Cryptocurrencies: what investors need to know about Bitcoin and others
Cryptocurrencies are grabbing the headlines in 2021. Commonly considered the currencies of criminals due to their anonymous nature, this year sentiment seems to be shifting, especially towards the oldest such currency: Bitcoin*.
So with more and more businesses accepting Bitcoin as payment or embracing it as an investment, we ask the question: Can we afford to ignore it or other cryptocurrencies any longer?
In this short series of blogs, we will delve into what cryptocurrencies are, how they work, why there are so many, and whether they are likely to have a future.
What are cryptocurrencies?
Simply put, a cryptocurrency is a currency that takes the form of digital ‘coins’ that exist on a distributed and decentralised ledger. Most use a system called blockchain. Transactions are grouped into blocks, and new blocks are added to an existing chain of blocks. Combined, these blocks contain the entire transaction history of that currency.
In order to succeed, cryptocurrencies have had to solve the double-spend problem – the need to prevent a user from spending units of currency they do not own by sending multiple transactions simultaneously. Different currencies solve the problem in different ways, and these different methods have their own advantages and disadvantages – something we will come back to later in the series.
Of the 4,000+ cryptocurrencies, Bitcoin is by far the most well known and highest valued. However, having accounted for over 90% of cryptocurrency market capitalisation in 2013, at the time of writing Bitcoin now makes up just over 40% of the current $2.4 trillion crypto market valuation, its dominance having fallen by nearly 10% in April alone.
It is important that we look at the whole universe of cryptocurrencies and not just assume they are all the same.
Why do we need cryptocurrencies?
It is hard to argue that we need them, but what can we gain from their existence? Some of the arguments put forward for them are that they:
• Are secure
• Are liquid
• Are cheap to store, move and transfer
• Cannot be taken away or inflated away by governments
• Can help the unbanked to store and spend money
If a cryptocurrency can be used like cash, securely stored, kept safe from government intervention, and can be sent to the other side of the world in a matter of seconds, then there may be some enduring value in them. However, the promise is not the whole reality.
Some of the many criticisms of Bitcoin, for example, are that:
• It is too slow. It can only manage five or six transactions a second, which is far too few for a world population of seven billion to use it as cash.
• It is too expensive. Fees for sending Bitcoin are often too large to make it practical for everyday items.
• It consumes too much energy. Bitcoin currently consumes more power than Argentina, the 30th most energy intensive country on the planet. Its energy use would only increase if Bitcoin continued to move into the mainstream.
Many among the vast number of cryptocurrencies are trying to be a plausible medium of exchange as well as a store of value. Such a quality is likely to be essential to their long-term survival, giving them an edge over commodities. And, with their ownership growing daily, the window to kill them off with regulation is likely to be closing.
As such, we should consider whether cryptocurrencies are an asset class in their own right. As I will discuss in the next blog, not all cryptos are the same, so we need to look deeper than just Bitcoin.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.