Of the many stories in 2017 about the rise of asset prices, perhaps the most ink was spilled on cryptocurrencies. The original and most widely cited cryptocurrency is bitcoin. At the start of 2017, the exchange rate for 1 bitcoin (commonly abbreviated BTC) was approximately $1,000 U.S. Dollars (USD) and by the end of 2017, that valuation was 15 times higher. Just what exactly is bitcoin and – the key fear that lingers in the back of many investors’ minds—are you missing out? To consider that last question, we’ll need to back up a bit (forgive the pun), and understand just what cryptocurrencies are in a little more detail.
What are they? Bitcoin (and cryptocurrencies generally – we’ll just use bitcoin in this piece to keep it simple) is a blend of two things you already understand. Imagine buying a new coffee maker online with Japanese Yen using PayPal. That’s bitcoin in an overly simplified nutshell – making (or receiving) a digital payment in a currency that isn’t USD.
Over time, we humans have more or less agreed that it is easier to use currency than directly exchange goods or services; that’s why your economics textbook defined it as “a medium of exchange.” The history of money across civilizations is littered with interesting examples of what different societies have used to represent value, from shells, to dolphin teeth, to pieces of silver, to the paper money we are familiar with today. The basics of all these different currencies are the same – a group of people agree on a token or some other way to represent value and exchange that token for the goods or services they want or need.
In the US, we are a community of people that pay for stuff with U.S. Dollars and accept U.S. Dollars as payment. Across the Pacific Ocean, there is a community of users that pay for things in Japanese Yen (JPY) and accept payment for things in Japanese Yen. What happens when we travel from US to Japan but still need to pay for a meal? We typically have two options. One, we exchange our normal way of paying for things (USD) for their way of paying for things (JPY). Because there are many people who look to exchange USD for JPY and vice versa every day (in other words, a market exists), we can make this exchange and know clearly at what rate we would exchange (about 112 JPY for each USD today). Another way to obtain JPY is to create value in Japan – say by getting a job in Japan or selling something of value into the Japanese economy—and getting paid in JPY.
Bitcoin is no different. There is a community of users that want to pay for things in bitcoin (BTC) and accept bitcoin for payment. If you want to buy from or sell to someone in that community, you either need to exchange your typical method of payment (USD) for some of theirs (BTC) or you need to create value in that community and get paid in BTC. However, one key difference with BTC is that the community of users isn’t defined by geography or country; it is defined by the ability to connect to the internet. So, in order join this community and to transact with someone in community, you just need to be digital. Connect to the internet and create an account with a “wallet” provider such as Bitcoin Core (sounds a lot like PayPal, right?) and now fund your account with BTCs. Again, you have basically two options. You can exchange currency you already have for 1 BTC, or your other option is to add value in the bitcoin community and get paid in BTC. The latter is known as “mining” and essentially you add value by dedicating your computer(s) to the bitcoin network. Why do you need to dedicate computing power (and therefore a lot of electricity) to the bitcoin community? Because the community needs to create a record of transactions and then encrypt the information (hence “cryptocurrencies”) to keep it safe. Modern day encryption takes a lot of computers cranking through a lot of math problems.
Are you missing out? While mining – trading computer power and electricity costs for BTC – has been lucrative for some, it is really the rapid rise of the exchange rate in 2017 that has caught the public’s imagination. Perhaps after talking to the 20-year-old son of your next-door neighbor, you opened a “wallet” on Jan 1, 2017 and proceeded to exchange $1,000 for 1 BTC that you then stored in that wallet. A year later, you log in to close your wallet and cash in your 1 BTC….and receive $15,000 USD! Just one story like that can easily spark that powerful and sometimes dangerous element in investor psychology: The Fear Of Missing Out, often abbreviated as FOMO.
FOMO has been used to explain events like the tech bubble in the early 2000s and the tulip craze in 1600s Holland. In fact, there is no shortage of news articles today that compare cryptocurrencies to tulips. Here at Denver Investments, we have always had a fiduciary duty when investing clients’ assets, so we look past those tulip headlines to understand the core value-creating elements of any investment opportunity. As always, we begin with the building blocks of our fundamental investment philosophy, in particular understanding an asset’s potential to generate cash earnings and then placing a reasonable value on those earnings. In addition to its value as legal tender, you can use a U.S. Dollar to make a short, highly liquid, and relatively safe investment such as a 3-month Treasury Bill. Investors use such interest rates to help determine the value of currencies. There is not yet an equivalent for BTC; in the absence of a BTC 3-month T-bill, the value of a BTC heavily relies on its utility to you or someone else as a payment method or a highly speculative investment.
While some of the risks of a BTC investment have been exposed-such as the security or solvency risk of wallet operators or exchange operators—we still need to know more about how cryptocurrencies work to develop a deeper understanding of the risk profile. To that end, we have been researching the underlying concepts that enable cryptocurrencies—such as the “blockchain” and “the distributed ledger”—which may have great value creation potential in the future, and at the same time we are also following some of the unintended consequences of bitcoin mining, such as the carbon footprint left by the large electricity demand. To date, we do not believe cryptocurrencies represent an investment that we would make on behalf of our clients, but we are following the developments closely. Please don’t hesitate to reach out to your portfolio manager if you’d like to learn more.