Investing in Cryptocurrency
What is cryptocurrency?
A cryptocurrency is a form of digital currency that can be used as a store of value and to pay for goods and services. Following the Global Financial Crisis of 2008, Bitcoin emerged as the first of the recognised cryptocurrencies, providing a way to conduct a financial transaction without using a third-party bank or other institution and ultimately giving rise to a new decentralised financial system known as DeFi. This rapidly growing sector of personal finance products built on blockchains using cryptocurrencies, is able to replace some of the functions of traditional financial institutions without the ‘paper trail’ and at a far lower cost.
Crypto comes from the Greek word Kryptos which means hidden – and cryptocurrencies rather than being attached to a specific country or government, are decentralised and controlled by the network that operates them. Governments across the world have started to look more closely at cryptocurrencies, uncomfortable with having a widely used currency out of their direct control.
Chinese regulators banned all virtual currency trading and speculation in 2021 and other central banks have issued warnings about the risks of investing in 'crypto-assets'- including digital currencies - branding them as 'highly risky' and 'speculative’. Regulatory authorities have a mandate to protect against anti-money laundering (with cryptocurrencies used to pay ransoms and bribes from cyber-attacks); provide consumer protection and ensure financial stability.
Despite these concerns, the increased global adoption of cryptocurrencies has been driven at least partly by speculation. While many dismiss cryptocurrencies as a bubble, they have ‘real world’ uses and now some countries have started to recognise their use may be inevitable – for example, government agencies are looking at the risks and benefits of cryptocurrencies and exploring appropriate regulation including the People's Bank of China which is rolling out a pilot scheme to test a digital currency e-CNY in selected cities, and a bill allowing the establishment of a digital Euro is expected to be published as soon as early 2023, with the expectation that a version could be ready for use by the middle of the decade.
How do cryptocurrencies work?
Unlike FIAT currencies, cryptocurrencies are not controlled and printed by central banks or governments. Bitcoin is produced (or ‘mined’) - by high-powered computers with costly electricity usage – to solve complex mathematical equations in return for cryptos which are stored in a digital wallet on a smartphone or computer.
Another cryptocurrency Avalanche uses a process known as ‘staking’ whereby validators are required to ‘stake’ or feed some crypto into the system to participate in the rewards, giving rise to the term ‘proof-of-stake’. The ability to handle huge volumes of transactions at extremely low cost means staking is considered more efficient than mining (with a much-reduced carbon footprint).
While digital currencies have existed previously, it was the innovation of blockchain technology that set Bitcoin and other cryptocurrencies apart. A blockchain is a shared public record of changes in the ownership of assets. The information is stored and encrypted in a block and no member of the network can change or tamper with it. These blocks are linked together in a chain. Any blockchain aspiring to support a global financial system must, at a minimum, be able to match or beat other global payment networks such as SWIFT, Visa, Mastercard, etc.,
There are more than 12 ,000 cryptocurrencies such as Bitcoin, Ethereum, Binance and Polkadot. While crypto coins are essentially digital versions of money, there also exists crypto tokens which track the price of currencies or other assets. The key difference is that tokens do not have their own blockchain and instead, they operate on other crypto coins' blockchains, such as Ethereum. Some of the most common tokens on Ethereum include Tether and USD Coin. You can buy tokens with coins, and they are either algorithmically traded against their reference asset and/or pegged to some external reference such as a currency or commodity (with the issuer claiming the token is backed by bank reserves and loans which match or exceed the value of the token in circulation).
An uncertain future.
