What are Cryptocurrencies?
Every week I get asked about Bitcoin and cryptocurrencies in general. My opinion is always the same. I see Bitcoin and cryptocurrencies as a type of investment with risk - not a store of value.
What is a cryptocurrency?
A cryptocurrency is a digital or virtual means of exchange. There are more than 6,700 cryptocurrencies today; among the better known are Bitcoin, Dogecoin, Ethereum, XRP, Tether, and Litecoin.
Unlike traditional currencies, virtual currencies currently operate without central authorities or banks, and they are not backed by any government. Cryptocurrencies are stored in “digital wallets” on a holder’s computer or phone, or in the cloud. The wallet serves as a virtual bank account that enables holders to pay for goods and services or simply store the currency in hopes of an increase in value.
Cryptocurrencies defy neat categorization. They are not a traditional currency, commodity, or asset class, though they share characteristics of each.
There are several reasons why cryptocurrencies are not a traditional currency. Although some merchants have begun to allow cryptocurrency payments, they are generally not accepted as a medium of payment. Cryptocurrencies also are not used as a unit of account because prices, trade invoicing, and contracts are not quoted in digital currency units. Finally, cryptocurrencies’ ability to serve as a store of value—a safe instrument to preserve the value of people’s financial wealth—is severely limited by their notorious volatility.
One reason why cryptocurrencies might not have the same quality as other well-accepted currencies is they are not issued by a central bank. Now this is one reason why investors seem to like it so much. However, the role of a central bank is to preserve the value of the currency by keeping inflation under control. That’s why prices are more predictable under Federal Reserve management of the U.S. dollar money supply.
Risks to keep in mind
Any investment has risk. Here are some to keep in mind for cryptocurrencies:
- Liquidity risk. Cryptocurrencies are unregulated, and no party is required to accept payments in virtual currency. As a result, certain market conditions might make it difficult or impossible to sell quickly at a reasonable price.
- Pricing risk. Cryptocurrencies trade in decentralized markets. In addition, cryptocurrency exchanges and platforms do not feature the regulations, controls, and investor protections available in traditional stock, options, and futures markets. For these reasons, there is no unifying single pricing mechanism that reflects digital currency values.
- Regulatory risk. Cryptocurrencies essentially compete with currencies issued by governments. At some point, governments may seek to regulate or restrict cryptocurrencies, or issue a digital version of their own currencies. Such developments could adversely affect cryptocurrency prices.
I found an good quote that sums up my views on cryptocurrencies...
“Cryptocurrency prices depend mostly on speculation about their adoption and use. That speculation creates volatility which, ironically, undermines their potential use as either a currency or asset class in an investment strategy.”
-Roger Aliaga-Díaz, chief economist for the Americas and head of portfolio construction at Vanguard