Whenever I meet someone who learns I work in finance, the first question I inevitably get is, "What are your thoughts on crypto?"
It's not a surprise. After all, the price of Bitcoin (BTC 5.32%) has gone up 77-fold over the past five years, from around $745 in 2016 to a stunning $57,500 today. Given the potential for market-beating gains like that, there are clearly reasons for investors to think about gaining exposure to cryptocurrencies.
However, with such a new asset class, there are amany risks to consider as well. Those risks may mean crypto is not appropriate for you, or at least that it shouldn't be a meaningful proportion of your overall assets.
Sifting through the main reasons to own crypto as well as the most glaring risks can help decide if you're ready to take the crypto plunge.
First reason to own cryptocurrency: inflation protection?
Obviously, the main reason to own any asset is that it can go up in value, and much of Bitcoin's original appeal is as a store of value to protect against inflation. Given the high inflation numbers we are seeing as the country opens up from the pandemic, inflation protection is on the top of many investors' minds right now.
Outside of inflation-protected Treasuries, investors looking to hedge against inflation have traditionally bought certain commodities, especially gold; however, Bitcoin could be on its way to displacing gold as the preferred hedge against general hyperinflation for a new generation. In fact, Bitcoin is probably a far better solution than gold for those in less-developed countries. After all, those looking to store wealth or transact in a medium would have a far easier time with Bitcoin than attempting to transact in ounces of gold.
Already, we've seen El Salvador formally adopt Bitcoin as legal tender, and Panama recently introduced a bill that would have it follow suit. Crypto use has also surged recently in Afghanistan, after this summer's Taliban takeover caused citizens to lose faith in the country's financial system.
As a medium that's easy to store, transact, and isn't backed by any one government, Bitcoin is emerging as one of the more compelling ways to hedge against currency hyperinflation today.
Enabling new innovation
Besides its use as a store of value, cryptocurrency also has the potential to enable entirely new digital finance (DeFi) applications. And these innovations have the potential to create serious wealth.
One of the more obvious ways DeFi can make a difference is by lowering transaction costs for traditional financial applications, such as cross-border remittances. In fact, this was one of the main reasons El Salvador adopted Bitcoin. The country uses the dollar, so its currency probably isn't at risk of hyperinflation in the near term. However, President Nayib Bukele has stated that Bitcoin could save El Salvadoreans $400 million annually on saved remittance costs.
Besides streamlining traditional financial transactions, crypto is also opening up entirely new markets, most notably in nonfungible tokens. NFTs are digital works of art or digital items authenticated as "original" through the use of crypto-enabled smart contracts, on smart contract blockchains such as Ethereum (ETH 0.92%) or newer Ethereum competitors such as Cardano (ADA -1.30%) or Solano (SOL 2.75%). By being able to authenticate a particular digital image or item as an "original" on a blockchain, Ethereum and its descendants are now creating an entire new market for digital items where there was none before.
NFTs are taking off in a big way, with major sports leagues such as the NFL and NBA developing their own NFT collectible programs, and Tik Tok now allowing famous Tik Tok-ers to sell "original" versions of digital clips. Hollywood is of course getting into the game, investing in NFTs it can sell to superfans of movies, TV, and music. In fact, film and television studio Fox just invested $100 million in its own NFT fund.
One of the more interesting DeFi innovation experiments is currently happening in Miami. Recently, the city created a crypto mining platform based on the Stacks (STX) protocol, a smart-contract platform built on top of Bitcoin. Miamians can submit STX token bids for MiamiCoin (MIA) tokens, with your odds of winning depending on how much STX you bid. MiamiCoins are mined and then distributed to the winners, with 70% of the proceeds going to the winning bid and 30% going to the city's crypto wallet. Since it started in June, Miami has already generated $10 million from its CityCoin mining program, and Mayor Francis Suarez says the new innovation could be so profitable that it may enable Miami to lower or even eliminate city taxes over time.
Crypto is gaining greater acceptance among mainstream financial institutions
Finally, though cryptocurrency may be of dubious intrinsic value (more on that later), a lot of its near-term value will be an output of supply and demand. The good news is that today, demand is clearly there, as 2021 has been a watershed for crypto's acceptance among mainstream financial institutions.
A recent study by Fidelity found that seven in 10 institutional investors plan to buy digital assets in the future. Earlier this month, analysts at Bank of America gave their official approval to recognize cryptocurrency as an asset class, becoming just the latest large U.S. bank to do so. Around the same time, U.S. Bancorp said it will be offering crypto custody services to its fund manager clients. Even Blackrock, the world's largest asset manager, has invested $400 million in Bitcoin mining stocks such as Marathon Digital Holdings (MARA 0.97%) and Riot Blockchain (RIOT -7.68%) in several of its funds.
