by Justin Kuntz, CFP ®
It has been the subject of many social conversations and news articles: Cryptocurrency and blockchain. The topic has inspired so many questions: What are they? Is it legitimate or just a scam created by internet thieves? What does it mean for the future of technology and the U.S. dollar? Should it be a part of my investment portfolio?
A digital asset designed to secure transactions cryptographically. Cryptocurrencies are required to participate in the blockchain ecosystem. Examples include Bitcoin (BTC) and Ethereum (ETH). There are more than 10,000 different cryptocurrencies and as of May 2021 and the total value was greater than $1.7 Trillion.
Popularity and Support
- Some see cryptocurrencies like Bitcoin as the currency of the future and are racing to buy them before they become more valuable.
- Central banks currently manage the money supply, and also have the power to reduce the value of money via inflation. Supporters of cryptocurrency like that the central banks are no longer required if mass adoption of these currencies occurs.
- Speculators have found the volatility of the crypto market exciting and a novel way to potentially make money quickly in a market other than stocks and bonds.
- The technology behind cryptocurrency, the blockchain, is another reason why many support the concept. The decentralized processing and record-keeping system can be more secure than traditional payment systems.
- Most cryptocurrencies do not generate any cash flow for investors. The path to profit is only if another investor is willing to purchase the currency at a higher price than one’s original purchase price. This is in contrast to a good business, which increases in value over time by growing cash flow and profitability.
- Volatility is substantially higher in the crypto market than in the stock market. For example, Bitcoin traded at near $20,000 in late 2017, and one year later its value had dropped to around $3,200. In December of 2020, it had climbed past $27,000 and pushed on to newer record highs. Bitcoin has had a correlation with the S&P 500 of 0.81 since 2016.
- Due to their speculative nature, cryptocurrencies provide the potential for substantial gains and catastrophic losses. Therefore, they may only be suitable for aggressive investors.
Source: Goldman Sachs Asset Management; 2021
Traditional vs. Decentralized Forms of the Transaction
Traditional transaction method
An intermediary is required to facilitate the transaction
- Step 1: John would like to give $100 via check to Bob
- Step 2: John's payment will be processed by an intermediary to clear and transfer the payment
- Step 3: The bank clears the check and funds are transferred
Decentralized approach to payment
In this example, a Bitcoin (BTC) transaction can be made without an intermediary
- Step 1: John announces intention to give 1 BTC to Bob
- Step 2: The blockchain network verifies historical transactions to confirm John's original receipt of BTC
- Step 3: The first solution is rewarded with the new Bitcoin and has transaction fees
Shared databases that are decentralized and encrypted. The technology continues to revolutionize many industries and has proven to increase efficiencies in numerous real-world applications.
- Blockchain stores information differently from a typical database in that it stores data in blocks that are connected as a chain (I.e. Block-chain)
- New data creates a new block, and once filled it is connected to the previous block. This creates a chronological chain of encrypted information.
- Many types of information can be stored on these data blocks, however, the most common use has been as a ledger for transaction history. All transactions on the decentralized ledger are permanently recorded and viewable to anyone.
- Financial Services
- Faster trade settlement
- Streamlined client onboarding
- Anti-money laundering reinforcement
- Electronic medical record efficiency
- Patient ownership of medical records
- Improved security among health information exchange
- Power and Electricity
- Efficiency in power grid energy distribution
- Reliable, low-cost record keeping
- Large scale peer-to-peer energy trading accessibility
- Government Services
- Secure and transparent voting
- Digital identity management
- Data sharing across different government agencies
- Anonymous data sharing improves transparency for pricing and coverage
- Real estate title record transferability
- Broker fee reduction as a result of streamlined processes between buyers and sellers
- COVID-19 Response
- Data reconciliation
- Seamless reporting of news sources
- Individuals able to flat inconsistencies for public health officials to review
Pros and Cons
- High data integrity as a function of decentralization
- Full transparency and unable to be changed, difficult to manipulate data
- Open source, highly configurable for many applications
- Assets have high-value density with more efficient ease of transport
- Impacted by the high volatility of the blockchain's underlying cryptocurrencies
- Scalability issues have not yet been solved, which could result in high costs and longer processing times
- Potential for use as a platform for illegal activity transactions
Blockchain technology has seen its fair share of scrutiny since its first research project in 1991, but it is proving to be an asset for business and culture. The technology and many linked cryptocurrencies are likely here to stay, as more businesses take advantage and refine the disruptive innovation.
As these innovations continue to assimilate into the investment ecosystem, Pacific Wealth Management will continue to evaluate their potential utility in our portfolios.