It seems you can’t go anywhere in the investment community without hearing something relating to blockchain or cryptocurrencies. A certain frenzied nature has taken over the discourse by both backers and detractors of digital assets. Yet, price movement alone is no reason to spend time understanding a potential investment; there has to be a fundamental opportunity. In this Market Update, we’ll introduce the concept of cryptocurrencies and their defining characteristics.
What is a cryptocurrency?
The term “cryptocurrency” describes many different digital assets, to include Bitcoin, Ethereum, Litecoin, and Ripple, among others. Cryptocurrencies use blockchain technology and a decentralized transaction accounting and verification network. We’ll now examine each of these characteristics.
Blockchain technology: Blockchain technology describes how cryptocurrency transactions are recorded. Essentially, every transaction on a blockchain is recorded as a “block”, verified by other users of the transaction network and affixed to the end of the chain as a permanent record. As additional transactions occur on the blockchain, these blocks are added to the end of the latest transaction record, creating an ever-longer record of historical transactions. This method of transaction accounting was created to move the record-keeping function of ownership away from the banking system toward a decentralized network. This record-keeping method is facilitated by the requirement that all transactions are 100% transparent to all participants in the network. A final critical feature of blockchain record-keeping is the concept of immutability. Once a transaction has been affirmed by the network and added to the blockchain, it is no longer able to be altered.
Decentralized network / distributed ledger: Blockchain’s unique system of accounting and verification is another key feature of cryptocurrency. The only way that a transaction is affirmed and added to the blockchain is through a network of authorized participants. A group of authorized participants must agree on a transaction’s validity. This feature is different from the traditional method of transaction verification currently utilized in the banking system, where a financial institution validates digital transactions in conjunction with the US Federal Reserve system. This decentralized feature removes the influence of any central bank.
All cryptocurrencies that utilize a blockchain have a cryptographic mechanism as part of their security protocol. This mechanism ensures that owners of cryptocurrencies do not spend the currency more than once. Transactions are verified by miners, who are compensated for verification with newly minted currency. In order for an authorized participant to engage in the validation of transactions and coin creation (a.k.a mining), they must possess the computer processing power to solve increasingly difficult mathematical equations. This feature helps preserve network integrity (via barriers to entry and quality of work) and also promotes a secure environment that is unmatched by existing security software architectures.
Differentiating characteristics among all the various cryptocurrencies would be too numerous to name, yet all claim to offer unique value propositions. Some examples include transaction processing speed, smart contracts, digital store of value, improved governance, etc. These unique value propositions are part of what drives differential values between digital assets.
The Investment Case For Digital Assets
Since its inception in 2009, Bitcoin has been a controversial topic in investment circles. The primary reasons relate to its intangibility (the concept of a digital asset can be difficult to grasp) and untested nature of the technology given its limited existence. Further, stories of Bitcoin theft and its proliferation in organized crime circles help account for why many in the investment community have viewed digital currencies skeptically.
Yet, now that the technology and digital assets have matured, the investment case for Bitcoin (among others) is transitioning from obscure and uninvestable to mainstream and speculative.
For investors with a high tolerance for risk (and associated volatility), an investment in a digital asset could be appropriate using a modest amount of one’s liquid assets. What follows are a few reasons digital assets would be appropriate for a “highly speculative” risk bucket:
- By many measures, blockchain and cryptocurrency are technologies still in their infancy. Though widespread adoption remains on the horizon, adoption could rapidly increase, especially in light of the myriad positive business/municipal applications. Here is an abbreviated list of ways blockchain technology could be positively transformative:
- (i) Real estate records: In countries where land records are unreliable (due to corruption) or non-existent (Greece), transparency via the blockchain could have a major impact. A 2015 Economist article describes this benefit. Not only would uncertainty around ownership and frivolous legal expenses disappear, but it would give governments the ability to levy taxes in a fair and consistent way.
- (ii) Campaign finance records: During every major political contest in the United States, invariably the discussion turns to campaign finance reform. A key first step in reforming this critical function of our democracy would be to bring transparency to the campaign finance system using a blockchain registry. A blockchain-based currency would provide complete transparency, requiring all sources (or “wallets”) to be documented. If everyone knew where the money is coming from, reforming campaign finance would be much easier.
- (iii) Remittance transfers: This utility of Bitcoin has already been recognized by those sending money to relatives in other countries. With the cost of transfers using Bitcoin at a fraction of what it would be using established services like Western Union, the appeal for both sender and recipient is undeniable.
- Venture capital firms and operating companies (e.g., IBM, Google, Bank of America) are spending large amounts of capital to advance blockchain technology initiatives. It’s too early to tell whether too much capital is being allocated to this technology, but very legitimate corporate investors believe the risk/reward justifies the capital spent.
- Prominent business leaders who once opposed any involvement in cryptocurrency are now tacitly endorsing its application. You may recall that in mid-2017 the CEO of J.P. Morgan (Jamie Dimon) noted that Bitcoin was a “fraud” and that it “won’t end well” for those who recently purchased the digital currency. Fast forward to 2018, and Dimon now “regrets” the comments he made and finds the underlying blockchain technology valid. Incidentally, J.P. Morgan is now a market maker for Bitcoin trading.
- Digital assets no longer appear to have the speculative fever of 2017 baked into prices. Price movement in 2017 could be characterized as parabolic, leaving Bitcoin and other digital assets vulnerable to a shift in sentiment. 2018 has seen a significant (~60%) fall in the value of Bitcoin, making for a much better initiation point for an investment.
In summary, cryptocurrency and blockchain technology are interrelated yet unique concepts. On the one hand, blockchain technology presents a new way to track and account for property in the digital age. There is no single investment in blockchain, and typically the only way to secure access to investments in blockchain is through either venture capital allocations or operating companies. On the other hand, cryptocurrency is a digital currency with an associated value attached to each coin. The creators of Bitcoin (or any digital currency) designed the currency using blockchain technology. Just like any other currency, Bitcoin can be purchased via a currency broker for relatively little cost. (Note, neither Charles Schwab nor TD Ameritrade are able to facilitate transactions in Bitcoin given they are not foreign currency brokers.) For those investors with an extremely long time horizon and tolerance for price volatility, Bitcoin could be considered a rare portfolio diversifier at a much better initiation price.
 Wallet is the cryptocurrency equivalent to an account where securities are held. All wallets are visible to Bitcoin network participants, yet ownership is anonymous.
Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of July 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell, or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.