It seems like everyone nowadays is talking about cryptocurrencies. Whether it’s the proselytizers on CNBC or the techie next door, it feels as if everyone is either talking about or buying into this next big thing.
Trying to adequately explain an emerging technology and it’s economic impact in less then a few thousand words is bound to neglect certain facets of the subject. This series attempts to cover the technical specification of cryptocurrencies, how they can be viewed in an investment environment, the narratives that accompany this new technology, and the future impact, applications, and risk of the cryptocurrency universe.
What Is a Cryptocurrency?
The first cryptocurrency, Bitcoin, was originally imagined as a system of value exchange that could bypass institutions and instead allow users to make transactions on a peer-to-peer basis. For such a network to succeed, there had to be a way to verify the veracity of the transaction for both parties.
This is where the revolutionary technology called the blockchain comes in. The blockchain can be visualized as its name suggests: a chain made up of individual blocks of transactions. At its heart, this is what Bitcoin is: a series of transactions leading up to the current moment. When an individual buys Bitcoin, they are simply adding their name to the transaction list (or ledger), saying, “I have bought x number of Bitcoins.” Of course, it’s not as simple as adding a line.
Bitcoin works by having computers (or nodes) confirm and document transfers. When a transaction between Person A and Person B occurs, this transaction is sent out over the Bitcoin network. These nodes then verify that Person A has the right amount of Bitcoin to transfer to Person B by looking at the blocks of historical transactions on the chain. Once the majority of nodes on the network (50%) verify that a transaction can take place, it is added to the blockchain transaction log.
This verification process is where Bitcoin miners come into the picture. Miners provide the computers and computer power needed to verify transactions. They provide this service and get “paid” for it by having the opportunity to mint a new Bitcoin. To mint a new Bitcoin, a miner must verify 1MB worth of transactions and find a solution to a cryptographic hash function, which is the difficult part. The Bitcoin miner who verifies the transactions and is the first one to determine the target hash is the one who gets to include a new transaction for themselves, essentially minting a Bitcoin. While cryptocurrencies differ in the exact way that they go about transactions and the minting of new coins, the Bitcoin method is a solid enough base to understand cryptocurrencies at their base level.
Where Do Cryptocurrencies Fit in the Investment Landscape?
Cryptocurrencies, especially Bitcoin, are sometimes referred to as digital gold. Like gold and other currencies, they are something that derives their value from the belief that they can be exchanged in the future for something else of value and that the future value will be greater than the present value. The term that is frequently used is “a store of value.” Perceptions of value can change much more quickly than physical objects, which leads to the volatility that has always been present in currency markets, digital and fiat.
One of the advantages of cryptocurrencies, unlike gold or silver, is the ability to store value in an even more concentrated physical form. A 100-gram gold bullion cost about $6,000 dollars in 2020. This gold bullion could be slipped into your pocket or placed in a safe. A small flash drive, smaller than the gold bullion, could essentially hold billions of dollars in Bitcoin.
As with gold, there is a physical limit to the number of Bitcoins that can be produced. There can only be 21 million Bitcoins in the current Bitcoin network. So far, almost 19 million have been mined. Many believe this commodity-like supply will result in the value of Bitcoin rising with inflation—or possibly even faster.
Cryptocurrency advocates have discussed how this feature also makes digital currencies immune to the hyperinflation that can result from governments printing money. On the one hand, that is true. However, on the other side of the coin, the creation of a new Bitcoin or other cryptocurrency via mining injects new money into the supply. And as has been seen with gold historically, short-term, localized abundance of even a limited supply commodity can result in hyperinflation. The famous 1849 Gold Rush in California is a perfect example of the phenomenon. The prices for various goods like eggs, bread, and boots in the local area rose to more than three times the original price. Allowing for the lower accuracy of CPI data from the late 1800s, there is general consensus that the various gold rushes of the era from the U.S., Australia, and South Africa all resulted in increased inflation rates. So, while cryptocurrencies may be more immune from government influence, it is unlikely that they are immune to supply and demand shocks.
Other types of cryptocurrencies, such as Ethereum or Cardano, offer different use cases by allowing the creation of new cryptocurrency assets or non-proof-of-work methods. The full effect of these other types of cryptocurrencies remains to be seen. One Ethereum-based crypto asset that has seen a lot of recent attention is the rise of Non-Fungible Tokens (NFTs). These tokens represent a unique digital item and are not interchangeable. This has created a marketplace for artists to sell digital items with the authenticity guaranteed by the blockchain. Many of the applications of varying alternative cryptocurrencies are still being figured out at this time. It has yet to be seen whether these become alternate stores of value or simply new, more efficient ways to transact.
Watch for the next installment where we discuss cryptocurrencies and recent market conditions.
Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.
It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Opinions expressed by Merriman are based on economic or market conditions at the time this material was written. Economies and markets fluctuate. Actual economic or market events may turn out differently than anticipated. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.
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As a Research Analyst, Lev works to improve Merriman’s core investment solutions using an evidenced based approach. Lev spends his days researching specific topics, performing custom client analyses, preparing client materials and improving automated systems. Before joining Merriman, Lev gained experience at Parametric Portfolio Associates a quantitative asset management firm.
Lev has a bachelor’s degree from the University of Washington where he studied physics and astronomy. While at UW Lev competed in pole vault and is still active in the community around Seattle, coaching at high schools and local camps.
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