Cryptocurrencies are the youngest, most volatile and perhaps the most interesting asset class. The first one - Bitcoin - was created by persons unknown (alias: “Satoshi Nakamoto”) in October 2008 on the heels of the global financial crisis and became operational in January 2009. Its goal was an open source "Peer-to-Peer Electronic Cash System” with no banks serving as middle men. This decentralization was made possible by a technological innovation called blockchain, which is essentially a public ledger that tracks a history of all transactions. These are secured cryptographically and validated by “mining”. Miners join the network if they have the right type of computer and are rewarded with Bitcoins in exchange for their computing power.
Since then many other cryptos have been created for different purposes. The largest of these is Ethereum which was created by Canadian Vitalik Buterin in 2013. Ethereum enables “Smart Contracts” or distributed applications to run on its network. Developers can build all sorts of apps meaning the value of Ethereum is not just as a cryptocurrency itself, but the value of its network which supports hundreds of other crypto tokens.
Most other cryptos are referred to as “alt coins”. Some of these are well established such as Bitcoin Cash, Litecoin, Dogecoin, Dash and Monero; while others are quite new. Overall, the entire ecosystem is young and its hard to predict the extent cryptos will be used in the future. Given their decentralization, low barriers to entry and the growth of computing power globally, its possible that crypto based services could form the basis of a “Web 3.0”. Breaking Finance says the future is always unknown.
Source: www.coinmarketcap.com
Unique Aspects of the Crypto Currency World
Crypto Wallets: Store the public & private keys of your crypto address and enable you to send, receive and use the crypto. The private key (or seed phrase) needs to be kept secure and hidden as that’s what enables you to send crypto to other addresses. The public key address can be shared with anyone as it only enables others to send crypto to you!
Wallets can be a hardware device or software based, that generate the private keys (using a 12 to 24 word seed phrase) and then stores them on the medium its designed to operate on (or in a paper wallet). Every crypto has its own native wallet you can download along with their blockchain, but the most popular general wallets include Exodus (software based) and Trezor (hardware based - more secure).
A Password Protects Your Account and Offers Easy Access:
Seed Phrase Can Recover Your Private Keys If You Lose Your Password:
Your Public Address Can Be Shared, Enables You To Receive Crypto:
Send Bitcoin (BTC) to: bc1qpg4nykadhdjyy5uwpllnp60vypjeryrllmvkl2
Here is a Bitcoin Wallet Running on a PC:
Here is a Software Wallet (Exodus) Holding Multiple Cryptos:
Crypto Currency Exchanges: Connect millions of people, their bank accounts and the crypto world. They match buyers with sellers and enable you to easily trade and control your crypto currencies. Coinbase, CoinSquare, Kraken, Bitbuy and Binance are some of the largest exchanges. While they try to be as secure as possible, unlike downloading a blockchain and controlling your private keys (which is very secure), crypto exchanges are companies with hundreds of people trying to make crypto accessible to all. Like any human based organization security breaches are possible, so a best practice is to keep some of your cryptos “off exchange”.
Initial Coin Offerings (ICOs): Companies making a product (usually within the crypto ecosystem), can chose to raise funds by offering a crypto sale to the public, these will often have a “pre-mined” supply controlled by the company. Note: This is NOT similar to open source networks like Bitcoin that anyone can join or copy and there is no organization that controls supply. As individuals buy into the crypto its value will go up enabling the insiders to sell their pre-mined coins for other cryptos or cash. They should then use these funds to develop their products. While some very exciting companies have come out of ICOs (like Filecoin), many others have been “pump & dump” scams in which the insiders sell out never fulfilling the development goals. When this happens the value of the new crypto often becomes worthless. Buyer Beware.
The 4 Ways to Invest In or Acquire Cryptocurrencies
Ella Exchanger: Ella wants to buy cryptos and be able to trade them, make payments with them or send them to off exchange wallets. She sets up an account at a crypto exchange and connects it to her bank account. She deposits her dollars so she can buy any of the exchange’s listed cryptos. Once she has some cryptos she can hold them, trade them for dollars, trade them for other cryptos or send them to her own (or other people's) wallets off exchange.
Manny Miner: He has some technical know how and can build computers for mining or effectively allocate his own PC for mining. In exchange for his computing resources he gets paid in crypto directly. Manny’s investment is therefore not in the crypto currencies themselves but in how much money he spends on the mining computer along with the cost of electricity. The more valuable the cryptos he mines, the more profitable mining will be. The cryptos get deposited into Manny’s wallet of choice. From there he can exchange the cryptos he mined into other cryptos, cash, or use them for payments.
Brandy Barter: Brandy sells items for crypto or choses to be paid for her work in crypto. Those that she transacts with can send their crypto directly into Brandy’s personal wallets or crypto exchange account. From there Brandy can use them to pay for things she wants, trade the cryptos into other cryptos or for cash.
Eaton Exposure: Eaton uses ETFs, futures, funds or other investments to gain exposure to the price of Bitcoin or other cryptos, but never owns crypto directly. While the value of his holdings will rise & fall with the prices of the cryptos his funds invest in, he will never be able to control the cryptos, send them to personal wallets, make payments with them or trade them for other cryptos. All Eaton can accomplish is getting his portfolio some diversification into this new asset class.
The Risks of Cryptocurrencies
- Volatility: Crypto currencies are extremely volatile. Prices can rise and fall rapidly. If you are uncomfortable with seeing an investment potentially fall 30+% in a single day, then minimize or avoid investing in crypto. If you can tune out the short term swings and hold for the long term you might be better suited for crypto.
