High returns, wild volatility and persistent media attention have propelled cryptocurrencies to the front of news cycles. In our view, these are speculative, high-risk investments that require more regulated, quality products before we consider it a robust and investable asset class. Still, we believe long-term investors may benefit from an overview of what they are, the material risks and what’s ahead.
What are cryptocurrencies?
To understand cryptocurrencies, we first must understand the blockchain technology that enables their existence. A blockchain is a decentralized record of all transactions across an open network, secured by cryptography. Blockchains allow users to transact without the need for a trusted central clearing authority. Potential applications of blockchain technology include transfer of funds, trade settlement and voting.
Cryptocurrencies are digital assets (not physical assets like cash) used within blockchain networks to send value, pay for transactions or provide network incentives. Prices generally are driven by supply and demand and cost of production (e.g., the computing power required to mine one bitcoin).
There are currently thousands of cryptocurrencies, which typically share these common traits:
- Connected by a network of computers around the world
- Beyond the control of governments and central banks
- Secured with encryption technology (cryptography) to block counterfeit efforts
- Bought and sold via online coin exchanges rather than traditional, regulated financial exchanges such as the stock market
Investors may own or buy cryptocurrencies for a host of reasons, such as enthusiasm around the potential of blockchain technology to disrupt long-established industries or simply speculative investment (short- or long-term). However, digital assets are young and still forming.
In our view, government regulation is likely to increase over time and could add volatility to an already tumultuous asset class. Regulatory actions aimed at limiting the ability to exchange digital assets or convert them into fiat currency (e.g., U.S. dollars) would likely cause demand to decrease and prices to fall. For example, in May 2021, Chinese authorities ordered a massive crackdown on bitcoin mining activities. According to China government media, more than 90% of China’s bitcoin mining capacity was estimated to be shut down by late June 2021. During this period, the price of bitcoin dropped significantly.
Given these issues, only investors with the highest risk tolerance, willing to lose most — if not all — of their contributions, should consider the space.
What is the origin?
In October 2008, an anonymous computer programmer using the alias “Satoshi Nakamoto” published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” The paper described how individuals could hold and exchange items of value digitally, without the need for a trusted intermediary such as a bank or investment broker.
The bitcoin software was subsequently released in January 2009 and became the first successful application of decentralized blockchain technology. As of July 2021, the number of cryptocurrencies worldwide has grown to over 6,000.
What are the main risks to investors?
- Valuation difficulties. One of the major challenges associated with cryptocurrencies is how to reasonably value them. Cash-producing assets like stocks and bonds have decades of research and time-tested valuation models behind them. Physical commodities like gold or crude oil don’t generate cash but have established pricing models that lean heavily on the supply and demand for these tangible assets. Compared to those traditional asset classes, there’s very little history to aid in determining an underlying value.
- Storage pitfalls. Another key concern in the cryptocurrency space is how to hold and store them safely. This is commonly known as “custody” and is something of which all investors in cryptocurrencies should be conscious.
Ownership is established by controlling a password. If that password is lost or stolen, the cryptocurrency is lost forever. The best practice is to keep a password in “cold storage,” such as offline on a piece of paper in a safe. Storing a password online exposes it to the risk of being hacked.
Some investors rely on specialized cryptocurrency exchanges to custody their digital assets. In this case, the investor trusts the exchange to hold their key and now relies on the exchange’s promise to return their assets.
- Rapid boom and bust cycles. Crypto is a very new development in finance, and we have seen many extreme price swings since the first bitcoin was minted in January 2009. Investors should expect significantly more volatility than the more mature stock and bond markets. Investors in cryptocurrencies must have the discipline to avoid giving into the lure of chasing outsized returns at the top of cycles and the temptation to sell at the bottom of severe downtrends.
What’s ahead for cryptocurrency-based investments?
Currently, several exchange traded funds (ETFs) designed to track the price of bitcoin are going through the registration process with the U.S. Securities and Exchange Commission (SEC). The SEC has until November 2021 to approve or deny the first of these applications.
Products in this area are still developing, and there are key considerations around them, including custody, underlying costs and divergence between market prices and underlying values.
As always, we recommend that you regularly meet with your Ameriprise financial advisor. They will review the asset allocation in your diversified portfolio and can offer personalized recommendations to support your financial goals, time horizon and risk tolerance.