Cryptoassets, not cryptocurrency

It’s important to form a view. It’s even more important to be open to changing it. I’ve never taken Bitcoin seriously, but based on recent institutional interest in cryptoassets, I decided to research and learn more.

Note that I said “cryptoassets” rather than “cryptocurrencies” – more on that later.

Nine pages to rule them all

In 2008, a white paper put forward a new way to transfer value over the internet. It was written by Satoshi Nakamoto, whose real identity is not known to this day. This document was the genesis of Bitcoin, although the concepts of cryptoassets can be traced further back to the late ‘90s.

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The document is only nine pages long but reading it makes me question why I studied finance instead of software engineering. The current Bitcoin price makes me wonder the same thing.

The basic idea is a “decentralised ledger” – if you can imagine a world where there is only one bank and everyone has accounts with it, you’re halfway there. The transaction processing time for cross-border payments is much faster than in a world of multiple currencies and banks, because that single bank has visibility of every account and therefore knows that the money is there and the transaction can be trusted.

This is the principle of the blockchain database, except there is no specific corporation maintaining or controlling this ledger. It’s like everyone in the world has bank accounts with the same invisible bank. The technological challenge to achieve this was the real breakthrough that brought Bitcoin (and other coins) into the world.

Today, around 55,000 computers around the world work to independently verify every Bitcoin transaction. The Bitcoin database has never been hacked and Satoshi Nakamoto (whoever that really is) is believed to be worth around $40bn thanks to a stash of one million Bitcoin.

Bitcoin miners operate powerful computers that solve mathematical problems to mine Bitcoins. There will never be more than 21 million Bitcoins in the world. Once these have been mined, the miners will be incentivised through processing transactions rather than mining new coins.

Although 18.5 million Bitcoins have already been mined, the rules of the system mean that it becomes much harder over time to mine the rest. Welcome to the world of “digital scarcity” that has been designed to limit supply and therefore drive demand.

After minting young millionaires a few years ago and ruining others, Bitcoin has now entered the institutional vocabulary. As the world faced an unprecedented economic crisis over the past year and central banks printed money to inject stimulus into economies, many turned to Bitcoin as a safe-haven asset.

“Keeping your savings with Bitcoin is not recommended…” provides this sobering warning:

“The price of a bitcoin can unpredictably increase or decrease over a short period of time due to its young economy, novel nature, and sometimes illiquid markets. Consequently, keeping your savings with Bitcoin is not recommended at this point. Bitcoin should be seen like a high-risk asset, and you should never store money that you cannot afford to lose with Bitcoin. If you receive payments with Bitcoin, many service providers can convert them to your local currency.”

Warnings aside, the concept of cryptoassets is here to stay. Having been through extremely volatile bull markets and pullbacks, Bitcoin is finally gaining acceptance among institutions, price volatility aside.

Why have serious investors noticed?

Cryptoassets represent an asset class, like equities, gold or government bonds. All asset classes have different characteristics and drivers of value. Institutional investors construct portfolios designed to achieve a certain return at an appropriate level of risk.

For example, despite what some Reddit or TikTok users might tell you, investing an elderly person’s entire pension in Tesla wouldn’t be appropriate. The risk is entirely wrong for the investor in question. It might work out spectacularly but could also crash and burn.

Similarly, young investors shouldn’t be putting everything in money market accounts. That’s not the way to build wealth over multiple decades.

So, including crypto in a portfolio is a similar concept to including gold. It’s an alternative asset that should behave differently to equities. It should theoretically rise over time but for different reasons to equities, which is helpful for risk management.

Of course, many are using crypto as a speculative tool. The same happens in gold, oil, forex and any other asset class. There are traders who drive market liquidity and investors who take longer term views. This is normal.

In fact, it’s critical for the success of capital markets.

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What are my views?

I was not surprised when Bitcoin crashed at the end of 2017. It had all the makings of a bubble. Hyped up by all the wrong people (like every Uber driver I had at the time, with the greatest respect to them), the music had to stop.

I didn’t invest and therefore didn’t lose anything. Of course, I wish I had bought after that crash though.

It’s a lesson in probabilities that I subsequently applied in my Sasol decision last year. Once something has fallen that hard, you have to carefully weigh up the likelihood of further pain vs. potentially significant upside. It’s the same principle I’ve used in buying shares in EOH.

Now, with a number of serious institutions adding Bitcoin to their portfolios, it’s a lot harder to ignore. I still believe the asset is difficult to value, but I’m not sure I can justify holding gold miners and no Bitcoin exposure.

The key thing I’ve learned about Bitcoin is that calling it a “cryptocurrency” gave me the wrong impression. I’m unconvinced that Bitcoin is capable of replacing fiat money (the currencies you already know like the Dollar or Rand).

Instead, Bitcoin offers a way to store value that is entirely independent from any government. The use case outside of this is limited, as the time taken to confirm a transaction means that you can’t use Bitcoin to buy your coffee. However, Bitcoin is excellent for transferring large amounts at a far lower cost than in the traditional banking system.

The lack of practical use cases for Bitcoin has led to a proliferation of other coins, which is where the cowboys really got involved.

The “penny stocks” of crypto

If you’ve watched Wolf of Wall Street, you’ll know that penny stocks are high-risk small cap shares. The world of crypto has its own penny stock list, made up of numerous coins that have technological differences to Bitcoin.

The problem is that coins with more flexibility also carry more risk. Two of these risks are worth highlighting:

  • Security: coins like Ethereum (the second largest cryptoasset by total value) have more transactional capabilities than Bitcoin but are less secure as a result of their complexity (vs. the simpler system behind Bitcoin that is harder to hack)
  • Regulatory: crypto products like Ripple (previously the third largest cryptoasset) try to achieve the best of all worlds, but fall foul of regulators in the process

Ripple recently fell apart under an investigation by the Securities and Exchange Commission (SEC). While coins like Bitcoin are created via open-source mining (by computers), the developer of Ripple controls the supply. This leaves the developer vulnerable to scrutiny under securities laws.

While diversification makes sense in most markets, many coins are complete garbage. The leading coins are interesting, but it does get scary to step beyond Bitcoin and perhaps Ethereum. After all, Ripple was the third largest before it crashed.

Playing in this space requires immense risk tolerance and caution. I’m taking Bitcoin more seriously these days, but I’m still nervous to invest at these levels. I’ll keep reading and learning.

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