- Loss of or Stolen Private Keys: If you lose your private keys (forget the pass phrase, the password of the device that holds them, or lose where you wrote them down) you will lose access to those wallets. If your personal computer is hacked, or your home is robbed and they mange to find your private keys they will have control over your funds. Mitigate these risks by having good security, not advertising your crypto holdings to others, storing your private keys off your computer, and having backups of keys plus multiple wallets.
- Hacking of the Exchange You Use: Exchanges attempt to securely store as much of the deposited crypto as possible into “cold storage” (offline), the rest is in “how wallets” (online) for easy access to customers. It is possible that a crypto exchange could suffer a hack that manages to steal some of the crypto stored. Mitigate this risk by utilizing larger or multiple exchanges and storing cryptos in your own wallet.
- Fraudulent Coins: Some ICO offerings of cryptos will be frauds. The insiders are hoping the price of their token rises so they can “cash out”. Spotting fraud can be extremely difficult, but generally if it’s a closed project (insiders control the supply of coins), they promise massive capabilities, use celebrities to promote the coin, have a small inexperienced team, are located in low regulation countries and don’t yet have a basic working product its probably best to avoid them.
- Technological Obsolescence: Given how young the ecosystem is, it is possible that the most useful crypto that will spur rapid global adoption has not yet been created. Its possible that millions of current users (along with net new users) move on to the new crypto. Similar to how millions of users moved from Yahoo! to Google in the late 1990s. While this would negatively impact the price of some cryptos in the short term, in the long term those who already have crypto will be in the best position to be early adopters of the new paradigm and the overall value of the crypto ecosystem will only increase under this scenario. The key is to be diversified across multiple major cryptos and have an open mind about new ones that millions of people are adopting.
- Government Bans: This is a unique risk as it is external to crypto community itself. We should expect that as crypto goes more mainstream, governments will more effectively regulate the space. Good regulations will help protect investors/users of cryptos and actually spur more widespread adoption. However, some governments (likely less democratic ones) will see crypto as a threat to their ability to control their own currency as well as keep money from leaving their country, and will seek to ban their use or buying/selling. If these bans take place its possible that it limits the number of people that can be part of the crypto ecosystem thus reducing its value globally. In the long term, its highly unlikely that such actions will be successful (for example, iPhones are banned in North Korea, but Apple is still valuable globally) since we live in a hyper connected world and technology is only advancing.
The Benefits of Cryptocurrencies
If you have read this far, you might be thinking that crypto sounds risky or complex, why would anyone use it? Well consider the points below:
- Use as Currency: Since blockchain ensures address values are correct, prevents double spending, is divisible, is transferable and has fixed or semi-limited supply cryptos have been successful as currencies. They fulfil the basic properties of both serving as a medium of exchange and as a store of value across time. Some of the top cryptos are already used by millions worldwide and accepted as payment for goods by hundreds of thousands of merchants. Note: Some people argue that cryptos are "just made up" or "backed by nothing" which of course is not true. Cryptos are backed by the power of mathematics, cryptography and computer science. A unit of crypto represents a unit of real computing power and the millions of people on the networks give it a real value. Compared to fiat currencies ($,€, etc.) which only have value because governments enforce their use for payments of taxes, cryptos are far more "real". Finally, even compared to gold which is physically real with a limited supply, it was never designed as a payment system. Instead, it just has a long history of use as a store of value because humans seem to like it more than copper, lumber, or other commodities as a store of value. In the end that's also pretty arbitrary.
- Diversification: Crypto is a young asset class not tied to any specific company, economy or government. Due to this its value is somewhat independent from the values of traditional assets (currency, stocks, real estate etc.). Whenever value is independent from other assets, adding it to your portfolio helps to diversify it. Meaning if your stocks are down but cryptos are up, on the whole your portfolio will be more stable.
- Security and Privacy: Blockchain is highly secure and it is extremely difficult to gain access to your funds unless you or your computers are directly compromised. Cryptos are also not tied to your real world identity and some (like Monero) prevent transactions from being viewed on the blockchain further increasing privacy.
- Low Transaction Costs: Crypto to crypto transactions are often very low cost, and enable value to be transferred to anyone anywhere in the world. Especially when compared to international money transfers, cryptos are over 90-99.9% less costly.
- Protection from Seizure, Inflation, Censorship: In countries where property rights are not respected crypto can be a safe haven since bank accounts can be frozen and property seized. Areas with high inflation also tend to use crypto as both a store of value and a medium of exchange (such as in Venezuela). Finally, since they are decentralized they are highly resistant to censorship of all kinds.
- Source of Passive Income: By mining, staking or loaning out cryptos for interest in crypto you can earn passive crypto based income.
- Crypto Based Services: Crypto companies offer many services beyond payments. These include social media (like Steem and BAT), cloud storage (like Filecoin, Siacoin, Storj), games, apps, decentralized governance and so much more.
Crypto in A Portfolio
Beyond diversification, as part of an investment portfolio crypto offers an asymmetric long term return profile, since many cryptos are still “cheap” the most one could lose is what they invest, but if wide global adoption takes place there is potential for cryptos to rise in value 10 to 100+ times over the next decade. This means that if one invests 1% of their net worth, in 10 years the worst that could happen is they are 1% poorer. But if it increases by 100 times, then they have doubled their total net worth! That’s an asymmetric return profile, a lot of upside potential with downside limited to what is invested.
As our previous posts cover, diversification is critical, crypto should be a small part of an overall portfolio (holding currencies, stocks, ETFs, bonds, Real Estate etc.) and no one should invest more than they can afford to lose. It's also best to invest in several cryptos that you believe in, since putting it all into one is no wiser than putting all your money on one stock. Cryptos can be tracked in our wholistic Investment Tool.
The crypto ecosystem is an exciting wild west of both tech & investing. Best of luck!