Since many cryptocurrencies have no inherent value (unlike an equity investment, where you own a piece of a company with tangible assets such as buildings or intellectual property or in case of crypto tokens which are pegged to a currency or commodity), their value is all ‘extrinsic’ rather than ‘intrinsic’; which makes it difficult to ‘invest’ rather than ‘speculate’. Crypto-assets have also shown a greater correlation with conventional equity and bond markets diminishing their appeal as a diversifying source of returns for investors. Despite increased global adoption and the possibilities of blockchain technology being able to revolutionise global payment systems, the brutal selloff in stock markets and cryptocurrencies, exacerbated by the complete failure of some crypto tokens to provide a stable value compared to their algorithmically traded reference asset, has literally caused a stampede out of cryptocurrencies. This volatility will be a huge problem going forward for increased real-world adoption of cryptocurrencies. It is difficult to use them as a medium of exchange or store of value if the price halves (or more) in just a few days or weeks. Also, the adoption of cryptocurrency as legal tender in El Salvador has recently seen the nation’s dollar bonds plunge as concern mounts that the government may now default. The notion of decentralized finance where crypto-assets are controlled by the network that operates them may allow ‘manipulation’ of the market/exchange and furthermore it did not prevent the Canadian government from ordering all regulated financial firms to cease facilitating crypto transactions by protesting truckers against Covid-19 mandate requirements.
Cryptocurrency as an Investment.
The reason banks and hedge funds have got involved is because their clients want exposure to cryptocurrencies through their portfolios. Morgan Stanley was the first investment bank to offer HNW clients access to Bitcoin assets through funds.
Cryptocurrency ETF’s are a relatively new asset class, and given regulatory uncertainty, this market is still being defined. But they might be one of the best instruments through which to own cryptocurrencies - with benefits such as significantly lower cost of ownership and outsourcing of the steep learning curve required to trade cryptocurrencies. The first cryptocurrency ETF, the ProShares Bitcoin Strategy ETF (BITO), only started trading in October 2021 and the following month Fidelity launched their Advantage Bitcoin ETF (FBTC).
Fidelity which is the largest provider of 401k plans in the US, is now offering the workers at more than 23,000 companies a chance to add cryptocurrencies to their retirement portfolio. The upper limit on how much of the portfolio consists of crypto-assets is up to the employer.
In the UK, pressure has been growing on the FCA to tighten regulation of crypto firms in order to protect consumers, amid worsening levels of scams and fraud. While certain crypto-asset companies are subject to money laundering regulations, investing in crypto-assets remains unregulated by the FCA and therefore there are no consumer protections under the FSCS (Financial Services Compensation Scheme). The FCA warning is that you may lose all the money you invest. Because of the regulatory framework governing financial advisors in the UK, it is not possible for them to include crypto-assets as a recommended investment; their platforms do not include crypto-assets; and their PI cover would not cover advice on unregulated investments in case a crypto-asset fails.
That said, cryptocurrency is still an asset and if purchased on UK-based cryptocurrency exchanges is subject to both income and capital gains tax (CGT) on any profits. HMRC’s Cryptoassets Manual explains the tax consequences of different types of transactions involving crypto-assets. Cryptocurrency gains could be used to secure a mortgage deposit (Nationwide was the only high street lender who previously allowed this). Furthermore, crypto-assets form part of an individual’s estate and could be left to a beneficiary within a will which are typical areas for which financial advice might be sought.
However, since crypto-assets are digital assets, transactions and balances, can be accessed via a digital wallet or via reference to a public blockchain, and proof of the initial transfer from a client bank account can also be provided. Therefore, it is possible to re-invest crypto-assets across more traditional asset classes, and a financial advisor would be able to assist in providing an investment recommendation especially in case of a financial planning need such as long-term savings for retirement etc.,
In summary, it is difficult to argue for investment in cryptocurrencies based on regulatory grounds, on volatility grounds and on diversification. The future of cryptocurrencies may depend on continued integration with legacy systems across financial services and other sectors, continued loyalty and speculation, as well as regulatory developments in the coming years to determine the future adoption rate in this space. However, central bank digital currencies are likely to be the versions that will ultimately be used i.e. if you get a regulated version of a digital currency, that’s the one big business is likely to adopt.
If you would like to discuss any area of personal finance, the author can be contacted at dermot.monaghan@holbornassets.com or simply use the Book A Call Back button at the bottom right of your screen.
