Cryptocurrency: the investor’s guide

Ben Rossi goes inside the crazy world of cryptocurrency to understand whether investors should be attracted or repelled by its volatile nature

 Cryptocurrency: the investor’s guide

‘As more and more banks examine the impact of these virtual currencies, it is clear that they are here to stay’

The money we use today, conventional currencies like sterling, is known as ‘fiat’ money. While in the past this was backed by gold or silver, today it is backed by governments or central banks that can decree its function as a medium of exchange and influence its value through fiscal policies and interest rates.

Cryptocurrencies are threatening this near-universal form of value exchange by disrupting the financial world with their digital, decentralised medium for transferring funds independent of governments or central banks. Unlike any other form of currency, they are based on mathematical proofs and regulated by encryption techniques. They are also increasingly used as a speculative asset.

When a user spends a cryptocoin, a transaction is added to an electronic public ledger, called a ‘blockchain’, which is similar to a bank record. Cryptocurrencies are controlled by a community of unrelated parties known as miners – independent computer farms in different parts of the world that validate transactions and are paid to do so in bitcoin.

There are believed to be over 900 cryptocurrencies, but bitcoin is the oldest and best known. Other well-known ones include ethereum, ripple and litecoin. Meanwhile, numerous exchange services are emerging to allow people to convert regular currency to cryptocurrencies.

The price of one bitcoin has grown from a few pence when it was created in 2009 to $3,432.90 at the time of writing, with most of that growth in the past couple of years alone. Initially suffering from slow uptake, driven by publicised hacks and reports that it was exclusively used for online black markets, bitcoin has gained legitimacy as governments, stock exchanges and large tech companies have become more open to investing in and using digital currencies.

With bitcoin’s market cap now over $50 billion and ethereum’s around half of that, numerous stakeholders are becoming increasingly accepting of cryptocurrencies being used for large-scale global transactions – and investors are wondering what opportunities surround them.

‘As more and more banks examine the impact of these virtual currencies, it is clear that they are here to stay, with more institutional buyers emerging and more businesses willing to accept cryptocurrencies as payments,’ says Balajee Sethuraman, head of banking and financial services for Europe at Cognizant.

Blockchain benefits

As well as its functionality and secure architecture, blockchain addresses some of the key challenges experienced in the financial sector for many years.

‘It can have a beneficial impact on pricing and costs in the market,’ Sethuraman says, ‘along with the opportunity for more accurate tracking of customer payment histories, across borders and banks, reducing the risk of defaulters.’

Omar Mohammed, financial analyst at Imperial FX, adds, ‘The decentralised nature of cryptocurrency means that it cannot be taken away with you. In an age of economic and political uncertainty, this offers a sense of financial security.’

Some businesses, including cosmetics seller Lush and technology firm Dell, have already announced they will accept bitcoin payments, benefiting from the increased security and privacy compared with traditional transactions.

As cryptocurrencies are not backed by governments or central banks, they transcend borders and can be used irrespective of which country the buyer or seller is in. Bitcoin is also governed by a protocol that limits its supply to 21 million units, making it a deflationary currency.

‘Since the number of bitcoins that can be created has a cap, the currency will not suffer from inflation in the way the pound would if the government prints too much cash,’ says Iqbal Gandham, UK managing director at eToro.

‘When you have circumstances such as in India, where 86 per cent of the cash in circulation was scrapped by the government, people are seeking protection from currency disorder,’ Mohammed adds.

Mayfair-based Dadiani Fine Art became the UK’s first fine art gallery to accept cryptocurrency as payment for works of art. Its owner, Eleesa Dadiani, was lured not only by the costs she can save on global transactions but also its speed.

‘Sometimes it takes the bank a few days to land money from point to point, but cryptocurrency transactions take place within an hour, or faster by some later technologies,’ she says. ‘It also honours privacy because participants are revealed only by their public keys, which are comprised of alphanumeric combinations, not the participant’s name.

‘Most importantly, it answers the riddle of rigid economies and the adverse conditions their citizens face in transacting democratically with other international markets. Cryptocurrency has eased global trade by bypassing central authorities and their rigid vetting processes, making it perfectly legal for citizens to acquire assets internationally without unnecessary scrutiny.’

Security is commonly touted as one of the most attractive elements of cryptocurrency. While hacks of cryptocurrencies aren’t unusual, the decentralised nature means that, unlike traditional banks, there isn’t one central point of weakness that can be exploited.

Meanwhile, the fact that cryptocurrency is shared means it carries an enormous amount of computer power.

‘It is said that the power behind the bitcoin blockchain is equal to 500 of the world’s most powerful supercomputers multiplied by 13,000,’ says Jakov Agbaba, risk analyst at Rathbones. ‘It would be prohibitively expensive for anyone to try and hack into this and take control over it.’

Price volatility

The clearest turn-off for investors interested in profiting from cryptocurrency is its volatility. While the value of the top cryptocurrencies has generally been on a sharp upward curve over the past few years, overnight drops of up to 20 per cent are far from uncommon. If timed correctly, large gains are possible for investors.

As they are still part of such a young market and their longer-term outlook is not yet clear, cryptocurrencies are still building immunity to various outside forces. Any event that has the potential to affect this longer-term outlook can cause large swings in value, including announcements of support from retailers, US Securities and Exchange Commission rulings and even rumours relating to the founders of the leading cryptocurrencies.

