INVESTMENT REPORT: What You Should Know About Cryptocurrencies

Chris Kamykowski, CFA | Director of Investment Consulting and Research

For Educational Purposes Only. Moneta does not offer investment advice regarding cryptocurrencies and does not bill clients for the education it may provide them on crypto.

2021 has been a roller-coaster ride for cryptocurrencies (“crypto”), which have continued to be in demand from many investors and traders despite rapid rises and equally precipitous falls. The persistent headlines over crypto reflect their dramatic proliferation and investor intrigue on how to engage with them. As with any new and exciting asset appearing to have the potential to provide
high returns, investors have been quick to take notice and seek answers on how to join the millions who have purchased them. Some investors see it as a “can’t miss” opportunity. Others believe crypto is a landmark innovation that will upend the global financial system over the long-term, while still others believe crypto represents a dangerous speculative asset. Whatever the motivation,
investors should at a minimum be cognizant of the aspects they should consider when developing an understanding if they desire to purchase cryptocurrency. This short piece aims to decipher the complexity of cryptocurrencies.

What is a cryptocurrency?

Essentially, cryptocurrency is a digital asset that is secured by cryptography and stored on decentralized networks over the internet, often employing a public, ongoing ledger (blockchain) to verify transactions via peer-to-peer networks. Cryptocurrencies are different from fiat currencies, such as the Dollar and Yen, which are issued by a sovereign central authority such as the Federal Reserve.
Cryptocurrencies may allow for transactions without a bank or payment processor and some transactions can happen in seconds. Some holders of cryptocurrencies are attracted to their relatively higher degree of anonymity, substitution for fiat money, and perceived benefit as a store of value or as an inflation hedge. Many are familiar with Bitcoin, which tops the cryptocurrency popularity charts; but there are many others such as Ethereum, Dogecoin, Stellar, Litecoin, Polkadot, Binance, and Cardano. These are just a sampling of the universe, which now tops out at more than 4,000 different cryptocurrencies worldwide.

Are cryptocurrencies regulated?

While many holders of cryptocurrencies believe they are not regulated, this is not in fact the case. In the United States, cryptos are regulated by either the Securities Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC) (with significant additional interest from the Federal Reserve, Office of the Comptroller of the Currency (OCC) and the Treasury Department). No
two cryptos are exactly alike, and which regulator has jurisdiction over each crypto can only be determined on a case-by-case basis depending on the crypto’s unique structure, technology deployed and purpose. The basic question that must be answered for each crypto is whether it is: a) a commodity, in which case the CFTC has primary jurisdiction; or b) a security, in which case the SEC has jurisdiction.

The legal tests to determine whether a crypto is a commodity or a security are too complex for this piece, but the SEC has ruled that the two largest cryptos by volume and dollar value, Bitcoin and Ethereum, are commodities. In addition, the SEC and CFTC are currently examining crypto exchanges such as Coinbase to determine whether and how to assert jurisdiction over them. Needless to say, regulation of this currency is uncertain and continually evolving leaving advisors and investors without clear direction.

Why are cryptocurrencies experiencing such high demand?

The last year saw a significant surge in flows into cryptocurrencies with the 12-month rolling total rising from $1B to more than $9B. Despite the modest outflows in April and May of 2021, inflows are likely to continue. Many reasons abound for why cryptocurrencies are capturing the attention of investors and serving as catalysts for increased demand. These include:

• Proliferation of Crypto Exchanges/Platforms
• Rise in Institutional Interest
• Increased Acceptance of Crypto for Payments by Financial Platforms and/or Merchants
• Investors’ Concern over US Inflation
• Investors’ “Fear-of-Missing-Out”
• Social Media

How have cryptocurrencies performed?

For the reasons noted above, we have seen immense growth in market cap over the last 12 months. To say it has been explosive is an understatement as even a cryptocurrency created as a joke (Dogecoin) has witnessed one year growth of nearly 13000%. Many market pundits argue we have reached a certain “bubble” state in cryptocurrency given the extraordinary advances in market cap, comparing the run up in crypto to past financial assets that have experienced rapid price appreciation. There is some truth to that when one looks at previous episodes; however, the recent run-up in crypto demolishes previous assets that received elevated market hype in the last five decades.

