Bitcoin and cryptos - your questions answered
For intermediaries and employers only
Nick Dixon, Aegon Investment Director
Cryptocurrencies like Bitcoin have grabbed a fair few headlines in recent months. Bitcoin circulation, in particular, has grown from 50 Bitcoins in 2009 to more than 16.87 million today* but you can bet this will have changed by the time you read this. And there are new entrants arriving almost daily – with Telegram the latest to intimate its intention to launch a new crypto. But it’s the price increases that have attracted most of the attention - Bitcoin’s price increased over 1,100% last year, while Ethereum started out at $7 and ended the year at nearly $720 a coin ($924 on 16 February 2018) and Ripple started 2017 at less than a penny per coin and ended the year at over $2 (currently £1.15 at 16 February 2018). But, to give you some idea of the volatility, Bitcoin started 2018 priced at just over $10,000, fell to $6192.44 on 6 February and currently sits at $9880 (16 February 2018)**.
So if, like us, you’re finding that you’re fielding lots of questions from clients and employees on this subject, you may be interested in this handy guide to cryptocurrencies from our Dutch parent company.
Iavor Botev, Investment Strategist, Aegon Asset Management
Cryptocurrencies are all the hype at the moment and are frequently the most popular topic in financial news media. Given this surge of attention, we explore what cryptocurrencies are and consider their investment characteristics.
Differences among cryptocurrencies
First of all, cryptos (short for cryptocurrencies/cryptoassets) come in many flavours and have different uses. Bitcoin, the largest and arguably the most popular cryptocurrency, is mostly used as a medium of exchange, i.e. as a means for making payments. The second largest cryptocurrency – Ethereum, aims to be a platform which enables the building and executing of smart contracts. Smart contracts are computer programs that verify and/or enforce actual contracts. Such ‘smart’ contracts can be used to build what is called decentralised autonomous organizations (DAOs). These are companies managed by automatically collecting proposals from stakeholders and then deciding on the implementation of those proposals through a completely transparent voting process. DAOs can then be funded by initial token sales. Other popular cryptos include Ripple, which is a real-time settlement system network for institutions, and IOTA, which is built on Tangle, a next generation blockchain. To sum up, there are big differences among cryptos one should be aware of.
Cryptos should not be treated as currencies
It is important to realise that cryptos are fundamentally different from traditional currencies like the British pound or the US dollar. Money, as exemplified by currencies (coins and banknotes) and electronic money (deposits in banks), are commonly characterised by at least three functions. These functions are medium of exchange (for buying), unit of account (for pricing) and store of value (for saving). Take one of the more money-like cryptos such as Bitcoin and one can see it does not currently possess the functions of money. For example, Bitcoin is too volatile to be a stable store of value, and people are only able to purchase a very limited selection of goods and services with Bitcoins. Bitcoin might obtain those functions over time if it becomes more widely accepted and less volatile. However, it is evident that cryptocurrencies are meant to serve more functions than those of money.
Decentralised and not regulated
Another general property of cryptocurrencies is that they are decentralised, which means that transactions are verified and maintained using a ledger distributed among the users of the crypto-currency. This is opposed to the banking system prevailing in most economies where there is a central bank servicing commercial banks, which then provide payment and deposit services to retail and corporate clients. Arguably the most popular decentralised control system in cryptos is Bitcoin's blockchain, although others are used as well, for example, IOTA`s Tangle.
Finally, cryptocurrencies are still not very well regulated by the authorities although this is changing quickly and may be considered an opportunity for the more risk-seeking and opportunistic investors. Also, we must realise that in most countries (with the notable exception of Japan) cryptos are not accepted as legal tender. For instance, if you tried to pay your taxes in Germany with Bitcoins, you would not be allowed to do that.
Cryptos are intricate instruments with large differences among them. While it is possible to get a broad understanding of what they are, things get quite complicated quite quickly when we try to dig deeper into the technicalities involved.
How to assess the investment characteristics of cryptos
We think that relying on personal and professional principles when making decisions in life is very important. This is especially relevant for investors, both institutional and retail, as investing is (always) done in light of incomplete information and one frequently ends up having to fall back to first-order principles. Warren Buffett, one of the most successful investors in the world, is said to operate according to the principle"Never invest in a business you cannot understand." While applying this principle, Buffet`s fund Berkshire Hathaway has managed to outperform traditional equity indices such as the S&P 500 Index in spite of not engaging in the speculative investment craze during the dot-com bubble in the late 1990s on the basis of not understanding tech well enough.
Advisers and their clients should apply the principle of having a good understanding of what a given cryptocurrency is before deciding whether to invest. A number of central banks have issued warnings that some cryptos exhibit bubble-like behaviours and people should be very cautious about investing in them. The famous economist Robert Shiller says that, while he thinks Bitcoin is a bubble, it might still be possible to ride it to some handsome returns. It is likely that out of the many cryptos in existence right now, or even those which do not even exist yet, only a few will dominate the market for a specific use: Bitcoin might be the crypto which dominates payments, Ethereum might be the dominant platform used to build smart contracts on, etc. These leading cryptos might see price appreciation. However, we think that it is extremely difficult to identify these winners beforehand making a decision to invest in cryptos even more complicated.
The value of investments may go down as well as up and investors may get back less than they invest. This article is based on Aegon’s understanding of the current and historical position of the markets and shouldn’t be interpreted as recommendations or advice. Past performance is not a reliable indicator of future results.
*Blockchain.info - Updated 15 February, 2018.