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The 3 Most Burning Questions About Cryptocurrency

Bitcoin, Ethereum and other  cryptocurrencies (also known as blockchain protocols) have been the talk of the town in recent months, primarily due to their usage of the revolutionary blockchain technology and their stratospheric price increase.

The 3 Most Burning Questions About Cryptocurrency

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As a millennial value investor, we are always on the lookout for the next 100-bagger. With the prices of bitcoin surging over 300x since the beginning of 2013, it is hard to ignore the cryptocurrencies phenomenon. Below is our take on the three most burning questions that investors have on cryptocurrencies.

Are cryptocurrencies a currency or an asset?

This topic has been generating a lot of debate lately so let’s dive right into what makes a currency a currency. There are two primary features of a currency: (i) generally accepted as medium of exchange and (ii) store of value. So how do cryptocurrencies fare in these two criteria?

(i) Generally accepted as medium of exchange – It is clear that cryptocurrenciess today are not generally accepted as a medium of exchange. There isn’t much you can buy with cryptocurrencies at the moment. While there are increasing number of individuals and businesses accept cryptocurrencies as a form of payment in exchange for services or products, the usage of these cryptocurrencies is still highly dependent on its relationship with fiat currencies.

What this means is that for example when an individual or business charge their customers in bitcoins, the amount of bitcoin they charge fluctuates significantly based on recent bitcoin-to-USD exchange rate.

Now then the question is will cryptocurrencies be generally accepted in the future when and if they become more widely adopted? At their current forms, we believe it will be difficult for cryptocurrencies to be widely adopted and here’s why. Cryptocurrencies are essentially unique due to their anonymity, irreversibility and decentralization.

However, it is precisely these features that would prevent the wide adoption of cryptocurrencies. These features would create significant problems for sovereign states in areas of taxation, money laundering, fraudulent activities, and implementation of monetary policies. It is our view that governments around the world would eventually either outright ban or heavily regulate the use of cryptocurrencies. In the latter case, cryptocurrency exchanges would likely be required to perform standard KYCs (know-your-customer) similar to what existing financial institutions do, and cryptocurrency addresses would need to be tied to real world identities.

The goal would be to ensure all transactions are fully transparent, traceable and permissible. Other intermediaries like wallet providers would be required to be registered with governments and would need to adhere stringent cybersecurity and anti money laundering rules. These are just a few examples of what regulations on cryptocurrency would look like. With that said, this begs the question, if cryptocurrencies were to be regulated to a point that they provide no real advantages over existing currencies, then why do we need them?

As such, it is our view that  cryptocurrencies, at least at their current forms, are unlikely to be generally accepted as a medium of exchange in the future.

(ii) Store of value – To evaluate whether cryptocurrencies are a good store of value, we can take look at whether they are stable in value, durable, divisible, transportable and difficult to counterfeit. While cryptocurrencies fare well in most of these criteria, pricing of cryptocurrencies lacks stability and has been volatile and erratic since conception.

As the supply of cryptocurrencies is typically limited and controlled by a schedule written in the code, their pricing is solely a function of demand. Central banks around the world utilize monetary policies to increase or decrease the supply of fiat currencies in response to large sudden fluctuations. This is to promote stability and avoid disruptions in economic activities. Without the ability to control the supply side of the equation, it is unlikely that the pricing of cryptocurrencies would ever be stable.

To sum up, it is clear that cryptocurrencies, despite the misleading name, are not actually currencies and would not replace fiat currencies. In that case, then what are they? While we believe the blockchain technology will eventually bring substantial fundamental changes to our society, cryptocurrencies today are simply vehicles for pure speculation of future demand in the different blockchain protocols.

Are cryptocurrencies a good investment?

As an avid value investor, we will apply the basic value investing framework to analyze whether cryptocurrencies are a good investment.

First, let’s take a look at the “moat” of cryptocurrencies. What value do they actually offer? The truth is existing blockchain protocols don’t actually offer much value for real world applications at the moment. In fact, many of these blockchain protocols are still in the proof-of-concept stage and are nothing more than science experiments. It is unclear whether there is actual demand for widespread adoption of these blockchain protocols.

For example, Ripple, which develops blockchain-based enterprise software that enables instant and low cost global financial transactions, has been struggling to convince its bank customers to utilize Ripple’s own XRP token. Our view is that most blockchain protocols are offering “solutions” to problems that don’t exist. More often than not, centralized systems are simply more efficient and make more sense than decentralized ones.

The second question that we should ask is what has been driving the prices of these cryptocurrencies? Because existing protocols have yet to present any value for real world applications, it is impossible to estimate their intrinsic value (if any). As such, the pricing of cryptocurrencies has been driven by pure speculation of future demand.

This is called the “Greater Fool Theory”, which means that the price of an asset is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. The purchase of these cryptocurrencies has largely been driven by the belief that another party would be willing to pay an even higher price in the future. Our view is that because there is limited basis for the pricing of these cryptocurrencies, it would be highly speculative and risky to invest in them.

Lastly, what could go wrong with cryptocurrencies and does the current pricing provide a strong margin of safety? The biggest uncertainty surrounding the future of cryptocurrencies remains to be their legality. As mentioned previously, it is our belief that governments around the world would eventually either outright ban or heavily regulate cryptocurrencies. As such, we believe the downside risks could be substantial and since the current pricing of cryptocurrencies is largely speculative in nature, margin of safety is virtually non-existent.

Where will cryptocurrencies go from here?

While we believe blockchain technology is here to stay, it is clear that there is a massive speculative bubble in cryptocurrencies similar to the tulip mania 400 years ago. Protocol developers are raising millions through ICOs (initial coin offerings) with only untested concepts, theoretical white papers and nothing more.

ICO investors seem to be ignoring the substantial risks of these investments. We believe the bubble will eventually pop and most ICO investors will see their investments getting wiped out.

Article printed from InvestorPlace Media,

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