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Cryptocurrencies: Potential For Profits, Or Traps For The Unwary?
5 December 2017 | World Views | AJ Cilliers
 


About two years ago we ran an article on Bitcoin, questioning whether it had become a legitimate target for investors.  In the light of current events it might be worth asking that question again.  For, at the time of writing in late November, the first of the cryptocurrencies had just hit a record high.  Bitcoin, invented in 2009 and launched in 2010, was trading at $10,000 per coin.  Not bad, when you consider that in 2010 the currency was worth just 5 US cents.  In fact, the first known Bitcoin transaction occurred in 2010, when an American computer geek paid 10,000 bitcoins to a British counterpart, to have two pepperoni pizzas delivered to him in the US.

Even those who decided two years ago that Bitcoin was worth a punt, would be smiling now.  They may even be reading this in a luxury villa on some island paradise.  Because in 2015 you could buy a Bitcoin for $200, so that a $10,000 purchase then would have netted you $500,000 now.  And if you had invested $100,000 in Bitcoin two years ago, you could now pocket around $5 million if you sold off your holdings.

Of course it’s easy to be wise after the event, and it’s a bit of fun to play these ’what-if’ games now, with the benefit of hindsight.  It’s also easy to convince ourselves that, given the opportunity, we would have piled into Bitcoin years ago.  The thing is, following on from the success of Bitcoin (and we’ll re-examine that later), new cryptocurrencies are being launched almost daily. 

So could one of these be the new Bitcoin, and are there fortunes waiting to be made from them?  To answer this question, let’s briefly remind ourselves what Bitcoin is and why it has become so valuable.  This will put us in a better position to evaluate the newer offerings.

Bitcoin: The basics

Back in 2009 a computer whiz (or group of whizzes), who calls himself Satoshi Nakamoto, developed a process whereby other computer owners could ‘mine’, or create, Bitcoins on their own computers.  This involved the solving of complex mathematical problems, and took up a lot of computing power and time.  The process is designed in such a way that a maximum of 21 million Bitcoins will be mined, thereby creating an artificial scarcity designed to drive up its value.  Around 16 million are currently in existence world-wide, and every two minutes this number increases by about five coins.

Although Bitcoins can be bought and exchanged for conventional currencies, they exist only in cyberspace, in the form of a numerical code.  A network of computers worldwide facilitates Bitcoin transactions, with each Bitcoin being nothing more than a piece of computer code which is assigned a unique number.  It can be transferred instantly to a recipient, to an anonymous online address.

The ‘crypto’ in cryptocurrency means ‘secret’ or ‘hidden’, and this is one of the reasons why Bitcoin has been embraced by the criminal underworld, and those wishing to keep their financial affairs hidden from the authorities.  Drug dealers, ‘ransomware’ computer hackers, tax evaders – these are just some of the people who have embraced the Bitcoin world.

However, Bitcoin has gone mainstream as well, with private investors, celebrities, and currency speculators now getting involved.  There seems to be a growing belief that the cryptocurrency could represent the future of money, allowing people to transact easily without the involvement of credit card companies or banks.  This belief is epitomized by people such as Michelle Mone, a UK underwear tycoon who recently launched a venture to sell property in Dubai.  Uniquely, all transactions will have to be settled in Bitcoin.

With growing mainstream interest and involvement in Bitcoin, the value of the currency has rocketed in 2017.  Starting the year at around $1000, Bitcoin has now hit a high of $10 000, raising uncomfortable fears that it has moved into bubble territory.

Bitcoin: Bubble in the making?

There is a big difference between Bitcoin and conventional currencies.  National currencies are protected by a host of rules and regulations, and their value is derived from many underlying economic factors.  While the short-term value of a currency may fluctuate slightly around its ‘true’ value, changes in the long-run values of currencies can be explained and predicted by way of changes in underlying economic factors such as inflation, interest rates, growth in the money supply, speed of circulation of cash, and so on and so on.

