Why am I writing this blog?
Everyone is chasing the Bitcoin hype right now. In the past month, Bitcoin has come up in the discussion during coffee breaks, office discussions, and in a training program. It’s hot! There is a buzz in all the social networks – I have multiple Ads on my Facebook daily with a strategy to become a crypto-millionaire. There are live advisors on Facebook (with a considerable fan following) and comic strips floating around all the channels, providing a daily dose of excitement and desperation(?). The following collage sums it up nicely.
Amidst all this, few are on the sidelines and constantly thinking – “Am I missing out on a life-changing opportunity?”. This blog targets this category of people on the sidelines. You are not alone if you are currently splitting your hair with so many buzzwords and feeling a bit left out. Don’t panic. Mr. Simplify it (yours truly!) is here to help.
I will draw a parallel between Cryptocurrencies and other monetary instruments in financial history. I will bring the pieces together to provide you a jump start. For starters, this article will provide the basics to understand the landscape of cryptocurrencies. Some of my readers are experts and have invested in cryptocurrencies already. They will be able to add their experience to this blog. I would welcome and appreciate the same. We are in the very early stage of this innovation, which will be a part of our life for a long time. This article is NOT intended to push you to invest in cryptocurrency. It will educate you to evaluate the same as an alternative asset class.
It’s always the basics! Let me spend some time to take you through the journey.
Why is it so complicated?
The complexity originates from various instruments and players involved in the ecosystem. I have created this simple chart to demonstrate the same. How many of you have really invested in currency trading? Do you understand the accounting/General Ledger? Do you understand Blockchain technology? There are few with answers to these questions. However, there is always a start. Let’s get going.
Cryptocurrency Explained –
The objective of money or currency has remained the same over the ages and will continue to be the same. The physical currency, over the last several decades, is disappearing fast with technology innovation. Every financial instrument is virtual these days e.g., Credit cards, Online banking, Dematerialized stocks, and bonds. Cash in the hands of ordinary Americans accounts for just 11 percent of the monetary measure known as M2a.
Whether technology or otherwise, innovations continue to shape the financial world. The Fiat currency in place of a gold coin had a similar impact when credit cards replaced the cash in the wallet. I have created a chart below to show the evolution of money through the ages. I enjoyed creating the collage!
Cryptocurrencies (Bitcoin, Litecoin, etc.) are the latest financial innovations. Simply put, they are digital currencies and never available in physical form. The digital currency has been in play for a long time. As you can see in the picture above, we have been using digital cash as credit cards since the 1950s. So, what’s new and different with these currencies?
As you can see in the table above, the key differences are the money supply and control. Cryptocurrency is moving the financial world to a new frontier with no intermediary, no government to control, and no geopolitical pressure on the currency. Too good to be true? This is the start of that evolution.
Will there be growing acceptance of all the cryptocurrencies?
The key to any currency is the acceptance of the same by a group. Mankind has used many instruments post the barter days to create a seamless movement of products and services. The governments have always tried to control the monetary system. This has the advantages and disadvantages as in any system. One of the extreme examples is the global financial crisis of 2008, which started with the irresponsible practices of banks. The governments supported(indirectly) by allowing them to lend risky loans and create financial instruments on top of that. The Quantitative Easing that followed the crisis, kept the economy floating, helping the big banks to survive. The Zimbabwe currency crisis is another example of irresponsible government practices to make the currency useless (a 100 Trillion Zimbabwe Dollar note is worth 40 US Cents!).
There is a steady increase in a number of people and merchants adopting bitcoin and the other cryptocurrencies in their daily life. Please find a select list of key merchants in the picture below. The list of merchants has started growing at a faster pace in recent years.
Okay, I want to use cryptocurrency for my transactions – which one should I use, and where should I buy or sell Bitcoin?
The cryptocurrency market has yet to mature; everyone is just trying out this novelty. No one knows for sure which currency will be the dominant player.
The current banking system is also trying to catch up on the blockchain technology to counter cryptocurrencies. These currencies are a threat to the central bankers and banking system. They fear of losing control of money supply/banking system and loss of revenue collected as transaction fees. The initial target for the financial institutions is to provide instant payment (& potentially no transaction fees). The following news clippings provide the latest around these efforts.
The following picture shows the top cryptocurrencies with the market cap. The price and market cap are highly volatile – Bitcoin has fallen to the $12,000+ level within days of receiving this data. (I decided to keep this picture instead of creating another one, which will change tomorrow!)
What’s the intrinsic value of Cryptocurrencies? I see a lot of ICOs with new Digital tokens or currencies every day – should I invest in those tokens?
Cryptocurrency, like fiat currency, does not have any intrinsic value. The price of cryptocurrencies is increasing as people are treating these as technology stocks at this moment. A limited number of currencies are in play, and people expect the demand to grow with increased adoption (& requirement) for the currencies. An analogy can be drawn between Cryptocurrencies and Precious metals in this regard. During 15th and early 16th century, Spain mined and brought tons of silver from South America and dumped into the European market. This resulted in high inflation (the “Price Revolution”) and reduced metal prices. Unlike silver, cryptocurrencies cannot be dumped into the network because of the algorithms in place. However, the plethora of cryptocurrencies will cloud the marketplace and decrease demand, resulting in a lower value for each cryptocurrency.
