There’s been an ever-increasing amount of hype around Cryptocurrencies, with many people either curious, clueless or outright keen to cash in. Here we outline some of the basics, as well as put forward the cases for and against investing in this emerging asset class.

What is a Cryptocurrency?

Perhaps the best starting point is to ask “what is money?” Simplistically, “money” is a widely accepted means of payment or exchange, which society invented to move beyond the barter economy. While some commodities have served this purpose (eg gold or silver), most money today is fiat money (government issued and backed currency) whose value is determined by supply and demand and confidence in the issuing government.

Digital money is any money that is not physically tangible. So money exchanged through credit cards, electronic bank accounts, and smart phones is digital money, as opposed to physical cash bank notes. Credit with an online retailer is another common form of digital money. Digital money has created efficiency and convenience of transacting not possible with physical cash money. However, these “traditional” digital money systems rely or various financial institutions and even businesses to manage the processing and accounting for the massive number of transactions, with varying costs, time delays, security risks and global regulations.

Cryptocurrencies (such as the well-known Bitcoin) are a form of digital money that aim to do away with these issues, by decentralising the currency using cryptography and Distributed Ledger Technology (a public ledger, known as a Blockchain). In the case of Bitcoin, all transactions are verified through a massive network of participating computers which host and maintain the blockchain (known as “mining”). As the earliest virtual currency to meet widespread popularity and success, Bitcoin has inspired a host of other cryptocurrencies, such as Ethereum, Litecoin, Polkadot, and Dogecoin.

The case for

The growth of cryptocurrencies as a tradeable asset has seen phenomenal interest in their investment potential. In Australian-dollar terms, one Bitcoin has rocketed from around $5,300 at the start of 2019 to a high of nearly $88,000 in mid-November 2021. So there’s no denying that some massive returns have been achieved in a short space of time, and this is attractive to speculators (both professional and amateur alike) hoping for this to continue into the future. It also appeals to people who feel the underlying blockchain technology will be profitably disruptive, and wish to have a stake.

Others invest in the belief that the volatility (and Bitcoin for example has seen many dramatic rises and falls) can be actively traded, producing profits.

Others still view Cryptos as an alternate asset, and use it as a diversifier or hedge against falls in other financial markets, treating it as a “digital gold”.
New frontiers in the Crypto investment space include Crypto Lending (a type of decentralised finance) as well as Non-fungible Tokens (NFTs – a digital proof-of-ownership of such assets as digital art, music, in-game items and virtual real estate) which has seen incredible speculation and growth.

Where these new developments, and cryptocurrencies generally, take us is yet to be seen, but it’s clear that the global market for these digital assets is increasing rapidly.

The case against

Many caution that every generation has its fads, and Cryptos is the latest. In 2000 it was technology shares. In 1987 it was shares in general, and way back in the seventeenth century investors were going nuts over tulip bulbs. Let’s not forget alpacas and ostriches. Investment fads have come and gone, making fortunes for a few, but big losses for many.

Given this potential, it pays to heed tried and true rules such as only investing in things you really understand, and diversifying investments to reduce risk.

When it comes to investment, fads occur when asset prices are driven up by irrational excitement, greed, and ‘FOMO’ – the fear of missing out. The fundamental rules of valuing an investment fly out the window and speculation dominates trading as hoards get caught up in the frenzy before experiencing a crash.

Apart from the extreme volatility exhibited for cryptos over the last few tears, consider the effects of significant events, such as Elon Musk’s tweets, or more importantly, actual government participation in cryptocurrencies. Another substantial risk in what is essentially an unregulated market is fraud – you’d be surprised how easy it is for the unsuspecting investor to get ripped off, and cryptos is a whole new avenue for scammers. Likewise, the internet abounds with stories of Crypto owners who have forgotten or lost their key, rendering their virtual currency completely lost.

In the case of Crypto lending, where the interest rates are so high, the traditional risk/return equation does raise quite a few red flags around the risk of the borrowers!

Finally, there are concerns being raised regarding the environmental impact of Cryptocurrencies, with the computing resources required being substantial (not to mention the impact on computer chip and graphics card supply).

While it may be difficult to resist the temptation to join in, consider putting money only into investments that you understand; those with values based on a more realistic capability of generating long-term income and/or capital growth. Are you going to invest the time to really know what you’re doing? Can you afford to lose? Question whether you’re really in a position to beat the pros, and avoid a “bursting bubble”. But if you can’t resist the urge to get in on the action, consider a very limited approach or treat it as a gamble!

Published : 24 Jan 2022