None of these factors apply to Bitcoin.  There is nothing to underpin the value of Bitcoin, other than a global consensus at any time as to what people are prepared to pay for it.  The scarcity factor does, however, introduce a level of price volatility that is unnerving to those who hold it or rely on the currency to transact with. 

Billionaire investor Michael Novogratz explained the situation as follows in an interview with CNBC: “What’s different about these coins other than commodities, is that there is no supply response here.  So it’s a speculator’s dream, in that as buying happens, there’s no new supply response that comes up. So every price move gets exaggerated.  It’s going to get exaggerated on the way up.  There will be fifty percent corrections.  It will get exaggerated on the way down.”

Novogratz accurately predicted that Bitcoin would hit $10 000 before the end of this year, and forecasts a price of $40 000 by the end of 2018.  Of course, such statements by an investor of Novogratsz’s status could serve to drive the price upwards, and one might cynically wonder if this is his intention.  Either way, with growing numbers of ‘ordinary’ people, conventional businesses and celebrities embracing a currency without sound fundamental underpinnings, the bubble threat cannot be ignored.

A number of financial commentators have likened the Bitcoin situation to the tulip bulb bubble in 17th century Holland.  In his book, Extraordinary Public Delusions and the Madness of Crowds, author Charles Mackay noted that: “Nobles, citizens, farmers, mechanics, seamen, footmen, maid-servants, even chimney sweeps and old clothes-women, dabbled in tulips.  Eventually, as Mackay puts it, ‘bulb prices reached astronomical levels.’  At this point some people decided that it might be a good time to sell, others followed suit, and in no time panic ensued.  When the dust settled, bulb prices had dropped to that of a common onion.

As the UK’s Financial Times of 25 November put it, “When celebrities known more for reality shows than financial prowess start endorsing a particular investment strategy, it is fair to assume that a bubble exists.”  Given the nature of Bitcoin and the historical evidence of human stupidity, it is hard to argue with this viewpoint.

The surge of the cryptocurrencies

On the back of Bitcoin’s phenomenal success, a host of new cryptocurrency players have entered the market.  By the end of October this year, 211 ICOs or ‘initial coin offerings’ had been launched.  They have been endorsed by noted financial experts such as Paris Hilton, actor Jamie Foxx and boxer Floyd Mayweather.  All have taken to social media to announce their support of cryptocurrency fundraising.

ICOs typically invite people to invest (on a crowdfunding basis) in a new project.  About one third of these initiatives have involved projects to build and support the virtual currency blockchain, but can relate to other business start-ups as well.  In return for their investment (typically made through a cryptocurrency platform such as Ethereum), investors receive ‘tokens’, which can either be used to pay for future services from the issuer, or can be sold on for cash.  Future shares in the profits made by the issuer will also be returned to investors by way of tokens.

These tokens effectively become a new cryptocurrency, as like Bitcoin they are digital in nature and share all of Bitcoin’s anonymity and ease of transfer.  It appears that the originators of ICOs are attempting to disguise this fact, but as a financial commentator has pointed out: “You can call it a coin or a potato, or whatever you want, but it’s the substance that regulators will look at.”

Conclusion

Whether you decide to invest (if that is the right word) in Bitcoin or one of the many new cryptocurrencies, will depend on your view of the investment value of such offerings.  They could be one of the great innovations of the internet era, or merely a clever technological version of the tulip bulb craze.  There is undoubtedly money to be made and lost via cryptocurrencies, but this does not make them a legitimate investment vehicle. 

Einstein once said something like: “I am convinced that only two things in life are infinite; the size of the universe, and the extent of human stupidity.  And I’m not so sure about the former.”  Perhaps, in thinking about cryptocurrencies as an investment strategy, we should take heed of his warning.

cta

 


 

aj

AJ Cillers

 
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.

 


Disclaimer:
The information contained in this article is for informational purposes only and must not be regarded as a prospectus for any security, financial product or transaction. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial issue. Investors should consider this research/article as only a single factor in making their investment decision. We recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs.

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