Some people have sought to profit in this growing market by investing equity into blockchain technology start-ups. The technology is predicted to bring about large-scale innovation and efficiencies within traditional financial institutions.

Long-term investment in cryptocurrencies and blockchain technology, and further promotion of uses cases for each of them, is the key to the wider community’s success and the financial gains that come with that.

In the short term, speculative investment like any other FX trade is available. Alternatively, mining the blockchain by dedicating computing power to the validation of blocks is also an option. A unique combination of the above is an initial coin offering (ICO).

‘A development team can auction digital tokens or coins to the public in order to raise funds for a particular project,’ says Christian Kourtis, senior associate at law firm Gowling WLG. ‘This enables development teams to raise vast amounts of money in a relatively short time frame – millions of dollars
in a matter of minutes. The coins may promise benefits in the future, such as preferred rights or features in the final product, but very often have little intrinsic value.

‘In some instances there is actually no underlying product yet behind the coin. ICOs should be treated with caution, and investors must diligence the investee projects to understand their potential value. Investors are not yet protected by securities regulations and so should be aware of so called “scamcoins”.’

The surge in pricing, particularly since the start of this year, has thrown digital cryptocurrencies into the public eye. Bitcoin in particular has been making headlines, as the possibility of it one day becoming a real-world currency used throughout the globe looks increasingly likely, even if this is a long way off.

But bitcoin’s sharp increase in popularity has also risked its demise. Demand has been so high in recent months that those creating it can’t keep up, slowing transactions. Although the bitcoin community recently agreed on a process for speeding up transactions, not everyone was happy – causing a split.

The split led to the creation of an entirely new cryptocurrency using a different process, called Bitcoin Cash. Investors are now faced with two bitcoin-related cryptocurrencies as potential investments, rather than one.

‘As an investor, I would let the dust settle,’ says Gandham. ‘The next few weeks will provide clarity on the likely success or failure of the new Bitcoin Cash. Only when it starts to stabilise, and only when enough miners start to support the coin, would I look at investing in it. Until then, I would stay with bitcoin.’

Crypto diversity

Investors should consider their risk appetite before choosing an investment. A more nascent cryptocurrency, such as litecoin, could present significant returns over the long run as it is just starting out. However, there is an increased risk that the cryptocurrency might not get off the ground and grow in popularity to the extent that bitcoin has.

One option is for investors to pursue a diversified strategy, to minimise the risk they are taking on. In addition to this, they should also understand the underlying business case for each cryptocurrency prior to investing.

‘Investing in these cryptocurrencies is similar to investing in any business,’ says Gandham. ‘If you like the idea, and like the technology and the team, then invest. The volatility in cryptocurrencies that we’ve seen in recent months presents an opportunity for investors.

‘The swathe of ICOs also presents an opportunity to get in early, though this investment comes with an increased level of risk. As with any investment, there is a risk that you will not get back the capital you put in. Over the longer term, however, technologies based on the blockchain are here to stay.’

There are two main categories of risk for investors in this space: market and technical. Market risks are those associated with adoption and trading – for example, volatile prices, regulation or taxation by authorities altering the way users access or purchase cryptocurrencies.

Technical risks are those associated with uncertainties in relation to undiscovered security flaws in the code or third-party applications, such as wallets, or hacks of the exchanges.

‘Volatility is partially caused by a relatively small user pool when compared with, say, a fiat currency,’ says Kourtis. ‘When considering trading volume, large exchanges or holders of a significant amount of currency can shift the price as they control a large percentage of the total currency pool. Wider adoption will rectify this. Volatility also comes from investors who buy and sell to make short-term gains, destabilising the price.’

Bubble trouble

Investors should also remain wary of warnings from some parts of the financial industry that cryptocurrency is a bubble. These kinds of warnings, of course, exist in all rapidly growing markets.

It is still early days for cryptocurrency, and developments are likely to take time. There are substantial changes that need to take place in the real world before the crypto world can truly come into the mainstream.

‘These changes won’t happen overnight,’ says Agbaba. ‘Although developments are taking place, most notably in the area of international money transfers, we don’t yet know how banks or other financial institutions intend to incorporate and harness the technology.

‘While there are numerous use cases, financial transfers are the leading cog in the crypto world and will continue to be so for the foreseeable future. At this stage, valuations do look like they have run ahead of themselves.’

Gandham adds, ‘In our view, cryptocurrencies still have a long way to go before we’re in bubble territory. Bubbles usually refer to situations that are unlikely to last. However, I strongly believe that cryptocurrencies and the blockchain are here to last. However, as in any industry, some will survive
and some may not.’

Predicting where the value of cryptocurrencies is heading would be futile. But for bitcoin to become a widely adopted currency that people use on a daily basis, it would need to reach a price where daily fluctuations of £100 to 200 are insignificant compared to its price.

‘The cryptocurrency space is complicated and volatile, but this technology, applied in the correct way, has the potential to revolutionise finance and financial institutions,’ concludes Kourtis. ‘Understanding it, even at a basic level, takes a bit of time and effort but, in my view, it is worth it.’

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