Cryptocurrencies Are Highly Volatile, but Some Say They Are Worth It
For some investors—those with stomachs for volatility—it may be time for a closer look at cryptocurrencies.
By now, most investors have heard of bitcoin, following its phenomenal growth last year. Bitcoin, an electronic currency made by computers creating series of unique numbers through complex math problems, is sold on unregulated exchanges and accepted by a growing number of individuals and businesses because of the speed and low cost of transactions.
One bitcoin was valued at virtually nothing in the early days and now costs around $437, as of Sept. 18. Other crypto coins tend to have less value, but cryptocurrencies in general are drawing increasing interest as potential investments.
CoinDesk, an online publication that tracks digital currencies, estimates by the end of this year there will be eight million bitcoin trading accounts, known as “wallets,” and 100,000 companies that accept bitcoin.
There have been notorious security breaches, including the loss of half a billion dollars worth of bitcoin at Mt. Gox, formerly the largest bitcoin exchange, which filed for bankruptcy protection. But supporters say it’s a misunderstanding to see such cases as a weakness in cryptocurrencies. Campbell R. Harvey, a professor of finance at Duke University in Durham, N.C., says the Mt. Gox loss exposed a lack of security at the exchange itself. “Blaming bitcoin for the Mt. Gox bankruptcy is like blaming the U.S. dollar for the downfall of Lehman Brothers,” he says.
John Normand, head of foreign exchange and international rates strategy at J.P. Morgan Chase & Co. in London, called bitcoin “vastly inferior” to traditional currency in a report earlier this year. “Bitcoin is currency with high return potential but also high volatility and low liquidity,” he said in an interview, advising institutional investors to steer clear. Individuals, however, should decide for themselves, he added, whether the return prospects “justify its illiquidity and volatility,”
Here’s what potential investors should know about cryptocurrencies.
Some Bitcoin Basics
Unlike dollars or any other traditional currencies, bitcoins aren’t printed or backed by a central government. They are created by individuals and businesses using high-powered computers. Creators of bitcoin are allowed to keep some of what they create as payment for the service. The rest is sold on unregulated exchanges.
When you buy a bitcoin, what you get is two strings of numbers called a public key and a private key. For encryption and convenience purposes, the numbers are often expressed as letters and digits. The public key is the number a person must know in order to send you bitcoin. The private key is the number that only you are supposed to know. By “signing” a transaction with your private key, you authorize the movement of all or some of the bitcoin from your virtual wallet into another.
All such bitcoin movements are instantly published in a ledger so that anyone can keep track of the overall money supply. The ledger floats on some version of the Internet cloud as a collaborative document rather than a centrally managed account. Users have adopted this mechanism for shopping, transferring money and speculation.
For users, the perceived value of a cryptocurrency is perhaps best understood as the price of a tool in limited supply. Demand is fueled by parties interested in peer-to-peer forms of payment that don’t involve banks and other intermediaries, making such payments cheaper and faster.
For investors, meanwhile, a cryptocurrency becomes attractive the more popular it proves to be among users. Say bitcoin becomes the most popular way for Filipinos working in the U.S. to send money home. The increase in demand for the relatively scarce strings of numbers will drive up bitcoin’s value, analysts say.
On the other hand, if one cryptocurrency supplants another, or if peer-to-peer finance proves to be a flash in the pan, then a bitcoin will be just another meaningless string of alphanumeric code floating around on the Internet.
Some have argued the opportunity for individual investors in cryptocurrencies has passed, since large hardware is now available for large investors to purchase and mine coins on a much faster, larger scale. “It has become less of a hobby and more of a business for people requiring constant investment and careful attention to margins and costs,” says Hansel Dunlop, a London-based developer and early acquirer of bitcoin.
Other currencies have developed out of the bitcoin technology and have added improvements on that platform, explains Mr. Dunlop. The differences are nuanced, he says.
For example, Litecoin, the second-largest cryptocurrency in terms of market capitalization, offers a more complex problem to solve and is therefore more difficult to “mine,” or create. Others, like Ripple, are not minable but can be acquired at cryptocurrency exchanges.
To Some, Companies Are Key
Investors don’t have to mine coins or speculate on the exchanges to make money in cryptocurrencies. Some observers recommend investing in companies that use or service cryptocurrency and other peer-to-peer payment forms.
These include companies that process payments, including Colored Coins or Ripple Labs Inc., with open-source protocols that allow users to trade anything of value instantly online for virtually no cost. These firms are in the early stages of development and so, by and large, are not publicly traded.
James Rickards, a financier and author, says he sees potential in technologies that process faster, cheaper and more transparent exchanges that go beyond trading money. Companies using these new technologies, he says, “allow consumers to buy products or to send payments in seconds at a fraction of the cost” of regular currency.
Jeffrey Robinson, author of a critical book about bitcoin, also says investors should be looking at these kinds of companies rather than cryptocurrencies themselves. Says Mr. Robinson, “This is not a commodity buy, but it’s a technology buy.”
Chris Larsen, chief executive of Ripple Labs, says cryptocurrencies are just the start of a wider technological revolution. Mr. Larsen says he envisages the Ripple protocol being used to exchange anything of value—from currencies to airline miles—instantly at a fraction of current fees.
Remember the Risks
Despite the excitement, keep in mind the risks. Cryptocurrency can be highly volatile and illiquid, says Duke University’s Mr. Harvey. The relatively limited market capitalization of bitcoin means it may be difficult to sell in large amounts without seeing a negative impact on the price, he says. Bitcoin’s market cap recently was about $6 billion.
“Bitcoin was never meant to be a speculative investment vehicle,” he adds. “Bitcoin’s main purpose is to enable the efficient exchange of property via minimal transaction costs and a high level of security.”
By: Javier Espinoza
“At any rate, the spook spoke the truth: cryptology represents the future of privacy, and more. By implication cryptology also represents the future of money, and the future of banking and finance. (By “money” I mean the medium of exchange, the institutional mechanisms for making transactions, whether by cash, check, debit card or other electronic transfer.) Given the choice between intersecting with a monetary system that leaves a detailed electronic trail of all one’s financial activities, and a parallel system that ensures anonymity and privacy, people will opt for the latter. Moreover, they will demand the latter, because the current monetary system is being turned into the principal instrument of surveillance and control by tyrannical elements in Western governments.” – J. Orlin Grabbe