The Wild Crypto West
As a city slicker from Chicago, I feel like I’ve been transported to the Wild West during the gold rush era as I watch the frenzy surrounding bitcoin and other cryptocurrencies. Back then, hundreds of thousands of people flocked to California, believing they could get rich quick by mining that precious metal. Today, lots of investors are hoping to make their fortune in the Wild Crypto West.
What does all the buzz mean?
Perhaps you remember learning about prospectors, claim jumpers and forty-niners in history class. Cryptocurrencies have their own lingo, and before you consider investing, let’s review some definitions.
Cryptocurrency denotes virtual, digital currencies created for secure online transactions made directly between two parties without needing to involve an intermediary, like a bank. Each unit is often called a coin or a token.
The blockchain is the digital ledger or database that permanently stores the crypto transactions in a transparent and verifiable manner, so it is almost impossible to hack. It is decentralized, which means no one person, group, or business controls it. Blockchain technology is currently used primarily for cryptocurrency transactions, but it’s possible that it will be utilized by traditional banking and other industries in the future.
Mining creates new cryptocurrency units by running complex math problems using sophisticated computer hardware. The new units are added to the blockchain and enter circulation. The process is time consuming and requires a large amount of computing power and electricity. These constraints limit the amount of new currency produced.
Bitcoin was the first cryptocurrency, and it is probably the one you hear about the most. However, there are hundreds of digital currencies.
Online wallets store the units of cryptocurrency on a secure website.
How much is my gold nugget worth?
At the time of the gold rush, the US government had an established fixed ratio of gold to the US dollar, which set its value. Gold and silver coins were legal tender for transactions, and miners could exchange their gold at local banks to purchase supplies and housing. The sudden increase of gold into the money supply revitalized the US economy. However, in today’s world, gold is a poor substitute for cash.
Cryptocurrency is designed to act like money, but it does not have any intrinsic value like cash, stocks or bonds. Few places accept it as a form of payment, and it is not backed by a central bank or government.
Unlike bond coupon payments or stock dividends, cryptocurrencies do not provide an income stream or future additional units. Crypto assets do not create or sell goods or services, which means they are not valued based on any future expected revenue or earnings. Their prices are determined only by supply and demand, which creates extreme volatility and real financial losses for some investors.
Who is the sheriff in town?
Small towns in the old west were often self-governing and attractive to outlaws. Federal or state law enforcement was lax due to a lack of manpower and the huge area of the territories. Theft, fraud and corruption were common.
In a similar fashion, the US government has been slow to catch up with regulations as the world of cryptocurrency has boomed. Digital wallets that hold Bitcoin and other cryptocurrency have no FDIC insurance to protect you from failure. Since the whole system is decentralized, there no company or government to turn to for assistance if you experience fraud or theft. Due to the anonymous nature of the blockchain, crypto assets have been linked to money laundering, black market transactions and ransomware attacks.
US Treasury Secretary Janet Yellen and SEC Chairman Gary Gensler have made public remarks about the need for tougher regulations for cryptocurrencies. The current environment lacks transparency and doesn’t do enough to protect investors. Many professional crypto investors welcome clearer regulations because it may help more people feel comfortable investing in this new industry. However, since crypto assets are designed to be decentralized from the government and banks, it will be interesting to see how new laws impact their popularity and use as currency.
Speculation – Boomtown or Ghost Town?
During the gold rush, rumors of newly found gold generated excitement, and new towns sprang up quickly. Hopeful miners rushed in searching for quick riches, and merchants and suppliers followed them. However, if a mine dried up, the nearby town could be abandoned for the next hot spot, leaving people out of money and out of luck.
Cryptocurrencies, including bitcoin, are considered speculative assets due to their price volatility and high risk. Since traditional metrics cannot be used to value them, it is nearly impossible to predict the wild swing in prices. Inexperienced investors caught in a downturn of the market may be left with large losses. However, with all the recent media coverage, crypto assets remain very popular, and many investors fear missing out on a piece of the excitement.
With hundreds of crypto assets to choose from, it can be difficult for a new investor to navigate the choices and determine if they’ll be in a booming hot spot, or if their investment will turn into an abandoned ghost town.
Proceed with caution before venturing into the Wild Crypto West!
Terri Velgara, CFP®
Terri is a Financial Advisor and Director of Financial Planning at Rappaport Reiches Capital Management. She serves as a resource for our firm's advisors in designing plans that empower clients to achieve their personal and financial goals. Please connect with Terri below. She loves to talk about investing, financial planning, and family game nights!