Since the year began, there's been no hotter investment than cryptocurrencies. Bitcoin and Ethereum, which are the one-two punch in terms of largest market cap among digital currencies, have returned about 300% and 3,200%, respectively, just since the year began. By comparison, it's taken the S&P 500 decades to return what Ethereum has for its investors in just under nine months.
Cryptocurrencies are skyrocketing for three reasons
Emotions have obviously played a critical role in pushing digital currency prices higher. Since financial institutions have either avoided cryptocurrencies like bitcoin and Ethereum, or are barred by management from trading them, it's left the price movement to the hands of retail investors. John and Jane Q. Investor are substantially more prone to having emotions sway their investment decisions than large investment institutions. Lately, the "don't miss the boat" mentality could very well be driving prices higher.
On a more fundamental basis, there's a lot of excitement surrounding the blockchain that underlies many of the top cryptocurrencies, including bitcoin and Ethereum. Blockchain is a digital decentralized network that records all transactions without the need for a financial intermediary, like a bank. Because these blockchains are often, to some degree, open-source networks, it makes altering data very difficult. Thus, blockchain could become the preferred peer-to-peer and business-to-business channel for transactions in the future for a variety of industries and sectors.
Even the U.S. dollar has given a boost to cryptocurrencies since the year began. The dollar recently hit a more than two-year low against the euro, and well over a one-year low against other major currencies. When the dollar weakens, it tends to lift U.S. exports, which is bound to make President Trump happy.
On the other hand, it reduces the value of dollars being held by investors. Usually a falling dollar will send investors to seek a safe-haven store of value, like gold. Lately, though, they've been opting for the safety of bitcoin, the largest digital currency. However, bitcoin's tenure as the cryptocurrency of choice may not last much longer.
Bitcoin could wind up eating Ethereum's dust
With the full understanding that the cryptocurrency model itself has no guaranteed future, it's my suspicion that Ethereum has a better chance of long-term success than bitcoin. In fact, the early evidence suggests that Ethereum could leave bitcoin eating its dust in short order.
The major difference between the two digital-currency powerhouses comes down to their blockchain technology. Ethereum's blockchain has one key advantage over bitcoin's blockchain: its support of smart contract applications. Smart contracts, which, in their simplest form, are computer protocols that help to facilitate, verify, or enforce the negotiation of a contract, help to automate complex physical and financial supply-chain procedures and compliance processes. In plain English, it's a protocol within Ethereum's network geared at big businesses that should allow business-to-business and client-to-business deals to be done securely and efficiently.
Ethereum already has a lot of interest in its blockchain, as evidenced by the more than 150 organizations that had joined the Enterprise Ethereum Alliance as of July 2017, including nine well-known brand-name companies. These organizations are testing out a version of Ethereum's blockchain in various pilot and small-scale programs.
Comparatively, bitcoin is valued more as a payment platform than for its underlying blockchain technology. While there are some well-known businesses that have accepted bitcoin since 2014, its network has been at a distinct disadvantage to Ethereum's. Bitcoin has traditionally had higher transaction costs, long settlement times, and for a while, its capacity was challenged. A recent fork in bitcoin, which saw the digital currency split in two -- bitcoin and bitcoin cash -- may help close the gap a bit, but that remains to be seen.
This fork involved bitcoin's engineers utilizing the SegWit2x upgrade, which lowered transaction costs and settlement times, while boosting capacity by removing some information from its blockchain. A majority of the bitcoin community was in favor of SegWit2x, especially since it would make bitcoin more attractive to big businesses.
However, bitcoin still didn't receive the required 80% support needed to keep it from fracturing into two separate currencies. The remaining minority, which became bitcoin cash, chose to expand capacity within the original blockchain framework. This minority would prefer bitcoin remain a Libertarian's dream currency.
It's really as simple as this: Big business currently favors Ethereum's underlying blockchain more than bitcoin's, and that's likely where the long-term value of these cryptocurrencies lies.
Before you get too excited, remember this
However, this writer is still not very excited about the long-term prospects of cryptocurrencies, in general.
To begin with, there's absolutely no way of knowing how much blockchain technology will be worth a year, three years, or 10 years from now. Though businesses are testing out the technology, there isn't a large-scale use of blockchain ongoing at the moment outside of digital currencies. Therefore, any valuation of cryptocurrencies based on their underlying blockchain is nothing more than a roll-the-dice guess at the moment.
We also can't overlook the terrifying role that retail investor emotions have played in bitcoin, Ethereum, and other cryptocurrencies. Without the stabilizing force that is Wall Street, emotions have the potential to whipsaw these currencies in the short term, possibly leading to quick and hefty losses for those who aren't prepared, or don't understand how digital currencies work.
Building on that last point, the lack of a central trading exchange is another potential issue. While decentralization is critical to the success of cryptocurrencies so as to reduce the likelihood of a cyberattack being successful, it also makes it difficult to legitimize cryptocurrencies. And having around a dozen exchanges can increase price volatility.
Even regulating bitcoin and other cryptocurrencies could be worrisome. While regulation would, in one sense, signify the acceptance of digital currencies as legal tender, some countries, like China, could choose to crack down on digital currencies altogether. China recently barred initial coin offerings and announced that it'll soon be shutting down domestic bitcoin and cryptocurrency exchanges.
Long story short, while Ethereum looks the best positioned to succeed over the long run, there's no guarantee that it, or bitcoin, will be around in a few years' time. My suggestion remains that investors steer clear of digital currencies until we have a better understanding of how they'll be regulated, and what their underlying technology is really worth.