Cryptocurrency: What you need to know
Are falling prices a golden opportunity to get in, or one more reason to stay out?
For Bitcoin and its cryptocurrency brethren, 2017 was quite a ride.
Last December investment in Bitcoin peaked, rivaling the market capitalizations of behemoths Bank of America, Exxon and Johnson & Johnson; a euphoric cap to an astonishing rise echoing the dot.com mania. Sadly, for those late to the party, prices of digital currencies have plunged in 2018 over fears of government regulation and abandonment by the likes of Google and Facebook.
Is cryptocurrency just another tech flash-in-the-pan? Or is it the next wave of digital disruption led by artificial intelligence and the Internet of Things, transforming industry and society the way the light bulb and combustion engine once did?
Buying into new technologies can pay off handsomely; however, it’s rarely a good idea to jump in with both feet before doing your homework.
Blockchain: the machinery behind cryptocurrency
Unlike metal coins and paper notes, cryptocurrencies don’t have physical form; they’re digital tokens created electronically. They aren’t controlled by central banks, or tied to any nation, and they’re used in every corner of the globe.
Apart from Bitcoin, which represents half of the $250 billion crypto market, there are nearly 1,600 cryptocurrencies in "circulation", including Ethereum, Ripple, Litecoin, Cardano and 14 others whose market values each exceed $1 billion.
Bitcoin may have fired up investors, but it’s distributed ledger technology, or blockchain, that makes digital currency possible.
Bitcoin transactions are recorded in a distributed public ledger that’s duplicated across thousands of computers globally, or nodes. These nodes make up the ledger - or blockchain.
Before a group of transactions, or block, can be added to the blockchain, it must be validated (for example, to ensure William has enough bitcoins to pay Kate). Proving validity is left to key nodes, the miners, who complete the required technical tasks, the proof-of-work, receiving new bitcoins for their efforts. This mining process is how new bitcoins are "dug out" of the Bitcoin program and the ledger is built, creating a detailed record that can’t be altered or erased.
Checks and balances are built into the system, making it extremely difficult for anyone to tack a fake transaction to a block or steal bitcoins, so for participants, there’s peace of mind without the need for a trusted intermediary like a financial institution.
While blockchain transactions themselves are visible to anyone on the network, identities remain anonymous. And, because no single entity or location controls the blockchain, information is better protected from threats like theft, damage and loss which dog centralized database systems.
How to buy
Mining isn’t easy, so for most people the sensible way to obtain digital currency like Bitcoin is to purchase it.
One approach is to use a cryptocurrency exchange, a portal for buyers and sellers of digital currency to transact. Another option is a Bitcoin "ATM", an automated exchanger that trades cash for bitcoins. Once bought, you can access your bitcoin through a digital "wallet" which you download and manage yourself or tap through a service provider. But no matter how you buy and spend cryptocurrency, be prepared to pay transaction and network fees.
While dollars are only divisible in hundreds (cents), bitcoins can be parsed into as many as 100 million smaller units (satoshi), which makes it possible to purchase small quantities. That’s good news when one bitcoin costs more than $8,000 Canadian.
Is cryptocurrency currency at all?
There’s an argument that digital currency should be viewed as more of an asset than as money. Why? For one, it can be hard to use.
Bitcoin and other digital tokens are not legal tender in Canada. Despite the hype around cryptocurrency, relatively few businesses accept it as payment. Morgan Stanley reports in the third quarter last year only three of the top 500 e-commerce merchants accepted bitcoins.
It’s estimated that $300 million of goods and services are bought with Bitcoin daily, versus $17 billion spent through Visa.1 Potentially high processing fees and delays are obstacles when paying with Bitcoin, especially for small purchases. Plus, once transactions are completed they can be difficult to reverse.
Because Bitcoin is not backed by any government or central bank, it has limitations as currency. It doesn’t pay interest, nor is it particularly liquid. Morgan Stanley says over a sample one-month period, an average of $5.4 trillion rolled through foreign exchange markets each day. Bitcoin’s daily trading volume was just $3 billion – a tiny slice of the global pie.
