There’s been much discussion in the past several years regarding cryptocurrency. Pundits, speculators and investors seem to have opinions on whether cryptocurrencies are indeed valuable or not. If you feel like the whole idea of cryptocurrency is hard to understand, you are not alone. First, there is the technology aspect – blockchain, hash, mining, digital wallet, cold storage, etc. Then, there is the seemingly endless number of cryptocurrencies themselves. Some of the common questions: Why are there so many cryptocurrencies? What makes them valuable? Which one should I invest in?
I’m not going to focus on the infrastructure and technology that supports cryptocurrency; I’ll leave that topic for another day.
As to why there are so many cryptocurrencies, it is important to know the different uses. In the parlance of cryptocurrency, this is referred to as the “use case.” There are three main use cases: 1. Store of value or currency. 2. Transacting between fiat currency and cryptocurrency. 3. Facilitating transactions on a particular blockchain.
The cryptocurrency everyone is familiar with, bitcoin, is a great example of the “store of value” or “currency” use cases. Bitcoin, in essence, is digital money. You can save it, like gold or silver, hoping it will be of more value in the future (store of value), or you can spend it at the local Starbucks on a coffee (currency). To be used widely as currency, bitcoin needs to be more stable. It is hard for merchants to price goods and services in bitcoin, as the value fluctuates wildly day-to-day. Due to this, widespread adoption from merchants remains relatively low, with estimates of 19%-33% of businesses accepting cryptocurrency. This has led to most people holding on to bitcoin, anticipating future price increases. The stability in value will most likely come from widespread adoption and usage as a type of money to transact, but widespread adoption will most likely come from stability. It’s a real “chicken or egg” conundrum. A recent crack in the store of value case emerged when Russia invaded Ukraine. Safe-haven assets like gold and silver rose in value, while the prices of cryptocurrencies declined.
Stablecoins are designed to be stable. Tether is the cryptocurrency most associated with stablecoins. Tether has various versions – one “tethered” to the U.S. dollar and another to the price of gold. The main use case for these cryptocurrencies is to purchase other cryptocurrencies. Typically, an investor in cryptocurrency will buy a stablecoin, then hold the stablecoin to purchase one of the more volatile currencies, like bitcoin. Due to the stable nature of these coins, there is a belief that these coins could potentially be used instead of fiat currency.
Stablecoins are also being looked at very carefully from U.S. regulators. There is concern that stablecoins could lead to a financial crisis if there is a run on the coins. Regulators are checking to make sure that the coins are indeed backed by the amount of gold or fiat currency they claim to be backed by. An interesting point here is that if a cryptocurrency is simply backed by fiat currency, why have the cryptocurrency at all? Users will point to the ease of transferring cryptocurrency quickly with minimal fees.
The final case is cryptocurrency use on a particular blockchain. Ethereum is most associated with this use case. The easiest explanation is to think about a casino, where you exchange your cash for chips. You then use the chips to play the casino games. With this cryptocurrency, you convert your cash to ethereum (the chips) to use on the ethereum network (the casino). The popularity of these cryptocurrencies depends largely on the popularity of the blockchain or network underpinning it. If no one does transactions using smart contracts on ethereum’s network, the cryptocurrency has no value.
There is a certain feeling of safety in numbers, which will lead most investors toward more established cryptocurrencies. The more speculatively inclined will look to purchase the next dogecoin, polka dot or shiba inu cryptocurrencies, hoping for dramatic price appreciation. Just remember, what goes up can come down.
In the end, cryptocurrencies may be regulated and/or banned to the point that they have little value. Many countries have plans to introduce a government-backed digital currency, following China and India. The U.S. Federal Reserve is also looking into creating digital dollars. This will continue to be a highly fluid space with several moving parts, and sharp price changes should be expected.
A good rule of thumb is to not invest more than you can afford to lose, no matter which cryptocurrency may pique your interest.
Jason Flores is a senior vice president and senior portfolio manager at Central Trust Co. He can be reached at firstname.lastname@example.org.
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