Easily the most hot-and-cold asset class we’ve ever seen, cryptocurrency investors are either being laughed at or seen as geniuses depending on the phase of the market. Over the past few years, we’ve seen blow up after blow up, with FTX and other implosions across the industry. Since this is such a hot topic, we wanted to put together a quick summary of the top questions we’ve heard over the years. We will warn you that this is a hard concept to grasp as crypto is a fascinating concoction of computer science, economics, finance, game theory, and coding all wrapped into one.
But before we get into the Q&A, please read this important disclosure: Cryptocurrencies are extremely volatile. They are not guaranteed, not insured, and you have a high risk of losing your principal. The cryptocurrency market is not regulated like traditional markets, therefore is subject to greater manipulation and speculation than traditional markets. This blog is in no way a recommendation to buy or sell cryptocurrencies. This blog post is meant only for informational purposes and is not intended as tax, legal, or investment advice.
1.) What the heck is a blockchain?
Keeping it as simple as possible, the blockchain is a way to store a group of transactions referred to as a digital ledger. When new transactions are broadcast to the network, they are bunched together into a block. After a set time, these "blocks" of verified transactions are permanently added to the blockchain, and the miners or validators are compensated in return for adding the transaction to the network.
2.) Other than being a digital ledger, what is the point of a blockchain?
There are four primary purposes:
Decentralization: The basic premise of cryptocurrency is that there is no centralized person or entity making decisions. The networks are typically comprised of a network of thousands of computers maintaining a digital ledger of transactions. Decentralization is a buzz word that has come up recently when it comes to taking power away from the big tech/banking companies/governments because they have too much centralized power.
Immutability: Once a transaction is put onto the blockchain, there is no changing it. If you send a transaction to your neighbor, that transaction lives forever on the blockchain.
Borderless: Moving around $1 million in bitcoin is certainly much easier than moving around $1 million in physical gold. And the ease of transferring crypto across the globe is drastically better than the traditional banking industry. Even sending within borders is much more efficient than wiring or ACH transferring funds (near instant settlement).
Censorship Resistance: With a censorship resistant protocol, there is no telling someone they can or cannot use it, as long as they have access to the internet, they can participate. However, that does not mean a country cannot make a law banning it or prohibiting the purchase of it.
3.) If Bitcoin is digital gold, is Ethereum digital silver?
Yes and no. Ethereum is certainly in second place in terms of market cap, but it has quite a different stance on what blockchain technology should be used for. If you ask a Bitcoiner, the main purpose of the bitcoin blockchain is to store value (like gold) and is a great alternative to leaving your money in fiat currencies subject to inflation risk. If you ask an Etherian, they believe the Ethereum protocol to be the next iteration of the internet, where various applications can be built on top of it using smart contracts. With smart contracts, there are endless possibilities of what a blockchain can do, from pledging your ether as collateral and taking a loan, to participating in a decentralized lottery, to creating a decentralized autonomous organization (DAO). So, I would say it’s more like comparing Gold and the Internet, versus Gold and Silver.
Ethereum is far from a finished product. There are hundreds if not thousands of developers working to improve and scale the network. The Ethereum network is famous for having cat pictures (cryptokitties) clog the network and skyrocket transaction fees. There have been many times the network has been borderline unusable. It is reminiscent of the internet in the 1990s, where it took pictures forever to load, and you wouldn’t even think about loading a video. Heck, it wasn’t more than two decades ago when it was easier for Netflix to mail DVDs than it was to have a video streaming service. The point is, these things take time to develop, and there are various solutions in the works to scale the network. I am not going to nerd out and start explaining layer 2 networks like optimistic and zk rollups quite yet, that’s a conversation for another day.
I would also be remiss not to mention proof-of-work (PoW) versus proof-of-stake (PoS) consensus. Proof-of-work is what bitcoin uses. If you’ve heard about the energy consumption of bitcoin mining being similar to that of a small country, this is what people are referring to. PoW involves using high powered computers to solve complex problems, and the first to solve the problem gets the reward. Ethereum is now a proof-of-stake network, which is over 99% more energy efficient, and stops the need of miners from selling their mined coins to pay their energy bills. PoS involves locking your ether up and validating transactions. The rewards are given at random to the participating validators. Ethereum also has a fee burn and burns a portion of each transaction fee, which makes Ethereum net deflationary, assuming the network isn’t a total ghost town (you need transactions to burn transaction fees).
4.) What about the other cryptocurrencies, like Solana (SOL), Cardano (ADA), Litecoin (LTC), Dogecoin (DOGE), etc.? Aren’t they faster and more efficient?
