Cryptocurrency and especially Bitcoin, has taken the world by storm in recent years. From being called a technological invention, then a digital asset, and now an investment avenue, it has grown tremendously in the past few years, both in terms of popularity and market capitalization. The internet is saturated with advertisements of crypto exchanges, and people who never invested in anything before (even teenagers), have started trading digital coins. There are certainly some overlooked misconceptions around the so-called asset class.
Bitcoin is often used synonymously with cryptocurrency and blockchain, but all these are different things with their features, brought together for a single purpose of digital currency. Let's understand this first.
What is it, really?
According to Investopedia, "A cryptocurrency is a digital currency that is secured by cryptography, a technology which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers." Such a currency is not supplied by any government and is free of their control.
Taking a top-down view, let us first talk about blockchain. A blockchain is a database that stores collected information in groups or "blocks". When a block is filled, a new linked block is opened and information starts to get stored there, forming a chronological chain. Hence, every block is attached to its previous as well as next block. As a time of information is recorded too, this forms an irreversible timeline of data. This innovation guarantees the fidelity and security of a record of data and generates trust without the need for a trusted third party, thus making it decentralized. Its best use is found as a ledger of transactions and the technology is believed to disrupt the financial services sector.
Cryptocurrencies, on the other hand, are digital currency secured by cryptography, built on blockchain technology. They are a type of secure online payments system, represented by ledger entries into the system, safeguarded by various encryption algorithms. Bitcoin, Ethereum, and Solana are all types of cryptocurrencies. Here is an unbiased view of the advantages and disadvantages of cryptocurrency:
Perhaps the most striking feature of such currencies is that they are not supplied by the government, thus making them free of government manipulation or centralization. Since any of the transactions made will be easily available for reference to anyone who wants to see it, there is no room for privacy, however big or small the transaction value is. Creating such kind of privacy yet transparency makes it an enemy of most governments and reserve banks of the world. Not only it is threatening their power to ultimately overtake respective national currencies, but cryptos also make it impossible for any kind of transactions (especially HNI's) to be hidden.
Though there is continuing debate as to whether Bitcoin and other virtual tokens can be used as a legit currency, here are some companies that accept cryptos as payment for their services:
Most countries are still busy developing a regulatory framework around cryptocurrency and don't accept crypto as a legal tender yet, some of the countries and their crypto status is as follows:
USA: Crypto is recognized as a security, a commodity, currency as well as a property by different regulations present in the country.
Canada: Though treated as a commodity for tax purposes, Canada was one of the first countries to approve a Bitcoin exchange-traded fund.
Japan & Australia: Treated as legal property, although investors have to pay a capital gains tax in Australia. Exchanges are free to operate but have to be registered with the respective regulatory authorities.
China: Banned crypto exchanges and Bitcoin mining
India: Though still undergoing revamp, crypto isn't accepted as legal tender yet and capital gain taxes are levied.
Is it an asset?
The different regulatory environments in various countries question the viability of cryptocurrency as an asset class. There have been endless debates on the strength of cryptocurrency as an asset class and even the best asset managers of the world do not seem to converge on a single opinion. An interesting discussion on this very topic is useful for reference:
Some features derived by combining the insights of various investment experts are:
Price of excitement:
In the words of legendary investor Warren Buffet, "Cryptocurrency is meant to be a currency, it is not an asset that creates value, like a piece of ownership in a company does."
It is difficult to find the intrinsic value of even a share of a listed company, whose detailed information is publicly available, let alone finding the value of a digital currency, whose capabilities we are still unsure about. Its value is based upon the strength of technology it is built on, which is difficult to quantify until completely explored. Since its supply is capped, the price of a coin is derived by forces of demand-supply and many are trading in it just because of the volatility and excitement, not because they understand it. The volatile prices indicate that people are still unsure of its strength and value as an asset class in these early stages.
Store of Value:
Given the direct relationship between risk and reward, many also believe cryptos like Bitcoin to be a store of value, just like gold, with possible protection against inflation. To remind you, the coins haven't lived long enough to be able to prove themselves as a useful hedge. Its utility, however, depends on whether it will be a major medium of exchange.
According to the Bitcoin White paper, the currency was formed to be used as a universal currency, trying to create a more seamless way of online payments system without the interference of a government or financial institution and free from frauds. The aim is to create more value for one coin as the supply is limited, ultimately leading to a fairer and more transparent world. Though sounds like a solution, it is difficult for governments to allow this as it threatens their power as a currency supplier and to protect confidential information. And seldom such a volatile asset can be declared as a medium of exchange/unit of account.
What should an investor do?
Invest in the technology:
The crypto trend has opened our eyes to one of the most potentially disruptive innovations: blockchain. Data is what the internet is made of, and blockchain technologies are revolutionizing the structure of that very thing. Understanding the framework of blockchain technology and its various implications can prove to be fruitful.
Try to understand the various industries and new-age companies that can leverage such innovation and become leaders in their respective fields. Identifying potential multi-baggers that efficiently make use of this can give you a lucrative RoI in the long run.
Since it proposes to be a currency, the most profitable way to deal in it is trading it, just as you would trade a currency. The extremely volatile chart of Bitcoin and other cryptocurrencies provide excellent opportunities to make short-term profits. The price of this move according to people's expectations of its value; and sentiments can be gauged to predict movements of its prices.
The virtual currencies are still in their early stages as an asset class, and therefore allocating a huge amount of your wealth is discouraged.
An approach that is adopted by most money managers is to allocate not more than 5% of your total portfolio value to cryptocurrencies, that too sticking to coins with big market capitalizations like Bitcoin and Ethereum, as they run less of default risk and less volatility relative to other players. The primary reason to invest in this alternative asset class remains diversification, to hedge against inflation, like gold and real estate.
Crypto currency is undeniably one of the most impressive digital assets of today, which are highly speculative and debatable. Some have become overnight millionaires while others have lost fortunes here. Whether you consider it to be a part of your portfolio or not, make sure to do your homework and be aware of the perils before investing, since market risks are just as bold as the returns appear to be.