Bitcoin and Cryptocurrency: What’s the Big Deal?

Back in December, I got a visit from a client; I’ll call him Scott. He’s about my age, also married with three kids still and home and in the accumulation phase of his life. Scott’s been doing well for himself for the past few years and has seen his investments grow. Like many investors in times of relatively low volatility, Scott’s looking for higher returns and he thought there was a fantastic opportunity in a new emerging “investment opportunity” called cryptocurrency. More specifically, Bitcoin.

You have probably heard a lot about Bitcoin – it’s mentioned in the news almost every day. But what is Bitcoin, anyway? And for that matter, what is “cryptocurrency?”

Cryptocurrency, including Bitcoin, is digital money. It’s fundamentally different than a US dollar – you can’t go to a bank, withdraw Bitcoin and hold it in your hand like you can with a $50 bill. It exists purely in the digital realm. Not everyone accepts Bitcoin. In fact, it’s still a rarity to find businesses that do. Bitcoin is the most popular cryptocurrency, but there are a few others that have garnered a lot of interest as well, like Ethereum, Zcash, and others.

At the time Scott and I met, Bitcoin’s rise had been phenomenal. A single bitcoin started out 2017 valued at about $1,000 (much in the same way 1 Mexican Peso is worth $0.05, as of this writing). By the time Scott visited me in December, one Bitcoin was worth close to $20,000 – about a 1,900% increase! No wonder Scott was so interested. Some TV financial “personalities” have suggested that the sky is the limit and have targeted an even higher valuation. Scott also thought there was no end in sight and wanted to get in while the getting was still good.

When Bitcoin first appeared in 2009, you had to be a pretty advanced computer expert even to understand what it was or how to get some. Now you can buy (with real money) Bitcoin using an exchange service accessible to anyone with a computer or a smartphone; in fact, there are even automated kiosks that let you purchase Bitcoin and other cryptocurrencies with cash, like buying a bag of chips or a can of soda (albeit, very costly ones).

Cryptocurrency gets its name from the computer encryption used to process transactions. Generally speaking, each transaction is added to a public ledger that the buyer and seller use to validate the currency while keeping their own identities secure. Every single transaction made with cryptocurrency is tracked in this public ledger, called a “blockchain.” Imagine if you could look up the serial number on a dollar bill in your wallet and see how it has been spent since it left the Treasury printing press. That’s generally how blockchains work.

“Mining” Bitcoin and other cryptocurrencies is the process of confirming those encrypted transactions, and, in fact, the process of minting new Bitcoin. It’s done by third-party computers that solve ever-more complicated mathematical problems. The first miner who solves the problem adds a new block of information to that public ledger – that’s the “chain” in blockchain.” The miner is then rewarded for their effort with a small amount of Bitcoin. Bitcoin mining has become lucrative enough that entire computer server data centers have been built to do it.

Bitcoin mining is so computationally intensive that it’s limited the supply of Bitcoin. This was the intent of Bitcoin’s creator; to help regulate the speed at which it is created. As a result, some investors view Bitcoin and other cryptocurrencies as an asset class like a precious metal, such as gold or platinum.

Here’s the problem: Unlike the dollar, Bitcoin isn’t backed by the full faith and credit of any government. Bitcoin and other cryptocurrencies were developed to be decentralized – traded from individual to individual, keeping government regulators out of the loop. Last December, Bloomberg reported that approximately 1,000 people control about 40% of Bitcoin. But without a regulatory framework in place, as there is with currency or equities, those few can play fast and loose to manipulate the value of their Bitcoin, which can hurt everyone else.

Another challenge is that crafty computer hackers have figured out ways to hack the very exchanges where cryptocurrencies are traded, getting away with millions of dollars in cryptocurrency value in the process. Banks and other financial institutions get hacked too, but far less frequently. And because there is little to no regulatory oversight, there’s no depositor’s insurance as there is with a bank – so some individual investors have lost millions of dollars in cryptocurrency value when these exchanges have been hit, with no financial recourse. US regulators are finally cracking down on cryptocurrency fraud, but it’s the old story about closing the stable doors after the horse has bolted.

China – home to the world’s largest population of cryptocurrency miners – has recently cracked down on cryptocurrency trading on its exchanges, which has contributed directly to the cryptocurrency volatility we’ve seen in recent weeks. China has also banned “Initial Coin Offerings” or ICOs – the cryptocurrency equivalent of a stock’s initial public offering. South Korea appears to be taking similar steps.

Scalability is another significant risk with cryptocurrency. The longer a cryptocurrency blockchain becomes, the more horsepower the mining computers need to solve the complicated math problems that allow them to verify transactions and add new blocks. That leads to longer and longer transaction times and more expensive transaction fees. Instead of the milliseconds it takes for you to make a credit card or debit card purchase using fiat currency like the dollar, cryptocurrency transactions take several minutes to process. Some companies that were accepting cryptocurrency as payment are no longer doing so for this reason. Others are charging much more for the privilege, which makes cryptocurrency lose its luster.

Folks, as a Registered Investment Advisor, I’m beholden to a fiduciary standard which requires me to put my clients’ interests first. I don’t look at investments as good or bad. Instead, I look at what is appropriate or inappropriate for the individual investor, based on their risk tolerance and client profile. Because there’s so much risk involved in cryptocurrency, I told Scott that I don’t think investing in it would be a wise move for him. Fortunately, he listened. And shortly after our meeting, the value of Bitcoin went into freefall. Scott would have lost a bundle if he’d invested at that peak.

Cryptocurrency is still in its infancy, and there may be excellent investment opportunities in the future. But for now, prudent investors may want to wait and see what happens with respect to its oversight. When an investment sheds more than 20% of its value in a month, as Bitcoin has done in the past, that’s a red light. I will tell you what I told Scott, the educated investor does not chase gains in any market without understanding the risk of loss. If you manage the downside risk, well, the upside takes care of itself.

Now, more than ever, please be vigilant and stay alert, because you deserve more.

Have a great week!

Jeff Cutter, CPA/PFS is President at Cutter Financial Group, LLC, a SEC Registered Investment Advisor, with offices is Falmouth, Duxbury, and Mansfield. Cutter Financial Group provides private wealth and investment management advice incorporating low risk, low volatility financial strategies. Jeff can be reached at jeff@old.cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a registered investment advisor.

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