We consider Bitcoin and Ethereum to be the “blue chip” investments of the cryptocurrency world. We say this because we believe they are more likely to survive the next decade. Beyond the top two, there are thousands of other cryptocurrencies. Keeping up with the other coins and tokens is next to impossible if you aren’t fully immersed in the crypto space. All these other projects come with far greater risk. To us, the “blue chip” cryptos are risky enough and there is no need to take on additional risks with other coins. Not to mention, smaller coins have smaller market caps and minimal trading volumes, so are much more likely to be the subject of manipulation.
As far as being faster, more efficient networks, that’s a difficult question to answer in a simple way. The easiest way to explain this is there are tradeoffs for everything in the investing world. For instance, a CD will give you a higher yield than a checking account, but the tradeoff is liquidity. A bond will give you a higher yield than a CD, but the tradeoff is interest rate risk. And so on. It’s the same with crypto. Sure, Solana is faster than Ethereum, but the tradeoff is more centralization (Solana has a network of just a few thousand validators compared to the Ethereum network of over 750,000).
5.) What are NFTs?
In 2017, a major driver of hype was the ICO (Initial Coin Offering). These were riddled with scams and failed projects, but it was an interesting way for new projects to raise tons of capital in a quick way.
During the 2020 bull run, a new acronym called NFTs garnered a lot of attention. NFTs are non-fungible tokens, typically issued on the Ethereum blockchain. What this means is that you can issue or “mint” a one-of-a-kind token such as a digital art piece. That’s right, digital art. If you think there would be no market for this whatsoever, you’re certainly not alone. However, an artist named Beeple sold a digital art piece for $69 million. The end goal, however, is for NFTs to be much more than monkey jpegs and digital collectibles. There are interesting projects using NFTs for gaming, music, or trading cards, and we’ve only scratched the surface on what these may be used for. A great example of this is Draftkings. Their NFT game called Reignmakers is projected to be about 5% of their revenue. Another exciting use-case for NFTs is the secondary ticket markets. Isn’t everyone sick of being raked over the coals by Ticketmaster and Stubhub when buying or selling tickets? Well, NFTs could eventually solve that problem. Imagine if every ticket sold came with a unique NFT, this NFT could be sold in the open market for minimal fees and the original seller could get a piece of the mark up (I.e., ticket face value is $100, is sold for $200, the original seller could take a 10% appreciation fee, in this case $10). It’s a win-win for most parties involved... expect Ticketmaster, but who cares about them?
6.) How do I buy it? Is there a way to get cryptocurrency exposure without having to buy crypto?
We do not recommend or endorse any exchange or crypto service. There are several large companies that operate in the US (Coinbase, Gemini, Fidelity, Robinhood, etc.). For retirees, it’s a bit of a stretch to expect them to custody their keys, protect their seed phrases, and quite frankly, avoid all the scams out there. For the less technical, it may be better to try to get exposure within your brokerage account.
If you prefer to hold it in your typical brokerage account, a company called Grayscale has cryptocurrency trusts that you can buy. These products typically carry around a 2% expense ratio and often trade at premiums or discounts, meaning they are more or less expensive than the underlying asset within the trust. This is not optimal, but these products give you exposure to cryptocurrency inside of a typical brokerage account.
Other companies, like BlackRock, VanEck, ARK, and more, are currently applying for spot ETFs to be approved, but we are waiting for the SEC to accept/deny their application. Grayscale is looking to convert their products to ETFs, and recently won a court case against the SEC which will help towards that goal. There are futures-based ETFs currently available for bitcoin, which have not garnered a ton of AUM because they don’t track the price as well as a spot ETF. At the time of this writing, the futures ETF BITO is up 57.28% YTD with actual bitcoin being up 63.79% YTD.
7.) Is now a good time to buy????
Ah, the million-dollar question. In all honesty, there is not a heck of a lot of demand right now for purchasing crypto. But times like this have historically been a much better time to buy compared to buying into the euphoric hype. In 2022, the cryptocurrency community took a few punches. It was an extremely painful year for crypto investors. I don’t believe much in looking at the cycles of an asset class that is just over a decade old, but it is hard to deny the four-year cycles that bitcoin has experienced. This correlates nicely with the bitcoin halvings, which reduce the payment to miners by 50%, and occur every four years approximately (reducing the mining rewards reduces the rate at which the supply of bitcoin grows). The next halving is expected to happen in April 2024. Global liquidity also has a tremendous impact on these assets, and we may see that tick up over the next couple of years. Should the trend continue, we could be in store for another explosive crypto rally in 2024/25, but remember, this is the most volatile asset class on earth, and you should only invest money you are fully okay with losing.
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.