on bitcoin, the blockchain, and "crypto" currencies

Let's get two things out of the way early: (1) there is a lot of noise in the news right now about Bitcoin and its crypto-cousins (and too little information, in my humble opinion), (2) this post is a contribution to the noise, but hopefully contains a little information relevant to my client base and readers.

the briefest of summaries

There are plenty of articles going around about what crypto currencies are supposed to be, and how blockchain technology is meant to work, so I will keep my comments on this aspect super brief.  The blockchain is sometimes referred to as a "distributed ledger" for financial transactions, which can in many ways bypass the existing infrastructure of banks and payment processors and clearance / settlement facilities currently involved in exchanges of value between parties.  And while this ledger is maintained and processed in a relatively "public" way by market participants, individual participants are able to act in a relatively anonymous way.
Bitcoin is a medium of exchange on one version of blockchain, and it follows a very specific protocol or set of rules about how new Bitcoins can be introduced to the market and how transactions in Bitcoin between parties can be processed (this activity is collectively referred to as "mining").
Bitcoin itself has "forked" into some new variants that have expanded or refined protocols that attempt to address some perceived challenges with actually using a crypto currency, and there are also different approaches to the blockchain that support other coins, like Ether on the Ethereum network.

so, should you own some?

Chances are decent that you are more aware of Bitcoin and its brethren because the prices of crypto currencies have risen so dramatically in the last year; it is a basic function of a "bubble" or hot market that big gains in value attract attention, which inspires a desire to participate, which pushes prices higher, which causes the cycle to repeat...for a time.
So are crypto currencies in a bubble?  Sure.  Is that "bad"?  It depends on your perspective.  The primary aim of this post is to offer a framework for considering an individual investment in Bitcoin or one of the other coins, so I will pivot to that:

• A rational investment should be based on an expectation of economic gain
• The opportunity to realize an economic gain requires an ability to enter, hold (and collect any distributions like dividends or interest or rent), and/or exit the investment, inclusive of any related costs.
• From the perspective of an individual investor, any one investment opportunity should likely be considered within a broader context of their financial circumstances.  In the planning profession, we talk about assessing risk tolerance, defining financial goals, identifying available resources, and developing a comprehensive approach that ties all of those facets together into an actionable plan.

Applying those bullet points to Bitcoin (or similar) offers some insights, and raises some additional questions:

• Is there a rational expectation of gain for people buying into a given crypto currency coin at present?  There seem to be a few schools of thought on what the value proposition is for these coins:
  • A "store of value".  This line of thinking makes crypto coins analogous to gold, which some market participants have looked to for years as a hedge against fluctuations in their home currency (like the US dollar); the belief here is predicated on an assumption that if there were a major devaluation in the dollar due to macro economic or political shifts, gold may retain more relative value.  This belief is highly subjective, and the performance of crypto through cycles that historically benefited gold has yet to be seen.
  • "Anonymity". Some market participants desire a means of economic exchange that does not flow through the legacy banking system and is less visible to the government.  Crypto coins do seem to offer this opportunity, although there are still points of contact between the legacy systems and the blockchain, the anonymous nature of the system has produced some examples of "wild west" abuses within the system, and legacy banks and governments are making moves to pull the blockchain into alignment with the existing infrastructure.
  • A medium of exchange, independent of anonymity.  This may be the most prosaic view of the crypto currency future.  In this model, one or more of the current coins could turn into the default option for digital exchanges of value, i.e. how you pay for stuff. The total number of Bitcoin that will ever be mined is already set, built into the currency's nature from the beginning.  That programmed scarcity has some market participants convinced that there will be a steady demand for coins (or fractions of coins) by people just wanting some to use for quotidian purchases. 
    
