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What is it with Cryptocurrency?

By Song Zhen Goh

Song Goh

What do Ethereum, Litecoin, Ripple and Bitcoin have in common?  The last one gives the game away as Bitcoin is the best known of the cryptocurrencies gaining popularity around the world.

What’s incredible is that as at 30 September, these alternative “currencies” have appreciated in value by 3296%, 1013%, 2691% and 292% respectively since the start of 2017. Comparatively, all of them have comfortably beaten the ASX All Ords (3.95%) and the S&P 500 (5.42%) over that time.

So what is cryptocurrency and should you be investing in it? I am no expert in the field, but the following must be contemplated.

What drives the valuation of cryptocurrencies?

Arguably the most important of a number of factors at this point is the same mechanism that drives the valuation of any asset – demand for the asset. What is clear is that there’s a good portion of demand for cryptocurrencies being driven by the pure hype that continues to surround the sector, and people not wanting to miss out on the rise of the next Bitcoin. Extreme price swings in very short periods of time have also accompanied the hype.

Cryptocurrencies have also proved popular with those working in the world of the ‘dark web‘ – terrorists, arms dealers, drug traffickers and the like, so wherever they can hide their activities from authorities, there will be demand.

Regulation is mixed at present.

Like so much in the technology world, it is very hard for regulators to keep up. The US Securities and Exchange Commission (SEC) has ruled that some ‘coins’ are actually securities and therefore subject to SEC regulation, while at home ASIC has attempted to provide guidance of its own. Elsewhere, Chinese and South Korean regulators have banned Initial Coin Offerings. A lack of standards in the issue of cryptocurrencies means that investors face significant risks with no protections.

When new coins or ‘tokens’ are issued to interested parties in exchange for money, the offer is known as an Initial Coin Offering or “ICO”. This is very similar in concept to an Initial Public Offering or “IPO”  where a private company issues new shares to public investors. The growing interest in ICO’s combined with the lack of regulatory oversight has seen a multi-fold increase in the number of new offerings. A consequence of this has been a growing number of ‘pump and dump’ schemes, where issuers sell off significant holdings at hyped up prices, leaving new investors with large losses.

What’s next for this opaque area of finance?

The stratospheric rise of cryptocurrency prices have drawn parallels with the Dot-com bubble of the late 1990s and the Dutch Tulip Mania of the 1600s. One of cryptocurrency’s most successful and highest profile investors has been on record agreeing with the bubble theory, however, emphasising that he was planning to profit from it. Other high profile finance professionals have spoken out, including the founder of the world’s largest hedge fund Ray Dalio who called the Bitcoin craze a ‘speculative bubble’, and Jamie Dimon, the CEO of JPMorgan Chase, has also publicly denounced Bitcoin as “a fraud”.

Despite the hype, there appears to be real merit in the technology that sits behind cryptocurrencies, known as blockchain technology.  But, at this stage at least, it is just potential. To that end, any investment in cryptocurrencies is speculative at best, and does not fit into the evidence-based investment portfolios we build for clients.

The only guarantee in all of this is that many, not just finance professionals, will be keenly observing as this fascinating technology continues to develop.

Song is an Investment Analyst with Capital Partners Private Wealth Advisers. To contact Capital Partners please call 6163 6100, or send us an email.

5,945 total views, 3 views today

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2 responses to “What is it with Cryptocurrency?”

  1. Ermie Robinson says:

    I don’t know whether I am particularly dim, but I am struggling to understand what exactly it is that one purchases when buying any of these “cryptocurrencies”? What backs their value – their doesn’t seem to be anything concrete to me?

    • Administration says:

      Hi Ermie,

      Thanks for your question. There can be real projects and ideas behind the issue of each cryptocurrency. There are a variety of projects and ideas coming forth, seeking funding in the form of Initial Coin Offerings (ICOs), purporting to solve problems in areas like money lending, online gaming and energy trading, to name a few.

      Take Ether, for instance, one of the largest cryptocurrencies currently available. At its core is Ethereum, a new platform developing decentralized execution of ‘smart contracts’, in simple terms a way of transferring anything from company shares to data without the use of an intermediary. If inefficiency in how various contracts are executed today is a problem, then Ethereum can be seen as a potential solution and could have significant disruptive implications in the realms of e-commerce, legal contracts, financial contracts etc. Coming back to Ether, they are the unit of currency which can be used to pay for services on the Ethereum platform. As with any good or service, the more successful the Ethereum platform, the more people and businesses will seek to use it, driving the proliferation of Ether usage, which in turn drives the value of Ether.

      Now, it is definitely not the same thing, but it might help to think of cryptocurrencies as similar to shares in a company. When you buy a share in a company, you are hoping that whatever the good or service it is producing will have mass appeal, which will drive sales, company profitability and subsequently share price. When you buy cryptocurrency, you are hoping that the underlying project or idea takes off to boost the value of your holding.

      As blockchain technology is still in its relative infancy, this is a highly speculative exercise!

      It is not the easiest subject to understand, but I hope this has helped somewhat.
      Thank you, Song Goh

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