Cryptocurrencies: More than meets the eye
Cryptocurrencies or digital currencies such as Bitcoin, Litecoin, and Dogecoin, are gaining mainstream acceptance by more individuals including merchants, while simultaneously attracting more attention from venture capitalists and regulatory agencies across the globe.
Let us begin with a brief introduction to the cryptocurrency Bitcoin. Bitcoin is a digital currency traded on on-line exchanges. Bitcoin shares some obvious attributes with fiat currencies such as the US dollar and the Japanese Yen. Both can be used to purchase goods and services. However, a fiat currency requires a financial institution to record and check the validity of these transactions. A cryptocurrency like Bitcoin requires no centralized entity like a bank and was designed to be a peer to peer digital currency allowing online payments to be sent and received without going through a financial institution.
This attribute of not needing a “trusted third party” aka financial institution is one of the most attractive and one of the most scrutinized features of Bitcoin and other digital currencies. The second most attractive feature is the blockchain ledger, which in my opinion is the more intriguing aspect of Bitcoin, but I will discuss the blockchain in another article.
Going forward, I will use Bitcoin as a proxy for cryptocurrencies in some of the paragraphs below. The value of Bitcoin continues to be volatile and highly susceptible to systematic risks and factors outside of the user’s influence. Additionally, there are several characteristics of Bitcoin that would imply that the view as primarily a global currency should be revisited. I will discuss these viewpoints in more detail below.
While not an asset class for everyone, Bitcoin could also be viewed as an alternative investment vehicle. The use of Bitcoin to potentially diversify a portfolio is not out of the question for individuals who have the appetite and resources to bear the risk of potential losses and huge swings in prices. The highly speculative behavior of people who use this strategy makes it controversial in traditional investing circles.
Bitcoin is also relatively new and lacks long term historical information, which limits the effectiveness of using price and volume trends to perform reliable technical analysis. The use of Bitcoin as an alternative investment vehicle may be positively impacted by the development of secondary market platforms that will enable individuals to hedge with derivatives some of the risks associated with holding a portfolio of Bitcoins.
The development by entrepreneurs of secondary market platforms using derivatives to manage the risk of Bitcoin, logically leads to the question of whether digital currencies exhibit some of the characteristics inherent in a derivative or alternatively digital currencies are hybrid instruments and potentially contain an embedded derivative.
A derivative is a financial instrument that provides a return based on the performance or return of an underlying asset, stock market index, foreign currency, or even changes in the weather. The text book accounting definition is even more complex and requires professional judgment. However, simply having derivative like attributes does not make a cryptocurrency like Bitcoin a derivative. There is also the highly subjective task of identifying and measuring any underlying that drives the cryptocurrency value. Likely candidates at this point are human psychology and regulatory action (perceived and actual), which cannot be modelled with traditional stochastic models. There is also the risk that the underlying has a spurious correlation with Bitcoin’s value and more information and analysis is needed before any final determination.
In conclusion, while the intent and form of Bitcoin and other digital currencies was to be a payment solution without involving a financial institution, in substance, it is a nuanced and versatile technology with far reaching implications. There is definitely more to cryptocurrencies than meets the eye.
All guest posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the editor or the author’s employer.
