What the heck is Cryptocurrency

Bitcoin has been in the news quite a bit lately with its recent run-up and celebrity investors (Elon Musk) buying in to it. But I’m guessing that a lot of us don’t know exactly what Bitcoin is, how to buy it, or what it can be used for. Or to expand the category a little bit, what the heck is Cryptocurrency?

Our friends at Buckingham Strategic Partners put together a helpful overview of Cryptocurrency that I hope might answer some of your questions.

What is cryptocurrency?
A cryptocurrency is a digital token that can be exchanged on a blockchain (see definition of blockchain below). The first example of a cryptocurrency is Bitcoin (BTC), which currently represents the largest share of the cryptocurrency market. Additional examples include Ethereum, Litecoin, XRP (aka Ripple), and Bitcoin Cash. Thousands of different types of cryptocurrency have been created. Exchanges have developed that allow cryptocurrency to be converted to traditional types of government-backed fiat currency (e.g., U.S. dollar, Euro, Yen, etc.).

What is a blockchain?
A blockchain is a software program that may run on a decentralized or centralized network. In the case of Bitcoin, the network is decentralized, meaning that independent parties from around the world are running the software. The software keeps a record of transactions and ownership. All new transactions are recorded in blocks that are linked in a chain all the way back to the original block. Every transaction is sealed and cannot be changed. The result is a publicly distributed ledger. There are thousands of high-powered computers on the blockchain network independently working to verify the transactions and create a new block. In the case of Bitcoin, a new block is created about every 10 minutes. After creation of the new block, the blockchain is approved and computing work begins to solve the next block in the chain. The incentive/reward for performing this work is the issuing of cryptocurrency native to the blockchain.

What are the investment characteristics of cryptocurrency?
Over the last decade, cryptocurrency has been marked by high returns, high volatility, and low correlations with traditional assets. According to a recent CFA Institute study, a $10,000 investment in Bitcoin on July 17, 2010 would be worth $2.2 billion as of September 30, 2020.1 However, an investor would have had to sit through six declines of more than 70% in order to achieve such a return. Unlike stock prices, which tend to follow the direction of cash flows over long periods of time, cryptocurrency prices are determined by other factors, like store of value and network effects, that are more difficult to quantify.

How can individual investors access cryptocurrency?
Individual investors can purchase cryptocurrency on several different exchanges. Setting up an account with an exchange is like setting up an account with a traditional brokerage firm. A bank account can be linked to fund the exchange account and purchasing cryptocurrency is like buying a stock or ETF. The exchanges charge a fee for each transaction. After cryptocurrency is purchased, it is common to move the cryptocurrency to another digital wallet provider for secure storage.

Over the last few years, several cryptocurrency-centric investment vehicles have launched. However, most of these investments are only available for private placement for accredited investors or to the public via Over The Counter (OTC) exchanges. These offerings are not subject to the same level of scrutiny and regulation as typical mutual funds and ETFs available to the public and recommended by Buckingham. The investment offering landscape continues to evolve and it is possible that mutual fund and ETF offerings will be available in the coming years.

In terms of asset allocation, how should cryptocurrency be categorized?
In its relatively brief history, cryptocurrency has exhibited low correlations with traditional asset classes. The risks associated with cryptocurrency are unique compared to equities and fixed income, which make up the largest allocation of most investor portfolios. From this standpoint, cryptocurrency should be classified as an alternative asset. As the use cases for cryptocurrency become clear, correlations with traditional asset classes are likely to change and the role of cryptocurrency in a portfolio will be easier to define.

How much should I consider allocating to cryptocurrency?
Buckingham does not currently recommend an allocation to any cryptocurrency. For clients that insist on an allocation, we would treat this like any other client preference and keep the allocation below 5%.

What is the tax treatment of cryptocurrency?
Cryptocurrency is subject to capital gains tax treatment just like other capital assets such as stocks. For cryptocurrency held less than one year, it is taxable as a short-term capital gain. For cryptocurrency held longer than one year, it is taxable as a long-term capital gain. One notable difference is that cryptocurrency is not subject to the wash sale rule.

Have I missed it?
Regret with investing is pervasive. Envy toward the early adopters who became fabulously wealthy (whether by genius or dumb luck) is a powerful emotion. There have been many times where investors could have thought they missed it (Nifty Fifty stocks in the 70s, technology stocks in the 90s, real estate in the 2000s, etc.) If cryptocurrency is a real game-changer with a unique source of risk and expected return, then there will be a market to participate in going forward. It is important to remember that the primary objective of a well-thought-out financial plan and investment policy statement is to create a high probability of accomplishing goals while controlling risk. Achieving high returns is not the primary objective and missing high returns in certain areas of the market does not mean failure. At present time, the prudent investor is probably wise to wait or to buy cryptocurrency with money for which a total loss is acceptable.