What is cryptocurrency?
Cryptocurrency is a digital currency that enables secure online payments without using a third party. This digital currency is purchased on cryptocurrency exchanges. While it can be used to purchase goods and services, it is not yet widely accepted for retail transactions. However, cryptocurrency has gained growing attention as an investment trading instrument, although it has been highly speculative and extremely volatile.
Questions continue to swirl around the viability of cryptocurrencies. It remains top of mind thanks to TV commercials, mobile apps, and even grocery store cryptocurrency kiosks.
Most cryptocurrencies are touted as “decentralized” currencies with no state central bank to issue it or oversee them. Transactions are verified in a public ledger known as a blockchain. A key feature of blockchain is that it records all transactions and can never be altered. Your balance – the sum of all cryptocurrency purchases and sales – would always be accurate.
Which names are leading in cryptocurrency?
Nearly 20,000 cryptocurrencies have been created,iii and about half of those have already been abandoned.iv Bitcoin and Ethereum, the two most adopted cryptocurrencies, comprise approximately two-thirds of the $1.2 trillion market cap (as of late May 2022). The top 10 cryptocurrencies make up about 85% of the market cap, and 99% of all crypto value is in the top 1% of coins.
Bitcoin is the most popular cryptocurrency, with about $500 billion in market capitalization as of June 2022, followed by Ethereum with a market cap of about $200 billion. As of 2022, there are about 250,000 to 300,000 Bitcoin transactions per day worldwide, while Ethereum – another popular cryptocurrency – has grown to more than one million transactions per day.ii By comparison, there are approximately one billion credit card transactions per day.
Who owns cryptocurrency?
While ownership surveys vary, the vast majority of U.S. crypto owners – at least 80% – are between the ages of 18 and 45. Less than 2% are Baby Boomers (57 and over).vi About 74% of crypto owners are men.vii About 34 million Americans owned cryptocurrency as of April 2022, up from about 10 million in 2019.i Worldwide, crypto ownership grew from about 106 million to 295 million in 2021, according to Crypto.com, which projects that worldwide crypto ownership may reach about one billion people by the end of 2022. That projection may be optimistic due to crypto’s recent slump.
Amidst the hype and user growth, cryptocurrency prices have been extremely volatile. After reaching an attention-grabbing high of more than $67,000 in November 2021, Bitcoin has steadily dropped to about $20,000 as of June 2022. While Bitcoin is often considered to be a hedge against inflation or other investments, that has not been evident in recent trading. As stocks and bonds declined in price over concerns about inflation in 2022, cryptocurrency prices fell even faster and further than any of the key market exchanges.
Cryptocurrency has been slow to gain traction as a means of exchange because of that volatility and the steep learning curve for consumers and businesses. Despite its flaws and extreme volatility, crypto has some strengths that could keep it on the forefront of the financial markets.
Is cryptocurrency an inflation hedge?
Bitcoin was designed to serve as a long-term hedge against inflation. A key feature of Bitcoin that has attracted a broad following is the limitation that only 21 million units can ever be put into circulation. Since an increasing supply of dollars is a key cause of inflation, the creators of Bitcoin attempted to curb that inflationary pressure by putting a cap on the total number of Bitcoin units in circulation.
By contrast, central banks of sovereign nations, such as the Federal Reserve (Fed), have the authority to issue an unlimited amount of currency. In recent years, the Fed has increased the money supply significantly in order to stimulate the economy. That means more dollars are chasing a relatively static supply of goods and services, which tends to trigger inflation.
As more dollars are poured into the economy, the supply of specific cryptocurrencies like Bitcoin remains stable. That means that a quickly rising supply of dollars is chasing a fixed number of Bitcoin units. Theoretically, that should drive up the dollar value of relatively static cryptocurrencies like Bitcoin. However, so far, there has been no reliable correlation between inflation and the value of Bitcoin.
Cryptocurrencies have not performed as either an inflation hedge or a market hedge. Instead, the crypto market has performed more like a speculative tech stock than a bar of gold.
Crypto as a new financial tool
While cryptocurrency is used as a form of currency for the purchase of goods or services, the financial aspects of crypto can go well beyond simple transactions. The greatest potential of cryptocurrency may be in an area known as “decentralized finance” – or simply “DeFi.”