As has been seen throughout financial history, rapidly rising valuations are a key element in attracting investors and traders to crypto as anything that sparkles in the market typically does. However, despite tales of riches made, the valuation increase has not been a oneway street as cryptocurrencies have been subject to tremendous price volatility. Using the Greyscale Bitcoin Trust (GBTC) as a proxy for cryptocurrencies, one can see in the charts below the volatility and drawdown risk from crypto are multiples of other established asset classes. Some argue that crypto should be seen as a current/future substitute for either gold or the US Dollar, but at this point, from a volatility perspective, the comparison is lacking.

What are the risks with cryptocurrencies?

Beyond the obvious risks of price volatility and potential permanent impairment to capital, there are other risks buyers of crypto should be aware of before purchasing. Below are some key risks to consider that can help you decide if the risks are worth the potential reward.

• Financial Regulation – While efforts are in place across developed nations to establish a formal regulatory framework, cryptocurrencies lack well-developed, consistent, cross border regulatory standards that reliably protect investors and consumers. The slowly emerging (in comparison to popularity) regulatory regime leaves investors exposed to unquantifiable risks that could impact values of cryptocurrencies. For example, Chinese authorities recently surprised many holders of crypto with guidance discouraging financial institutions from using crypto for payments or services, which caused significant price declines(2).
• Central Bank Competition – According to Reuters(1), the U.S. Federal Reserve is considering establishing a Central Bank Digital Currency (CBDC), which would be the digital equivalent of banknotes and coins, giving holders a direct digital claim on the central bank and allowing them to make instant electronic payment. These “stable coins” could have some of the advantages
  and benefits of cryptocurrencies without the extreme price volatility and other problems. This could limit the uptake (and value) of cryptocurrencies in the future if investors seek a more stable form of cryptocurrency.
• Cyber Security / Criminal Exploitation – Fraud and cybercrime involving cryptocurrencies are growing more regular as these markets expand. For example, cybercriminals recently launched a ransomware attack against one of the nation’s largest gas pipelines, which shut down gas and caused supply disruptions on the East Coast until the pipeline paid a ransom of more than $4 million in cryptocurrency. For individual investors, usernames/passwords for crypto exchanges and security keys associated with their crypto holdings can be compromised and allow cyber criminals access to digital “wallets” containing crypto holdings. In addition, the same exchanges can come under cyber-attack or face outages limiting the ability for crypto holders to transact or
  access their crypto holdings. Knowing the security protocols on exchanges is very important.
• Tax Treatment – Currently, cryptocurrencies (or “virtual currencies” per the IRS(3)) are subject to a tax liability when used in transactions much like transactions involving property. Therefore, maintaining accurate records of cost basis, trades and gains/losses is important as the IRS includes a question on 1040s regarding transactions in virtual currencies.
• Elon Musk – While not a traditional risk in the truest financial sense, it is hard to avoid mentioning the Tesla and SpaceX entrepreneur in the list of risks. There are not many in the world who can drive prices for cryptocurrencies up or down based on Saturday Night Live monologues or singular tweets, but Musk’s whims literally move crypto markets.

How would one use crypto in a portfolio?

Many debate whether one should view cryptocurrency as a currency or an investment.

Currency should serve as a store of value and as a medium of exchange. Crypto’s store of value properties are difficult to justify given observable volatility relative to the USD. As a medium of exchange, its acceptance is rising but it lacks the widespread acceptance and regulatory protocols that major currencies benefit from today.

Investments are assets acquired with the goal of generating income or appreciation. Crypto is hard to classify as anything other than a highly speculative investment at this time. Valuation considerations are important for any investment and valuations are derived from an investment’s sum of its future cash flows discounted to today. Crypto has no cash-flow properties and relies on appreciation through another party’s desire to purchase at a higher price.

Put together, crypto’s inability to serve as a reliable store of value, lack of cashflows, and overreliance on demand/supply to drive price appreciation, means it should not be relied upon for long-term wealth accumulation.

How do I access cryptocurrency?

