Your humble scribe has fielded a few enquiries recently about the merits, or otherwise, of investing in Cryptocurrencies such as Bitcoin. So it’s timely to demystify this cryptic world.
Cryptocurrency is a digital payment system that doesn’t rely on banks to verify transactions. It’s a peer-to-peer system that can enable anyone anywhere to send and receive payments. Instead of being physical money that is carried around and exchanged in the real world, cryptocurrency payments exist purely as digital entries to an online database that describe specific transactions. When you transfer cryptocurrency funds, the transactions are recorded in a public ledger. You store your cryptocurrency in a digital wallet.
Cryptocurrency got its name because it uses encryption to verify transactions. This means advanced coding is involved in storing and transmitting cryptocurrency data between wallets and to public ledgers. The aim of the encryption is to provide security and safety.
Cryptocurrencies are usually built using blockchain technology. Blockchain describes the way transactions are recorded into “blocks” and time stamped. It’s a fairly complex, technical process, but the result is a digital ledger of cryptocurrency transactions that’s hard for hackers to tamper with. As such it’s a way of creating transactions that are secure and certain, between parties that don’t necessarily trust each other. So, for example, cryptocurrencies could obviate the need for escrow arrangements in international trade. Also, in the case of developing and “emerging” economies, where one often cannot trust the central bank or invest in foreign currencies, the opportunity to stow one’s savings in a digital currency is obviously an inviting one.
So, the potential for cryptocurrencies is very real but are we there yet? Time for a bit of basic monetary theory.
For a currency to be credible it must meet three criteria. It must serve as a means of exchange, a store of value, and a unit of account. At the moment, it is hard to see how a cryptocurrency could meet all three of these conditions all of the time. True, some cryptocurrencies have demonstrated an ability to perform some of these functions some of the time. But the price of Bitcoin, the canonical cryptocurrency, is so volatile that it is almost impossible to imagine it becoming a reliable store of value or means of exchange. Elon Musk recently announced that you could buy a Tesla using Bitcoin and almost immediately afterwards, he announced that the offer was retracted, ostensibly because Bitcoin is not environmentally friendly (Bitcoin servers use the same amount electricity as all of Argentina) but the underlying reason is that he couldn’t set a realistic Bitcoin price. The cost of production of a Tesla is incurred in US dollars and the USD Bitcoin exchange rate varies wildly from second to second.
Furthermore, underlying these three functions is the rather important role of monetary policy. Currency management is a key macroeconomic policymaking tool. Central banks are highly unlikely to surrender this function to some anonymous or amorphous force such as a decentralised ledger, especially one that caps the overall supply of currency, thus guaranteeing perpetual volatility? There are reports that China is developing its own state-controlled cryptocurrency and it would not be surprising to find other countries doing the same thing.
So, are you likely to receive a recommendation to invest in crypto from Harvest? The quick answer is a definitive no! Here are some reasons why.
Whilst Bitcoin is the most famous of the cryptocurrencies, at the time of writing there are over 2000 cryptocurrencies, with more coming online each day. At this early stage of development, it is impossible to predict who the winner(s) might be.
Although they’re called currencies there are very limited opportunities to actually use them as a means of exchange. So, their value at the moment is purely speculative and incredibly volatile. Unlike investing in gold (which we also don’t recommend investing in) there is no underlying asset to support a valuation. This means that investors have to just believe in the concept and hope that at some point, someone else will buy the currency from them at a higher price than they paid. This is a textbook definition of a bubble, and hence we’ve seen both rapid rises and equally rapid falls in valuations as shown in the chart below.
Bitcoin (AUD) 1 Year Movement to 26 June 2021
There is a big difference between speculating (aka gambling) and investing. At Harvest, we only recommend investing in real assets, such as bonds, shares & property that can generate long term cash flows. Less exciting for sure, but a much more reliable and proven way of building wealth.
Speculative bets do, of course, sometimes pay off, and good luck to those who bought Bitcoin early on. But I would offer them the same advice I would offer to a lottery winner. You’re not an investment genius, you got lucky.