A cryptocurrency is a digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of this security feature. A defining feature of a cryptocurrency, and arguably its most endearing allure, is its organic nature; it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation. – Investopedia
Prudent investors only invest in assets that have value. This is why so many heavy hitters in the world of finance, such as Muhammad El-Erian, look at the run up in Bitcoin price with a mix of confusion and disbelief. Bitcoin is the first cryptocurrency. It is the biggest fish (market share of 85%) in a fairly small pond (only $24 Billion in cryptocurrencies). It has no real intrinsic value and only exists as a string of numbers on a blockchain or prior transactions. So why are people drawn to crytocurrencies like Bitcoin and how could a prudent investor justify such a trade?
First, we need to clear up a misconception regarding the value of money. It’s all an illusion! This was best illustrated by an Onion article titled, “U.S. Economy Grinds To Halt As Nation Realizes Money Just A Symbolic, Mutually Shared Illusion” (below). The fact of the matter is that all fiat money, including the US dollar, is only worth as much as people think it is worth. Of course, the dollar is less volatile than Bitcoin and is more widely used. However, there are many less liquid currencies and more volatile currencies that people still use everyday as a store of value and to buy and sell goods and services. Prudent investors in Malaysia and Bulgaria have no qualms with keeping Ringgits and Levs in the bank. Crytocurrencies are no different, in theory, than other currencies in the sense that no modern currency is backed by anything “real”. What gives any currency value is the belief that it will have value tomorrow.
Some have argued that fiat currencies are more real than cryptocurrencies because you can hold them in your hand. However, this distinction is quickly fading. Nearly all of the world’s fiat currencies (i.e. those not backed by gold or some other real asset) are stored digitally rather than as paper currency. Countries like India are pushing hard to reduce the use of large paper currency bills because of the anonymity of paper money. This may actually increase demand for cryptocurrencies which can be traded anonymously; although the use of Bitcoin for anonymity has been somewhat overblown.
What makes crytocurrencies different is the lack of centralized authority. Central banks are generally given the responsibility to maintain the value of fiat currencies. They are given the power to print money and set short term interest rates. This is an important distinction, but it doesn’t make a clear cut case for or against cryptocurrencies. A key reason for the rise in use of cryptocurrencies is, in part, because a small niche of investors prefer the idea of using a currency that cannot be printed at the will of a centralized authority. There have been several occasions where fiat currencies have been abused such as Germany 1921-23.
This may seem like a small matter, one reserved for bunker builders and tin foil hat wearers. After all, major currencies have nearly all been fiat since the United States left the gold standard since 1971, and no major world currency has suffered anything quite like the German mark hyperinflation. Still, the lack of any “real” value for fiat currencies may have had an effect. Sovereign debt is nearing an all time high.
As industrialized countries pile on debt, their central banks buy it up. Japanese and European central banks are printing over $80 Billion a month for this very purpose. This hasn’t resulted in any significant inflation scare yet because the money is being plowed into financial assets instead of goods and services. This has contributed to exceedingly high stock prices, lower interest rates, and higher home prices. There is probably a limit to how high sovereign debt and quantitative easing can go before the growth in printed money spills over into real prices, but it is hard to say if we are anywhere close to that limit.
Prudent investors needs not believe in imminent or even eventual hyperinflation of fiat currencies to invest in crytocurrencies. Another good reason is as a means of exchange. Today you can buy many goods and services using Bitcoin, Etherean, and some other cryptocurrencies. Each day it gets easier.
What has driven the rise in the price of cryptocurrencies like Bitcoin and Ethereum? Like any market it comes down to supply and demand. Until now, investing in crypto was only for the most adamant and extreme supporters. A twitter search for “Bitcoin” reveals a cult like following where owners proclaim the new “currency” as destined for greatness. If their forecasts are to be taken at face value…fiat currencies will eventually cease to exist leaving only cryptocurrencies with their lack of central authority.
Of course, this forecast is unrealistic, but it does explain why the price has been rising. The only people selling Bitcoins are those who believed in Bitcoin enough to buy some in the first place. They may have bought on faith, but after making 500% Return in the past year their faith is now backed by something everyone agrees has value…profits!
Suppose you wish to buy Bitcoin or Ethereum. You run a quick Google search and find an exchange such as GDAX. Once your bank funds are transferred you are presented with the order book. There you can see all the limit orders currently available that are near the current market price. Some orders are small, for only a few fractions of a coin. If you are patient you can set a limit order which then goes to the order book. Limit orders don’t cost anything. However, market orders do cost about 0.25% of the trade. The cost is paid by those who don’t want to risk having the current price move away from them.