“DeFi offers the ability to earn income from lending, staking and providing liquidity to trading pools,” explains Paul Landahl, Thrivent Asset Management Senior Quant Analyst. “This capability could ultimately lead to a sweeping transformation across the financial landscape. DeFi is the most important thing going on in the crypto space right now, and it could eventually reshape the financial world.”
Crypto innovators have already replicated most of the financial system on the blockchain, according to Landahl. “For example, with only a web browser, someone can construct something similar to an ETF (exchange traded fund) and sell it to investors.” (ETFs are similar to a mutual funds in that they typically hold a portfolio of stocks or bonds.)
Adds Landahl: “Bitcoin was about replacing money; DeFi is about replacing finance. Decentralized autonomous organizations (DAOs) create a new way for people to build and manage organizations, corporations, and foundations. Hardware projects are underway that could replace the physical infrastructure of the internet with a truly decentralized network of wireless internet. The eventual goal is an uncensored world-wide financial system and communications network that is both private and broadly distributed.”
Security concerns for cryptocurrency
Some critics speculate that cryptocurrency could be subject to malicious hacking attacks and security breaches, although traditional financial services do also suffer from frequent attacks, scams, and breaches. “The value of the Bitcoin protocol is that it guarantees irrevocable and verifiable transactions. The block chain is public, and we can see a chain of custody for every unit of value,” said Landahl.
However, Landahl is quick to point out that “new cryptocurrencies are created every day, and many contain fundamental flaws which could be exploited.” While the blockchain can guarantee safe transactions, Landahl points out that cryptocurrency is subject to the same risks as traditional financial accounts. “They can be stolen by attackers who target user’s phones, computers, or even centralized exchanges which take custody of funds – just as traditional financial accounts can be compromised by con artists who exploit account holders.”
To this point, the U.S. has not instituted measures to regulate the use of cryptocurrency, but in March, President Biden signed an executive order designed to develop a path toward regulating the use of cryptocurrency and protect consumers and businesses against harmful practices in the cryptocurrency industry.
Dealing with extreme volatility
Perhaps the most troublesome aspect of cryptocurrency is its extreme volatility. It tends to go through bright periods of soaring growth followed by dark stretches of gut-wrenching declines, propelling crypto owners through a perpetual financial and emotional rollercoaster.
A quick look at Bitcoin’s recent price history tells the story:
At the start of 2017, Bitcoin was selling for about $900 and quickly rose to nearly $20,000 by the end of that year. But by the end of 2018, it had dropped all the way back to about $3,000. After that, it meandered between about $5,000 to $10,000 through mid-2020, then exploded to about $62,000 in March 2021 before dropping back to about $30,000 in July 2021. Then it rocketed all the way up to about $67,000 in November 2021. After that, it reversed course all the way back to just under $30,000 in May 2022 – then crashed even further in mid-June to about $20,000.
The massive swings in price that cryptocurrency owners have experienced continue to evoke the expression, “who will catch the falling knife?” Because no one really knows where crypto is headed at any given time.
With the stock market, there are well-accepted methods for determining a likely price range for each individual stock, such as earnings and earnings growth, revenue and revenue growth, cash flow, dividends, and the price-earnings ratio.
But there are no such universally accepted measurements for cryptocurrency. While the industry is making progress in this area, according to Landahl, “Analysts’ estimates often diverge wildly in magnitude and direction.” When things start heading south, most investors can do little more than hang on for dear life and hope that the big hitters will ultimately catch the falling knife and start to bid the price back up.
That’s why crypto investing is not for everyone.
There’s no financial industry standard for how much crypto investors should hold in their portfolios. Landahl suggests that conservative investors may want to skip crypto altogether, while younger aggressive investors who are willing to take the risk of owning cryptocurrency may want to put a small allocation of their investments into crypto.
Because of its highly speculative nature – and the possibility of experiencing steep market declines – investors should carefully consider whether owning cryptocurrency is appropriate for them in light of their experience, objectives, financial resources, and other relevant circumstances.
Investors may wish to consult with their financial professional before determining whether or not to invest in cryptocurrency as part of their long-term financial plan.
Cryptocurrencies including Bitcoin and Ethereum are very speculative, unregulated, experience significant price volatility, and are not suitable for all investors. Fluctuations in the underlying cryptocurrency’s value between the time you place a trade and the time you attempt to liquidate it will affect the value and the potential profit and losses related to it. Be very cautious and monitor any investment that you make. Speculating in these markets should be considered a high-risk transaction. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment, and a potential total loss of their investment.