    Do any of these points lead to a rational view that Bitcoin will trend higher from here?  Each of those possible vectors for expected growth involves a number of highly subjective assumptions that I am not confident to make at this time.
• What about the mechanics of investing in a crypto currency?
  • Early adopters in these markets have seen a number of "wallets" and exchanges arise to provide ways to buy, hold, and transact with their coins.  While the experience for many has been unremarkable (in a good way), there have also been a number of high profile failures with coins "lost", "destroyed", and stolen in ways that would seem foreign to people whose financial experience is limited to dealing in dollars and with established banks.
    With that in mind, it may be reasonable to assign a "carrying cost" to holding Bitcoin, with the cost less a financial one, and more a percentage chance of losing some or all of the holding due to quirks in the still developing infrastructure.
  • The current market in Bitcoin, Litecoin, Ether, etc suggests that there is presently a steady buy side demand for the coins; as mentioned above, this steady demand has been self-perpetuating, as new buyers push the prices higher, attracting new buyers, etc.  The sell side of the market, and how the market itself would react to demands for liquidity for future sellers, has been relatively untested -- and this is currently my own, personal preoccupation with these market as a potential "investment".  Having watched the stock and bond and real estate markets for a while, in both a personal and professional capacity, I have seen these supposedly mature asset classes go through cycles of paralysis, crisis, and illiquidity.  The very nature of the still nascent crypto currency market causes me significant concern about what a liquidity crunch would look like for these coins.
  • At present, there do not appear to be any sources of distribution-type returns from simply holding Bitcoin...as with gold, there are no dividends or interest or rents available to owners.  That may change in the future (maybe coin holders will be able to "lend" their currency to people who need some for transactions?).
  • There ARE transaction costs within the blockchain, and at least with in the example of the Bitcoin blockchain, those transaction costs (and times required to actually complete a transaction) have been rising, from a few pennies each time to as much as $20 or so.  These variable costs are in some ways analogous to commissions, and present a source of friction or drag within the network for exchanges of value.
    
    None of the above suggests that the actual process of buying, holding, and selling a crypto coin for a (desired and potential) profit is impossible, just that there are some legitimate challenges in the current scenario.
• Now, in terms of how an individual investor might perceive an investment in a crypto coin and place it within their overall investment framework, the thought process can be a bit more straightforward.
  For most individual investors, the best practice these days revolves around a basic approach:
  • Have an emergency fund in place before risking any meaningful money in the market
  • Have a clearly defined budget, and a good understanding of what resources are available to invest toward well articulated goals
  • Prioritize among goals, and make use of goal specific strategies for efficiency (retirement accounts for retirement goals, employer match for workplace retirement plans, etc)
  • Choose investments based on match to risk tolerance, investment objective, and time horizon, with a focus on low cost and diversity among the investment options
    
    In that framework, if a person were motivated to invest in Bitcoin (or similar), it may be most appropriate to treat it as one component within a larger portfolio, with allocation size determined by desired risk exposure.  By way of example, many investors may now focus their stock and bond allocations on internally diversified investment products, like mutual funds or ETFs.  A purchase of Bitcoin as an investment, in contrast, would look more like investing in a single company's stock; further, based on the relative volatility, size of the market, and potential liquidity constraints of Bitcoin, the comparison would need to be to a similarly sized and volatile stock...I'm thinking a bio-tech stock whose potential profit is entirely based on the unproven efficacy and eventual approval of a drug might be a reasonable analog.  It would be difficult to rationalize an investment allocating a large percentage of an investor's available resources to a highly volatile stock with a non-zero chance of failure and collapse; similarly, it would likely be inappropriate to commit those resources to an investment in a crypto currency, simply based on the risk of loss.

too long, didn't read? (tl;dr)

Everyone's talking about Bitcoin and the other so-called "crypto currencies".  Much of the present attention seems to be driven by a fairly typical "fear of missing out" bubble.  Investments in crypto coins have both idiosyncratic and traditional considerations for investors.  Proceed with caution!

Current and prospective clients of DRW Financial should feel free to email or call David with questions on how or if it is appropriate to incorporate an investment of this sort within their overall plan.