So now is the moment you have been waiting for. Are you really going to take your hard earned money and invest it in a serial number worth more than an ounce of gold? Why would any prudent investor do such a thing?
Of course, no one can predict the future. The team at Intuitecon is no exception. That said, we think there is still potential for Ethereum, the second largest cryptocurrency by market capitalization. Here is why:
- The small market is still dominated by retail investors that have a strong belief in the value of Ethereum. This belief is quite robust. Many Ethereum investors were early investors in Bitcoin which survived scandals and cyber-attacks. Some investors lost everything and yet the market recovered. These early struggles bred stronger exchanges more focused on security. It has also battle-hardened investors so they are less likely to panic.
- Growing market of institutional investors; especially if the SEC allows for Bitcoin ETFs. On March 10 the SEC voted no to the first of several decisions regarding whether Bitcoin can be allowed to trade in an ETF. However, many believe that at least one ETF will be allowed. The ease and security of trading on an ETF could make a big difference. Unlike futures, an ETF must actually posses the underlying asset. If institutional investors start buying a Bitcoin ETF, the ETF must purchase Bitcoins on exchanges like GDAX. You can see from the order book that it wouldn’t take much demand to move the price of Bitcoin, and that it is the most liquid cryptocurrency market.
- Growing acceptance of cryptocurrencies as a means of exchange and store of value. There is clearly an upward trend in both the value and interest in cryptocurrencies. The chart below comes from Google Trends.
- Relitively small size compared to Bitcoin gives Ethereum more room to grow. The total market cap of Ethereum is about $2B which is only 10% of the size of Bitcoin.
There are big risks involved in trading cryptocurrencies. Just two months ago the price of Bitcoin dropped 20% in just one hour! In 2014 the price fell from above $1000 to near $200 following the Mt Gox scandal. There is also the risk of having your currency stolen outright without any possibility of recourse. This occured during the Mt Gox scandal but has happened on several other occasions to multiple cryptocurrencies. Even if one invests in a diversified basket of cryptocurrencies (of which there is >100) they could lose everything if they have it all stored on one exchange that fails to adequately protects investor funds.
Of the 100+ #cryptocurrencies most will end up ponzi schemes. Those who get in early are the most profitable. Those who get in late could lose everything. Selling profits is a simple way to limit exposure, but that requires discipline. For example, one could could half their coins every time the price doubles. This works…assuming the price rises the way Bitcoin has, but that is a huge if. There are no guarantees in the Wild West of cryptocurrency and one should only play with amount they are willing to lose completely.
Describing the risks of Bitcoin is really no substitute for the data. Here are the charts that Team Intuitecon put together when writing this article:
Bitcoin Price Drop and Historical High Since June 2015
These charts illustrate a highly volatile price history since June 2015. Ethereum has not been around long so it’s historical price behavior is quite erratic. However, the nature of Ethereum is similar to Bitcoin so understanding Bitcoin helps to understand Ethereum.
The biggest difference between the two right now is that Ethereum is much more volatile. Ethereum has also responded much better to the SEC decision on March 10 to not allow the first Bitcoin ETF. The two were highly correlated leading up to the announcement. After the no decision both prices fell, but are now both up over 25%. That spells resilience.
Cryptocurrencies are growing up and starting to get recognized. If institutional investors take notice they could have a big impact on this small market of only $24 Billion. Skeptics point to the fact that cryptocurrencies have no intrinsic value. However, neither do fiat currencies. The argument that cryptocurrencies are less real because they do not exist in physical form quickly becoming irrelevant as most fiat currency only exists on computers. Real goods and services can be purchased with a growing number of cryptocurrencies. For these reasons a prudent investor could reasonably invest in a cryptocurrency. However, there are tremendous risks include the possibility of a complete loss of capital due to fraud, theft, cyber attacks, or simply a loss of faith (which could occur as a response to a major theft/attack). We don’t believe that cryptocurrencies are (yet) a good alternative to cash because the price is far too volatile. However, cryptocurrencies might be a profitable investment for the right investor.
Feel free to share your own thoughts on cryptocurrencies, Bitcoin and Ether. There is no better compliment you can give us than your thoughtful criticism. You can reach us at firstname.lastname@example.org, or follow us on Twitter @intuitecon
Disclaimer: IntuitEcon Team owns Bitcoin and Ether. These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.