Having laid out several observations and risks to be aware of with cryptocurrency, one may still ask, “I understand all this but what are my avenues to access cryptocurrency?” Direct access to singular cryptocurrencies via traditional investment platforms like Schwab and Fidelity is not currently available, because they are awaiting regulatory guidance and investor safeguards.* However, Schwab and Fidelity do allow for the purchase of private placement crypto funds and secondary market purchases/trading of these funds. Direct purchase can be completed via cryptocurrency platforms such as CoinbasePro and River Financial. To be sure, engaging any of these options requires due diligence to understand the pros and cons of each. Each is unique and has its own risks one must understand. The table below walks through a few sample options and some pertinent items to be aware of when seeking to engage cryptocurrencies:

Conclusion

The proliferation of cryptocurrencies has caught the attention of many investors and caused some to experience “fear of missing out.” There are rapid changes occurring in finance due to the rise of fintech and non-bank actors entering the fray to compete with traditional financial institutions and banks. There are ample reasons why the theme and demand for cryptocurrencies makes sense and there is a plethora of interested actors seeking to make it so. While returns have stoked the envy of some and caused considerable pain for others chasing the momentum and the story, we are still in the early stages of what may be a financial transformation with highly uncertain outcomes. Significant price volatility is an ever-present danger one should respect. The risks associated with cryptocurrencies are many, including regulatory uncertainty and a lack of well-established investor protections. At this point in the cryptocurrency narrative, investors should at minimum view it as a speculative play versus an asset class one can rely on to drive long-term wealth creation and stability in one’s portfolio. Tread carefully with those that offer access to cryptocurrency and know the risks and uncertainty inherent with cryptocurrencies; remember to be very diligent in one’s oversight, storage, platform usage and tracking of cryptocurrency transactions.

Sources and Disclosures

1.  https://www.reuters.com/business/finance/digital-dollar-project-launch-five-us-central-bank-digital-currency-pilots-2021-05-03/
2. https://www.wsj.com/articles/bitcoin-and-dogecoin-prices-tumble-as-investors-sour-on-cryptos-11621435489?mod=searchresults_pos5&page=1
3. https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions
4. Morningstar; As of 4/30/2021; Representing each item are: Greyscale Bitcoin Trust (Bitcoin) is a private placement that seeks to reflect the value of Bitcoin (BTC; 9/25/2013) held by the trust. NASDAQ Composite index (Nasdaq; 1/1/1995) is a market cap-weighted index, simply representing the value of over 3,000 stocks listed on the Nasdaq Stock Market. LBMA Gold Price (Gold; 1/1/1970) is overseen by the ICE Benchmark Administration and represent gold prices as determined by regular auctions in London. The S&P GSCI Index (Commodities; 1/1/2001) is a world production-weighted commodity index that, in 2021, will be composed of 24 exchangetraded futures contracts on physical commodities across five sectors: energy, industrial metals, precious metals, agricultural, and livestock. The MSCI China Index (China; 1/1/2001) captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings. The Nikkei 225 Index (Nikkei; 1/1/1985) is a price-weighted index, operating in the Japanese Yen (JP¥), and measures the performance of 225 large, publicly owned companies in Japan from a wide array of industry sectors. FANGs (3/27//2014) represent the equally-weighted return stream of the following stocks: Facebook, Amazon, Netflix, and Alphabet (Google).
5. Closing market values as of 4/30/2021, Morningstar. Greyscale Bitcoin Trust (Bitcoin) is a private placement that seeks to reflect the value of Bitcoin (BTC) held by the trust. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic U.S. stocks. LBMA Gold Price (Gold) is overseen by the ICE Benchmark Administration and represent gold prices as determined by regular auctions in London.

^Quotation began on 6/20/2019.
*On May 25th, Fidelity filed an application with the SEC to launch an ETF linked to Bitcoin.
**Private placement investment with Bitwise is available weekly on Wednesdays.
***Digital wallets allow for storage of cryptocurrencies for holders. Two types exist: “hot” means they are held and accessed online; private keys to one’s cryptocurrency help to minimize threat of cyber theft. “Cold” wallets are offline storage devices (USB drive, for instance) that also store a user’s private key. Security is stronger given the device has to be connected to a computer/internet to allow for use of cryptocurrency holdings. One version of a cold wallet is a paper wallet which essentially means private and public keys are provided to a crypto currency holder and printed out. These keys are then stored in a safety-deposit box or a safe.

© 2021 Moneta Group Investment Advisors, LLC. These materials were prepared for informational purposes only based on information deemed reliable, but the accuracy of which has not been verified; trademarks and copyrights of materials linked or noted herein are the property of their respective owners. Given the dynamic nature of the subject matter and the environment in which these materials were prepared, they are subject to change as additional information and analyses comes forth. Nothing contained herein represents an offer to sell or buy cryptocurrencies or any other commodities or securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. Past performance is not indicative of future returns. These materials do not take into consideration your personal circumstances, financial or otherwise.