Background on Cryptocurrency
A cryptocurrency is a digital asset that is created and maintained by open source software run by a network of computers anywhere in the world. Since the software is open source, anyone can verify the software’s code and be assured that it will run appropriately. As a result, there is no central authority controlling the asset’s issuance and transactions between accounts – the network is controlled only by the software and those who choose to run the software. This stands in contrast to fiat currencies like the US and Canadian dollar, where the government and central bank are the controlling actors.
Most people think of Bitcoin (BTC) when they hear the word “cryptocurrency”. This is because Bitcoin was the first digital currency, invented in 2008. What is often overlooked is that before Bitcoin, it was thought that “internet money” was impossible. Why? Because the internet exists to share copies of information, not revoke information after it has been transferred. Bitcoin managed to solve this problem by combining cryptography and the concept of a blockchain secured by a network of computers (aka “miners”). Since Bitcoin’s inception other cryptocurrencies have been developed, most notably Ether (ETH) in 2014, which is the cryptocurrency of the Ethereum blockchain.
Putting Crypto into Context as Assets
Let's compare two of the largest cryptocurrencies: Bitcoin and Ether.
As a platform, Bitcoin is a blockchain that facilitates the transaction of digital cash in a peer-to-peer fashion. However, Bitcoin has limited functionality and, as a result, applications on the Bitcoin blockchain are not possible. Ethereum as a platform, unlike Bitcoin, explicitly allows for feature rich applications and the ability to program money or value natively into an application on the Ethereum blockchain itself.
BTC is often referred to as “digital gold” in the context of its scarcity and status as a store of value asset and it has established strong brand recognition in this regard. Ether, by contrast, can be considered a proxy for financial exposure to the activity on the Ethereum blockchain. In this context, many view Ether as “digital oil” since Ether is the fuel of the Ethereum blockchain in the same way that oil facilitates economic activity in a real world economy. Another analogy of Ether’s value proposition is that it is similar to owning “a piece of the internet” where blockchain applications use Ethereum as a platform similar to the internet. Another analogy is viewing Ethereum as a kind of digital toll road, where anyone with an internet connection can build and use interoperable financial infrastructure and pay a small fee to the Ethereum network for securing it.
The concepts referenced above can be contextualized in the diagram below, where Bitcoin can be thought of as a calculator and Ethereum can be thought of as an operating system. If we look at Bitcoin as a “digital gold”, then Ether would be the “digital oil”. Consider that Ether as the fuel used to run applications on the Ethereum platform. When Ether is “staked” then we would call this a digital bond. The Ether that you hold is not a virtual commodity anymore, it’s more like a financial asset on which you’re paid dividends or interest. What makes Ether unique from Bitcoin, is its ability to provide its holders with a yield. To learn more, check out this article, Ethereum: Birth of the Digital Bond.
Technology is at the core with crypto. On one hand, Bitcoin behaves mostly like a currency and is concerned primarily with transactions, on the other, Ethereum is focused on coding and platform principles.
Blockchain Mechanism and Security
Blockchain is the decentralized or shared public ledger. It relies on peer-to-peer exchange rather than relying on a governing agency to facilitate the transaction. Blocks contain the unique and specific transactional information such as date, time, and amount. They also store the records on the transaction and the participants, including their digital signature. Blocks are stored chronologically along a chain, forming a “height” as a measure of the ledger.
Each block in the chain is unique with its own “hash” code, it’s difficult to go back and change the contents in any block. If a hacker were to try to edit a transaction with say a new amount, the hash code would need to change. This would mean a new block would be added to the chain and contain the old hash. For a hacker to cover up their tracks, they would need to edit the next block’s code in the chain, and on and on.
Today, custodians are emerging globally to set up proper lending guidelines and insurance policies to secure these assets. In addition, the transaction speed with the custodial infrastructure has improved significantly.
Is This a Long-Term investment or a Fad?
There has been significant awareness, investment into the improvement of cryptocurrencies from both institutional and retail investors. Recently, PayPal announced their participation in the space. With announcements like this, their vested interest will ultimately drive technology and the currency forward by allowing their merchants to accept crypto. When big players want “in” we’ll see a shift to mainstream.
As large financial institutions begin to recognize the cryptocurrencies and platforms as a cheaper and faster means to move billions of dollars this will be powerful and certainly drive things forward.
Cryptocurrency as an Investment
Inflation outlook and global interest rates are looking, quite frankly, stale. While fiscal stimulus is printing money at unprecedented rates, owning currency as an inflation hedge today is no longer as viable as it once was.
Precious metals have historically been stores of value in the portfolio but do not behave with the same speed and flexibility of digital currency. Plus, you’re not in know as to how much gold or silver exists. With crypto, you have full visibility on what is outstanding and the flexibility of ease of use on the internet. Meaning that crypto can be viewed as a long-term inflationary hedge or store of value for investors.
As mentioned earlier, there are now potential yield opportunities that exist with crypto. Generating income through providing blockchain validation or mining to simply lending assets on the blockchain itself. Moving from ‘Proof of Work’ to ‘Proof of Stake’.
Proof of Work
Blockchains like Bitcoin and Ethereum use ‘Proof of Work’ to make sure that everyone who modifies the ledger has mathematically proven to the network that they have ‘skin-in-the-game’. They must invest in mining infrastructure and are known as miners.
Proof of Stake
With ‘Proof of Work’, there can be serious problems including competing or biased interests. ‘Proof of Stake’ solves for this as mining resources are invested in cryptocurrency tokens, meaning that the token-holders are the miners. And that means it’s in their best interest to ensure all participants are acting fairly and valid players in the crypto world.
How to gain exposure
In 2020, the performance of Bitcoin and Ethereum have shown great promise. There’s a number of products on the public markets where investors can seek out crypto exposure. If opening a personal account on a cryptocurrency exchange and doing the research on the custody procedures is for you, you’ll need to understand the reputation and risks of these exchanges. ETFs also exist, and fully acknowledging exactly what you own is critical to aligning your expectations.
With any investment, understanding the risks and aligning the potential reward with desired outcome is critical. Cryptocurrency in the digital wallet or investment portfolio may not be for everyone today.
Gaining access has been the challenge, up until Purpose Bitcoin ETF (BTCC), the world’s first physically settled Bitcoin ETF has allowed investors access to an efficient and simple way to own a piece of history.
— Josh Bubar is Vice President of Product at Purpose Investments and Mike Scott is an Analyst on the Portfolio Management team at Purpose Investments.
All data sourced to Bloomberg unless otherwise noted.
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