Litecoin – make up just over 80% of the total cryptocurrency market. Still less than a decade old, Bitcoin is on of the oldest cryptocurrencies available. Investors who bought one Bitcoin for $10 or less in 2012 or earlier have seen the price accelerate to over $5,000 as of October 2017. The future of these cryptocurrencies (aka digital currencies) is highly uncertain; however, we don’t believe we can completely ignore them, either. As a recent Barron’s article stated, whether these currencies have staying power or not, the technology behind them, known as “blockchain,” is likely to change financial markets in the coming years in avenues other than digital currencies. Read on for an introduction to the world of digital currencies, an illustration of some of the risks, and a perspective on whether it is an investment opportunity.

Wallet and Key

How A Blockchain WorksCryptocurrencies were created to be used like any other currency such as the dollar or euro, but stored digitally. The creation and transfer of these currencies are based on an open source encryption network that is completely independent of any central authority.

The currencies can be bought and sold using a currency exchange and stored in a digital wallet – no physical tokens exist. All transactions that have ever happened with Bitcoins or other currencies are stored in one long, giant digital ledger called the blockchain which is kept and validated simultaneously by a network of computers. Computers on the network are often referred to as “miners” that are racing to verify the block of transactions in the hopes of earning new Bitcoins as reward. This process can be loosely compared to having a shared Excel document that no one person can change without the verification by others. In reality, these miners are mostly Chinese-owned computer programs that are verifying transactions, not individuals like us. Today transactions are started, completed, and verified within 10-20 minutes (beating credit cards by days), but in the future, the goal is to complete/verify within seconds. Each Bitcoin owner then has a “key” to access their money. The keys (strings of characters) are used to verify transactions and validate them in a block.


Possible Risks

While not an exhaustive list, here are some of the risks that exist within the Bitcoin/digital currency world today:

  1. Regulatory risk could come in a few forms

    • Cryptocurrencies could be considered as not legal tender, and their value could go to essentially zero.
    • Investment taxes could be modified to higher rates to discourage use. This would also decrease the value of a Bitcoin and other digital currencies.
    • It is too early for governments to settle on what type of asset it is and how to treat it. For now, the U.S. government has encouraged central bankers to study it. In September, China’s government implemented a trading ban on cryptocurrencies on exchanges.
  2. Volatility

    • As a very young asset, there is very much to be learned about how digital currencies will react in different scenarios. Additionally, Bitcoin and others have been very volatile assets (five times more volatile than the S&P 500 as measured by the daily standard deviation since 2012) for the duration of their short history.
  3. Large-Scale Cyber Attacks

    • Since Bitcoin’s inception, approximately one-third of its exchanges have been hacked. Others could be susceptible to similar cyber attacks.
  4. Digital Wallet Storage

    • The currencies are stored in a digital wallet in the cloud or on your computer’s hard drive. As mentioned above, the cloud could be hacked. If stored on a hard drive, there is the risk of a computer virus destroying them, accidental deletion by the user, or even theft.
  5. “Altcoin” Risk

    • Perhaps in the future, one cryptocurrency will prove superior and become the leading currency/investment option. This dominant currency could be Bitcoin, Ethereum, Ripple, or any other cryptocurrency (potentially not even in existence at the present), and all other cryptocurrencies could become essentially worthless.
  6. Greater Fool Theory

    • Warren Buffett claims an investment in gold is based on finding a greater fool to buy it from you for a higher price at a later date because there are no cash flows to the investor between the initial purchase and the sale of the asset. This theory applies to cryptocurrencies as well.

An Investment Opportunity?

Bitcoin and other cryptocurrencies have only gained traction due to their potential opportunities. Many look to move away from cash toward a more efficient, electronic payment. Others would like to handle their money without utilizing the current banking system. And somewhat sensibly, citizens of countries with economies that have fallen on hard times buy cryptocurrencies as an alternative method to maintain the value of their assets.

Clearly, there are many risks to owning Bitcoin or any other cryptocurrency, but it is also true that there is potential for reward. It may be something you have interest in testing for yourself; however, at this time we consider it more of a gamble than a long-term investment opportunity. Other than the supply and demand effects on price, there are no fundamental earnings or coupon income expected similar to what one would look for in stocks and bonds. Furthermore, for the time being, there is no tie to inflation which other investments might provide as an attractive characteristic. Lastly, there is no history of evidence that these are a prudent investment for a long-term investment portfolio.

Source: itBit, NASDAQ, Business Insider, Coin Market Cap, Barron’s

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