By Ryan Brooke
The topic of Bitcoin and other cryptocurrencies has come up more recently in meetings with clients, friends and family who want to know, “what is all the buzz about?”
Cryptocurrency (known colloquially as ‘crypto’) is digital currency designed to be used over the internet as a medium of exchange. It is also considered an alternative asset class but is not appropriate for everyone. Cryptocurrencies allow an individual to transfer money anywhere in the world online, 24/7, without using a bank or payment processor, and the payment transactions are near instant.
Like other alternative assets, cryptocurrency can be illiquid at times and its value may fluctuate from the investor’s purchase price. While Bitcoin and other digital assets trade twenty-four hours per day, exchanging these assets to, say, U.S. Dollars, can come with a cost and time delay. These assets can be significantly impacted by a variety of forces, including economic conditions as well as supply and demand. Only investors with a high-risk tolerance should consider investing in cryptocurrency.
While speculative, it’s important to note that these markets have matured over the past few years due to more widespread, public adoption. For example, by late 2017, Bitcoin became the first cryptocurrency with a derivative contract available on an established exchange. In December 2020, a major insurance company purchased Bitcoin, and a publicly traded company invested in the cryptocurrency. Furthermore, in late April 2022, we saw further adoption as Bitcoin was announced as an available investment option within employer-provided 401(k) plans held at Fidelity.
We expect a continuation of this adoption trend in 2022 and beyond. We understand the allure of the ‘shiny new object’ and the fear-of-missing-out mentality that a lot of folks exhibit when trends like these burst on to the scene. Our goal is to educate you on the risks of investing in crypto to ensure you are as informed as possible should you decide to participate in this asset class.
So, what are some of the things to keep in mind as you consider cryptocurrency? Let’s start with a look at some of the risks involved:
Volatility
Be prepared for wild swings. Serious investment in the crypto space requires a high-risk tolerance. For example, you can see the drastic change in price over the following time periods.
- (1/1/17-12/16/17) Bitcoin (BTC) gained 1,718% but then lost 79% of its value the following year (12/16/17-12/27/18)
- For illustrative purposes, a $1,000 investment would have grown to $18,180 then declined to $3,817.
- (3/12/20-4/13/21) BTC gained 996% but then lost 53% of its value in the subsequent three months (4/13/21-7/20/21)
- For illustrative purposes, a $1,000 investment would have grown to $10,960 then declined to $5,151.
Your risk tolerance is put to the test when you experience losses in the high double digits, which can last months and even years at a time.
Regulation
Crypto regulation remains uncertain.
Despite the growing public adoption, we have yet to experience an official stamp of approval from our government, although the Biden administration recently announced an executive order related to further exploration of the space.
There is also a lack of regulation of the exchanges where crypto is traded. This has contributed to the growth of fraudulent exchanges and market manipulation. Exchanges may charge excessive fees and provide little to no protection from scammers trying to steal from you.
Politicians have yet to determine any regulation surrounding mining efficiency, blockchain technology, taxation of complex cryptocurrency situations among other matters.
Government intervention could have a significant impact on crypto values.
- Countries that have banned Cryptocurrencies – Algeria, Bangladesh, China, Egypt, Iraq, Morocco, Nepal, Qatar, and Tunisia.
Tax Reporting
Cryptocurrency can be taxable if sold at a gain.
Realized gains and/or losses from crypto trading should be reported on your tax return.
Many crypto exchanges do not provide a tax reporting form, such as a 1099; therefore, additional recordkeeping will be required on your part.
Keep track of your initial purchase, the amount paid in US dollars, the date sold, and the proceeds received for each transaction. Most exchanges will provide a list of transactions to help you organize this data.
Although we do not officially endorse them, here are a few popular programs that may assist with tax reporting:
- CryptoTrader.Tax
- Accointing.com
- Koinly
There are other programs available with an integration system that can upload your transactions directly to the software via your crypto account login credentials, API key, or uploading a .csv transaction file produced by your exchange.
Cybertheft, Hacks, Ponzi Schemes and Scams
Scammers took home a record $14 billion in cryptocurrency in 2021.
The majority of scams and Ponzi schemes occur on a Decentralized Finance (DeFi) protocol platform. DeFi is the cryptocurrency alternative to traditional banking. These platforms offer a variety of services which allow people to trade, lend, earn interest, and even offer borrowers loans at lower interest rates than traditional banks.
DeFi platforms also allow investors and speculators to participate in ICOs (Initial Coin Offerings). ICOs are currently unregulated and serve to raise funds for developing crypto ventures. They can be extremely dangerous and purely speculative. Once scammers have promoted their ICO and raised money within the DeFi platform, they will perform a ‘rug pull,’ which occurs when crypto developers abandon a project and run away with investors’ funds.
It’s estimated that DeFi ‘rug pull’ scams amounted to $2.8 Billion in 2021 alone.
Binance (the world’s largest crypto exchange) was hacked in 2019 with thieves stealing 7,000 Bitcoins worth approximately $40 million.
Be careful where you get your information regarding cryptocurrencies. Everyone has undoubtedly seen YouTubers, read news headlines, or heard about your neighbor’s cousin’s nephew who day trades cryptocurrencies and made it big. Although some may be true, it is important to proceed with caution with these sources of information. Advice taken from your brother-in-law, a person you overhead at the gym, or someone who is a self-proclaimed crypto expert should be taken with great caution.
FOMO (Fear of Missing Out)
Throughout history, investors have faced strong temptation to join the investment bandwagon based on emotion. Behavioral finance labels this phenomenon as herding, or more commonly known as FOMO. These emotions can lead to irrational decisions.
Be sure to do your due diligence. You may be taking unnecessary risk based on emotional decisions rather than sound financial strategy.
Don’t base your decision to invest in crypto purely on emotion. You have an investment strategy, and for some, investing in crypto may add unnecessary risk that could jeopardize retirement goals if not approached strategically.
No Intrinsic Value
Cryptocurrencies have no intrinsic value, meaning they are not backed by underlying fundamentals. However, some may argue that smart contract and proof-of-stake capabilities, along with the technology and math behind cryptocurrency is its intrinsic value.
Why is intrinsic value important? It helps us determine the current market value of an asset based on fundamentals.
So, what determines the price of a cryptocurrency? The same force that controls the price of many goods and services: supply and demand. The more demand and adoption of a cryptocurrency, the higher its price may grow.
Now that you know the risks, what are some of the opportunities investors find appealing about crypto?
Diversification
In theory, cryptocurrency can provide diversification to an investor’s portfolio uncorrelated from stocks, bonds, real estate, etc., although there may be periods when these assets may move in lockstep with each other.
Accessibility and Cross-Border Payments
Easy transactions across international borders for purchasing goods and/or services or sending money.
24/7 Market
This can be a pro and a con. You can’t turn the crypto market off on the weekends like you can the stock market.
If you are interested in cryptocurrencies, a good first step may be to track them for some time so you can experience the fluctuations in price firsthand.
If you are comfortable with the volatility and want to learn more, a simple internet search can generate a lot of information. Be careful. It may be helpful to stick with content created by well-known publications.
If you have an interest, keep us updated as you explore the cryptocurrency world. We welcome the opportunity to hear your thoughts and discuss how cryptocurrency may or may not be appropriate for your individual situation.
Sources Available Upon Request