Making Sense of Crypto
You've heard of Bitcoin but do you have any idea what it really is?
Since Bitcoin was first introduced in 2009, cryptocurrency (crypto) has been on a wild rollercoaster of ups and downs. Mostly recently, with the election of President Donald Trump – who is an advocate of crypto – Bitcoin has soared to new heights. However, this does not mean that in the past crypto hasn’t experienced some pitfalls. Take, for example, the FTX scandal of 2022, which majorly impacted consumer confidence in the crypto market.
Regardless of Bitcoin’s position in the market, it is crucial as an investor to understand what crypto is and if it is right for you to diversify your portfolio. By taking a few minutes to read this article, you’ll be able to learn about the beginnings of Bitcoin, the components of cryptocurrency, and the risks associated with investing – arming you with the basics you need to begin to evaluate if it has a place in your portfolio’s allocation.
Introduction
One of the first cryptocurrencies was?Bitcoin, which was first released as open-source software in 2009. As of June 2023, there were more than 25,000?other cryptocurrencies?in the marketplace, of which more than 40 had a?market capitalization?exceeding $1?billion.
Some consider it a pyramid scheme, while others believe it is the currency of the future. Questions like, “Is it an actual asset class?”, “Is it right for your portfolio?”, “How does an investor buy it?”, and “Is it safe?” are common amongst investors.
Although I do not have special certifications around cryptocurrency, as a financial advisor, it is my job to provide information to my clients regarding financial matters that impact their lives. The goal of this article is to help answer basic questions regarding crypto so readers have a foundation on which to continue to evaluate if crypto is right for their portfolio.
To begin, let’s go over the basics of cryptocurrency, starting with understanding the technology on which crypto is built.
Blockchain
Cryptocurrency uses a technology called blockchain. According to Investopedia, “A blockchain is a?decentralized,?distributed, and often public, digital ledger consisting of records called?blocks?that are used to record transactions across many computers so that any involved block cannot be altered retroactively, without the alteration of all subsequent blocks. This allows the participants to verify and audit transactions independently and relatively inexpensively.”
Picture this: you and your friends decide to keep track of who owes money after brunch every weekend. Rather than one person keeping a notebook, you all share a notebook where each transaction is written down, and everyone has their own copy. If one person tries to change something in their individual copy, it won’t match the copies that everyone else has, meaning that the change would get rejected. This is sort of how blockchain works – using computers to keep shared records safe, accurate, transparent, and difficult to change.
PricewaterhouseCoopers?LLC states, “blockchain technology has the potential to generate an annual business value of more than $3 trillion by 2030.” This real-life technology is extremely useful, and it is experiencing rapid mainstream adoption.
Digital Assets
The IRS broadly defines digital assets as “…any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.”
Digital assets include (but are not limited to):
Digital assets are technically not real?currency because they are not the?coin and paper money of the United States or a foreign country and are not digitally issued by a government’s central bank – however, this does not mean they don’t have value. Now, let’s take a look at each of these digital assets and some of the advantages associated with each of them.
Cryptocurrency
Crypto is a?digital currency?designed to work as a?medium of exchange?through a?computer network?that is not reliant on any central authority, such as a?government?or?bank, to uphold or maintain it. Simply put, cryptocurrencies are a type of digital currency that facilitate people making payments through an online system directly to each other.
Bitcoin – designed as a decentralized alternative to traditional currencies for secure, peer-to-peer transactions without intermediaries – is one of the oldest and most prolific examples of crypto. However, many types of crypto exist that are used for various functions, and knowing what a particular cryptocurrency is designed to do is crucial as an investor in order to make informed decisions with your portfolio.
Convertible?Virtual Currency
Another type of digital asset is convertible virtual currency, which has an equivalent value in real currency, or acts as a substitute for real currency. These are different from non-convertible virtual currencies, like loyalty points or in-game coins in an app, which are confined to specific platforms and cannot be exchanged for real-world currency.
Ethereum and Tether are examples of convertible virtual currencies that can be used as payment for goods and services, digitally traded between users, and exchanged for or into real currencies or digital assets. Essentially, think of convertible virtual currencies as a bridge between the digital and real-world economies.
Stablecoins
Investopedia defines stablecoins as, “...cryptocurrencies?whose value is?pegged, or tied, to that of another currency, commodity, or financial instrument.” They were invented to help to solve the issue of price volatility that crypto experiences. Several examples of stablecoins are pegged to Fiat currency (e.g., USD, EUR) and commodities (e.g., gold).
Stablecoins are useful for a few reasons. They are much more stable than cryptocurrencies like Bitcoin, making them ideal for transactions and savings, as well as for cross-border payments. Stablecoins can also serve as a bridge to traditional finance, acting as a middle ground for converting between traditional currency and crypto.