Another strike against cryptocurrency is its volatility. Financial markets rely on stability in foreign exchange. But for digital currency rampant swings in value are the norm, making it unsuitable as a reliable medium of exchange or repository of wealth. Examining a recent 6-week period, Bitcoin gyrated in a 50% range in US dollar terms. By contrast, the Loonie fluctuated a mere 6% against the greenback while the Euro traded in an even tighter channel.
Understanding the risks
Advocates for Bitcoin point to its promise of smoother and cheaper funds transfer, particularly for large transactions, avoidance of currency conversion in international trade, and better identity protection because parties are anonymous. But that doesn’t mean there aren’t serious risks to either using or investing in cryptocurrencies.
1. The crypto rollercoaster
An astounding rise followed by a shocking fall in the price of Bitcoin and other cryptocurrencies has demonstrated just how sensitive these assets are to investor sentiment, seeing dramatic price moves daily, even hourly. If you buy into that kind of volatility, don’t be surprised if you wind up losing a chunk of your investment, even if you hold it for only a short time.
2. Fraud, theft and cybercrime
While blockchain technology may offer a more secure way to exchange data, there are plenty of minefields within the crypto ecosystem. You could be lured in by a fraudulent cryptocurrency exchange. An exchange or digital wallet provider can fail, be hacked, or simply shut down and run off with your savings. Cryptocurrency scams have now cracked the Better Business Bureau’s Top 10 list of frauds, fleecing victims for more than $1.7 million dollars in 2017.
3. Little or no regulation
There’s a pronounced lack of consumer protection in the cryptocurrency space. Don’t expect the same safeguards you enjoy when shopping with credit or debit cards, or when you choose mainstream investments. Digital currencies aren’t covered by government deposit insurance programs. What’s more, new cryptocurrencies brought onto the market through an initial coin offering (ICO) fly under the radar of securities regulators.
4. Government intervention
If you’re a bitcoin owner, government action is a wildcard which could negatively affect the value and function of what you hold.
So far, cryptocurrencies have operated free of state influence. Now that may be changing. For example, Chinese and South Korean authorities have taken steps to shut down cryptocurrency exchanges, ban ICOs and curtail Bitcoin mining.
One target of government is taxation. Another? Money-laundering by criminal and terrorist elements who exploit anonymity in the cryptocurrency markets. There’s also worry the growth of digital currencies could eventually hamper the ability of central bankers to conduct monetary policy.
Bitcoin and the Taxman
If you invest in cryptocurrency or spend it, Canada Revenue Agency wants to know.
Using bitcoins to pay for goods or services invokes the barter rules under the Income Tax Act, meaning GST/HST applies. And if you sell your bitcoin? Like other capital property such as real estate or shares, you must report the sale when you report your income. Any profit is subject to capital gains tax.
Cryptocurrency and your portfolio
It’s challenging to incorporate cryptocurrencies into an investment portfolio. They’re missing the proven track record of equities, bonds and other conventional assets. They’ve demonstrated outsized volatility and cannot be evaluated on core financial metrics like revenue, price-to-earnings ratios or yield. Regulation protecting investors is lacking and trading is fragmented. We’ve yet to see a mutual fund or exchange-traded fund focusing on cryptocurrency approved for sale in Canada.
The safe approach? Treat cryptocurrencies as speculative investments and consider the following:
Only invest what you can afford to lose. Limiting digital tokens to a small percentage of your portfolio, say a maximum of 5%, may cap any big gains. But it will also help preserve your wealth if your Bitcoin bet doesn’t pay off.
Have a plan to handle volatility. The dizzying market action around cryptocurrencies can be difficult to stomach. That’s why it’s important to put rules in place for how you’ll handle the ups and downs – before you get in – so fear or greed don’t lead you astray.
Monitor your portfolio’s risk level. As 2017 demonstrated, catching cryptocurrencies, or any volatile investment, on the way up can be highly profitable. The flip side is those profits quickly evaporate when prices head the other way. It’s important to regularly revisit the risk level of your portfolio and rebalance to keep the portion of speculative assets in check.
When considering any investment – cryptocurrency included – the key is to make sure it’s appropriate for your goals, time horizon and risk tolerance. Need advice? Your BlueShore Financial advisor has the know-how to help you make smart choices for your hard-earned savings. Speak with us to learn more.