Before I jump into the ICOs, let me explain the most critical technology enabling Bitcoin and other cryptocurrencies – Blockchain!
“A blockchain is a distributed computing architecture where every network node executes and records the same transactions, which are grouped into blocks. Only one block can be added at a time, and every block contains a mathematical proof that verifies that it follows in sequence from the previous block. In this way, the blockchain’s “distributed database” is kept in consensus across the whole network. Individual user interactions with the ledger (transactions) are secured by strong cryptography. Nodes that maintain and verify the network are incentivized by mathematically enforced economic incentives coded into the protocol.” – Ethereum Github ReadMe.
Simply put, the tasks performed by the centralized transaction database, clearing houses, or SWIFT are replaced with a network of nodes/computers to verify and confirm the transactions!
The Blockchain 101 Infographic from www.ibm.com explains the technology very well. Please see the complete Infographic by clicking the link provided under the References.
There are many flavors of blockchain technology implementations today. Bitcoin Blockchain is focused on building a currency network. There is an open-source blockchain platform, like Ethereum, that has attracted many ambitious projects. A blockchain project or application typically provides a business service free of intermediaries. A new project can design and build its own cryptocurrency/cryptotoken, which is typically used to compensate the developers and administrators of the network. The project tries to attract funding through the Initial Coin Offering or ICO.
Cointelegraph explains this further –
“An ICO is a recently emerged concept of crowdfunding projects in the cryptocurrency and Blockchain industries.
ICO stands for Initial Coin Offering. It’s an event, sometimes referred to as ‘crowdsale’, when a company releases its own cryptocurrency with a purpose of funding. It usually releases a certain number of crypto-tokens and then sells those tokens to its intended audience, most commonly in exchange for Bitcoins, but it can be fiat money as well.
As a result, the company gets the capital to fund the product development and the audience members get their crypto tokens’ shares. Plus, they have complete ownership of these shares.”
The value of these crypto-tokens will increase if the platform attracts more participants and gains popularity. Again, as with IPOs, the stock or crypto token is as good as its underlying business model. More tokens will be needed if the business model is robust, resulting in a higher price.
Some of the top-performing crypto tokens are depicted in the picture below.
My view – Should you consider crypto as an alternative asset in your portfolio?
Diversification of investment is the most crucial aspect of financial planning. Before considering Bitcoin or any Cryptocurrency as an alternative asset, we need to make sure that it is sustainable and liquid for the long term. In my view, there are two categories of assets in the marketplace now – Assets which are growing continuously and Assets which are stagnant. The stocks are growing at a steady pace for last several years. The other category of assets e.g., Gold, Real Estate, and Oil, are stagnant for some time now (please see the chart below).
At this time, cryptocurrency behaves like technology stocks. If(hypothetically!) listed on NASDAQ, they will carry an ultrahigh PE ratio, which means, investors are expecting a very high growth for these currencies. This is like the DOTCOM boom where investors expected every DOTCOM company to grow. During that boom, there were startups to offer every service online – Music, toys, beauty, pets and much more. The ideas were great and still relevant. However, a lot of those went bust because of various reasons (Remember, eToys.com or pets.com?). We are seeing a very similar pattern with blockchain enabled service offerings now. There are many ICOs in the marketplace now for many services of similar nature. From smart contracts to Charity or microfinance, the core ideas behind these are the same.
So, my two cents (Disclaimer – I am not a financial advisor. Please use your judgment before any investment decision):
- Digital or Cryptocurrency is here to stay. So, rather than being on sidelines, start now to get in the game and understand the mechanics. Open an account with Coinbase or any equivalent provider. Get engaged and play safe. Digital currencies are very volatile, so wait for a big drop to buy some. Do not invest all of your hard-earned savings to get the imaginary astronomical growth in a short period.
- Since most of the new blockchain projects / ICOs are built on Etherum, it’s going to grow stronger in future. It’s a good bet to keep invested in Ethereum. The Ethereum smart contract platform has generated interest from IT vendors (E.g., Microsoft) and Financial Institutions.
- Everyone should look at the business model and viability of the project before jumping on to buy a new digital currency(Cryptotoken) through ICO. The history of dotcom bust is repeating in front of our eyes – A lot of these blockchain projects are going to shut down very fast. Like dotcom era, a lot of these projects are either not sustainable or cannot be profitable so fast. So, you need to find the Amazon, Netflix, and Youtube and discard boo.com, ritmoteca.com, and DEN.com(similar yet unsustainable for various reasons).
I have enjoyed reading and learning about this new revolution over the last several months. This is one of the reasons why I got delayed with this blog. There is a lot more to this financial revolution. I would urge all of my knowledgeable readers to send their feedback.
Before I sign off, some bitcoin entertainment for your information below:
References:
- https://www-01.ibm.com/common/ssi/cgi-bin/ssialias?htmlfid=XI912346USEN
- https://cointelegraph.com/
- https://www.ethereum.org/
- https://www.coindesk.com
- Photo Credit: https://pixabay.com/