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Non-Fungible Tokens (NFTs)
According to Investopedia, non-fungible tokens (NFTs) are defined as assets that have been tokenized via a blockchain. Tokens are unique identification codes created from metadata via an encryption function. These tokens are then stored on a blockchain, while the assets themselves are stored in other places. The connection between the token and the asset is what makes them unique.
Essentially, NFTs are unique digital assets that represent ownership of a specific item or piece of content – think artwork, music, videos, or even virtual real estate. Let’s think about this in practice. Imagine owning a digital version of the Mona Lisa. Although others can view and download your image, you personally own the original verified version, which is also recorded on the blockchain. This helps to increase the value of the asset, makes it impossible to duplicate, and allows owners to resell their NFTs to make a profit.
Risks
As with any type of investment, crypto carries a certain level of risk. Engaging in activities such as buying, selling, or holding cryptocurrencies is highly speculative and involves significant uncertainty. Investors should be prepared for the possibility of substantial losses, including the total loss of their investment.
While crypto holds advantages like cheaper and faster money transfers, there are also disadvantages – such as price volatility, high energy consumption for mining activities, and use in criminal activities. In recent years, price volatility and high energy usage continue to be a prominent challenge, with criminal activity diminishing with less anonymity surrounding crypto.
Let’s explore some of the main risks associated with crypto.
Cryptocurrencies as a whole are a young and emerging market and unlike traditional stock markets, crypto is 24/7. Many trading programs run nonstop, surveying the network for recognizable patterns. When these occur, it can create a cascade effect as many of the algorithms use similar criteria to predict future price movements.
Government bodies around the world are examining how to revise their tax laws and guidance to address different crypto activities. This means the legal landscape can change quickly, and there can be uncertainty as to how new or existing tax laws apply to various crypto activities.
When sending cryptocurrencies, you need to input a receiving address. These come in the form of a long string made up of a mix of numbers and letters. Mistakes can be common while typing or even copying and pasting a receiving address. As transactions on the blockchain are irreversible, if you send your funds to the wrong address, there is no way to get them back.
Cryptocurrency holders and users are often targeted by scammers and hackers. It is especially important to be wary of fake websites and phishing emails that pretend to be from reputable sources—no reputable crypto asset issuer or service provider will ask for your private keys or passwords.
Purchasing Digital Assets
Now that we know more about digital assets and the risks associated with them, it’s important to understand how investors can purchase digital assets.
Exchanges - Companies, like Coinbase, provide platforms on which to buy and hold digital assets. It is important to understand the fees associated with trading and transferring digital assets, which typically vary from platform to platform.
Exchange Traded Funds (ETF) - Some forms of crypto can be accessed by buying an ETF. This is easily done in your brokerage account like you’d purchase any other ETF. In January of 2024, Spot Bitcoin ETFs were approved by regulators. These differ from earlier Bitcoin ETFs that invested in Bitcoin futures since spot ETFs hold actual Bitcoin. Spot Etherium ETFs were later approved in June. It’s very possible that other cryptocurrencies could receive similar approval in the future.
Holding Digital Assets
Holding digital assets can be different than what investors are used to. There are generally two types of storage: custodial and non-custodial, and within these types, there are hot and cold wallets for each type.
A custodial wallet is managed by a third party, such as an exchange like Coinbase. Non-custodial wallets are those you use to store your keys with no one else involved.
A hot wallet is software that stores your keys and has connections to the internet. These wallets create vulnerability because they generate the?private?and public keys needed to access crypto. While a hot wallet is how most users access and make transactions in Bitcoin, they are vulnerable and can be hacked.
A cold wallet is not connected to the internet; therefore, it holds far less risk of being compromised. These wallets are also called offline wallets or hardware wallets.?Risk here is mostly the risk of losing your keys. It's estimated that about 17% of the Bitcoin that will ever be in circulation has been lost due to forgotten keys.
Conclusion
Cryptocurrency represents a revolutionary shift in how we perceive and manage financial systems, offering both exciting opportunities and significant risks. By understanding the foundational technology behind crypto, as well as how to purchase and store it, investors can better evaluate whether crypto aligns with their financial goals or not.
As with any investment, it’s essential to consider risk management, do your due diligence, and continue your education around the type of asset. Contact your Farther advisor today to help you navigate the dynamic and rapidly evolving world of crypto with confidence.
Disclaimer: Information is provided for informational purposes only and is neither intended to be nor should be construed as legal, accounting, tax, investment, or financial advice. Please consult your attorney, accountant, or tax advisor for the latest and most accurate information. Farther makes no representations or warranties as to the accuracy or timeliness of the information contained herein.