And this month, many expect the SEC to approve Bitcoin exchange-traded funds, which would invest in Bitcoin futures on the Chicago Mercantile Exchange and comply with 40 Act protections for investors. As one might expect, ARK Invest's Cathie Wood has filed to open her own Bitcoin ETF called the ARK 21Shares Bitcoin Futures Strategy ETF, which would trade under the symbol ARKA.
With institutions falling in line behind mainstream cryptocurrencies, it's highly unlikely that cryptocurrency will fall by the wayside anytime soon, as some have predicted. All this new demand from financial institutions and their clients looking to gain crypto exposure for the first time should support crypto prices in the near to medium term.
But there are reasons to be cautious -- extreme volatility, for one
Of course, there is no such thing as a free lunch, and this adage applies for crypto assets as well -- exciting as they are.
One obvious risk is the huge volatility in cryptocurrencies, which many investors may find hard to stomach. This could be doubly true if you're a relatively new investor, or if you put too much of your assets into crypto. In fact, although Bitcoin's price has skyrocketed over 10 years, Bitcoin holders would have had to weather 20 different official bear markets -- drawdowns of 20% or more -- during that period, including five drawdowns of 50% or more and three of 80% or more.
So if you're going to invest in cryptocurrencies, make sure you're sizing your position appropriately for such downside scenarios, and please, do not use leverage. A severe drawdown while using leverage could force a margin call, which means you would have to sell your cryptocurrency at the worst possible time to cover debts.
Hacks can happen, and there is no insurance
As with any new technological innovation, sometimes developers move too fast and break things -- and by "break things," I mean lose your tokens. For instance, a flaw in the software code for DeFi-token exchange platform Poly recently led to a hack and the loss of $610 million worth of tokens.
Even Coinbase (COIN 1.24%), often considered the gold standard for crypto wallets, saw 6,000 customer accounts get hacked earlier this spring. While some of the fault surely lies with customers who unwittingly gave up email addresses, passwords, and phone numbers to a large-scale phishing campaign, Coinbase still decided to compensate victims because of its lack of comprehensive customer service when the hacks occurred. Still, those victims were lucky Coinbase is well capitalized and was able to compensate them. There is no FDIC type of insurance that will insure crypto assets up to a certain amount as there is with cash holdings at U.S. banks.
And because of the anonymity and lack of government oversight of crypto wallets, crypto has become a favored means of exchange for hackers and criminal ransom payments. Because crypto transactions are harder to track than traditional currencies and exist outside the purview of the government, crypto wallets will probably remain targets for hackers and other criminals for the foreseeable future. That means you need to take extra care with your security systems when deciding on a crypto wallet and when purchasing crypto assets.
Finally, what's the value? Warren Buffett and Jamie Dimon say "zero."
Finally, for investors who adhere stringently to the value-based framework that any asset is worth only the present value of future cash flows, a cryptocurrency's value may seem illusive or even fraudulent. After all, Warren Buffett has called Bitcoin "rat poison squared," and JPMorgan & Chase CEO Jamie Dimon just called Bitcoin "worthless" as recently as last week, even as the cryptocurrency is surging back toward its all-time highs.
While it's true that Bitcoin doesn't produce any cash flows or other tangible benefits, it wouldn't be the first asset class to retain significant value for long periods of time despite zero useful "output." This, again, is true of gold, which doesn't have many practical industrial applications yet is currently valued at roughly $1,800 an ounce. The same goes for scarce items such as famous works of art (or, these days, digital NFTs), which are basically only valued for their scarcity and because somebody attributes value to it.
Still, the speculative nature of Bitcoin and other cryptocurrencies is something to watch out for. Those who hold Bitcoin or other cryptocurrencies should be aware of the risk that one day, people may decide they agree with Buffett and Dimon for whatever reason, and the value of your Bitcoin could go to zero in an instant. That could come about for any number of reasons, including the fact that other coins may come along and displace the current leaders. After all, many initial dot-com companies flew during the early days of the internet, only to later go bust. Remember how MySpace was the first major social media platform?
Basically, it's still the early days of the crypto movement. With a highly speculative asset of nebulous intrinsic value, there are lots of reasons to be cautious with your crypto investment and allocation decisions.
Which side do you fall on?
With compelling reasons to own cryptocurrencies as well as several reasons for caution, the decision to own crypto or not comes down to your own understanding and risk tolerance. If you're thinking about buying cryptocurrencies for the first time, make sure you can answer one basic question: "Why do I own this?" Is it to hedge against inflation, to participate in new innovative markets, or to speculate and trade based on current mainstream interest? And of course, the most important question is, "Am I aware of the risks, and how will I react when the inevitable drawdown occurs?"
If you can answer why you own crypto and also devise a plan for what you will do if its value declines suddenly, then by all means, go ahead and invest or speculate in this exciting new asset class. But if you can't answer these basic questions, or predict how you would react if things were to go south, I would stay away from crypto until you can.