Summary
Volatility is a huge risk factor and source of inefficiency.
Safety is a real issue.
Unmanaged, largely unregulated nature present additional risks.
Greater regulation of cryptocurrencies appears likely.
Central bank backed digital currencies could derail cryptocurrencies.
The rise of cryptocurrencies over the last few years has created an unwelcome element of risk in a world economy and society already full of them. The utility of cryptocurrencies is highly suspect, and the risks and dangers they present far outweigh any perceived benefits.
What are they anyway?
Many people wonder what cryptocurrencies are, and what their purpose is. The answers to that question – and there are several – should give investors pause. Trying to explain how they work or why they should go from curiosity to mainstream use should also draw a healthy dose of caution and doubt. All this leads to a very good question: why bother with them in the first place? For purposes of a briefer discussion, I’ll focus on Bitcoin (BTC-USD) as the leading cryptocurrency.
The Origins of Bitcoin
Bitcoin originated in 2009 as a software program by an anonymous creator or creators known by the alias Satoshi Nakamoto. The software rewards those who solve its increasingly complex computer puzzles (cryptography) with Bitcoin. Roughly 900 Bitcoins are created every day by massive, high-powered computers solving those highly complex puzzles, otherwise known as mining. Roughly 18.5 million of the maximum total of 21 million Bitcoins have been mined. Roughly every four years, the software halves the reward for mining bitcoin, while the puzzles become increasingly complex to solve, requiring more computing power. It’s unclear if any of this software programming can be changed. After all Bitcoins have been mined, it is said that Bitcoin miners will maintain the network with fees. How, or how much, the fees will be assessed remains an open question.
Extremely Inefficient
US Treasury Secretary Janet Yellen has called Bitcoin an “extremely inefficient” transaction mechanism, among other things. Part of the reason is the cost to create a Bitcoin. The electricity used by computers to mine Bitcoins is estimated to leave a carbon footprint roughly equal to that of New Zealand – estimated at 78.9 million tons of CO2 equivalent in 2018. This of course begs the question of how much does it cost to mine a Bitcoin – outside of the carbon cost?
The estimated answer is that in parts of China- Inner Mongolia being one of them- where most Bitcoin miners are thought to operate because of low electricity cost – only about 4 cents a kilowatt hour – the electrical cost to mine a Bitcoin ranges between $5,000 – $8,500, depending on the size of the bitcoin mining operation. Presumably there is a cost for the computers and other costs too. And given that the Bitcoin reward halves every four years – the next time is estimated to occur in 2024 – that means the cost to mine a Bitcoin will double – assuming Bitcoin mining costs don’t increase. But that seems unlikely.
China Banning Bitcoin Mining
The reason it seems unlikely is because China is banning Bitcoin mining operations in Inner Mongolia, home to cheap and dirty coal, and will shut them down beginning in April. China is also clamping down on virtual currency transactions and has banned new coin offerings. It’s estimated that 65% of Bitcoin miners are located in China, because of cheap energy, labor, and chip manufacturing. 90% of Bitcoin trades are thought to have originated in China in the past, but that percentage has declined due to the clampdowns, forcing crypto-traders to move outside of China.
Okay, so we know that Bitcoin, the most popular cryptocurrency, is: a cryptography software network created anonymously; is produced mostly in obscure parts of China with cheap electricity, labor, and computer parts by solving complex computer puzzles; China doesn’t support it; It’s value, while quite volatile, has increased near parabolically recently, as has its profile, and some are saying it could become the currency of choice for international trade.
What could go wrong?
The first thing to understand about cryptocurrencies is that its main purported strength – decentralization – is also a weakness. There is no strong authority defending the currency, or regulating it, and no country is bound to it. That makes it easier for countries to regulate them, or even ban them if they choose. It’s not too difficult to anticipate more regulations on cryptocurrencies in the near term. China and other countries in Asia have begun that process, and seem likely to continue down that path, which could bring adverse consequences to its value. Comments from both Treasury Secretary Yellen, the Boston Fed President Eric Rosengren, the New York Attorney General, and authorities in China all suggest more cryptocurrency regulation is coming. Added regulations bring costs, which will be passed on to those that use cryptocurrencies. That is unlikely to support their value, or widespread adoption and acceptance.
Additionally, cryptocurrency is attracting the attention of the IRS. Atop the 2020 form 1040 is a question if you’ve had any dealing in cryptocurrency. The IRS has already sent out over 10,000 letters to taxpayers thought to have been involved in cryptocurrency transactions that may be subject to tax, such as being paid in cryptocurrency, or making a profit in one. Failing to report taxable cryptocurrency transactions could result in some hefty fines. And given that a notable amount of cryptocurrency transactions is known to occur in illicit enterprises, or gambling that may or may not be legal, dealing in cryptocurrency could draw some additional law enforcement scrutiny as well.
Secondly, there are safety concerns with cryptocurrencies. As a virtual currency, or store of value, or whatever you want to call it, it only exists in cyberspace. If you lose the key to your digital currency wallet, there is no password reset option. Whatever digital currency was in your digital wallet then becomes inaccessible forever. It’s not gone, it’s just lost forever. It’s estimated that roughly 3-4 million Bitcoins – out of the 18.5 million created so far – have been lost permanently.
Additionally, what we’ve all come to know is that if it’s in cyberspace, it can be hacked – and stolen – with no recourse. The bank isn’t going to refund your loss or cancel the transaction. This isn’t a minor issue either. Nearly 1 million Bitcoins have been known to have been stolen, 850,000 in the Mt. Gox hack, and another 120,000 in the Bitfinex hack. There may have been others.
It’s also thought that the anonymous creator of Bitcoin, known by the alias Satoshi Nakamoto, may have kept a few Bitcoin for his/her own use. 900,000 some claim, while others claim it’s more like 300,000. Nobody knows for sure. But what if he/she decided to dump his/her Bitcoin? What if his/her/their identity became known? Some claim either event could cause Bitcoin’s value to plummet.
In any case, with China shutting down cryptocurrency miners and clamping down on cryptocurrency transactions, the New York AG warning the cryptocurrency industry, “play by the rules or we will shut you down,” and Treasury Secretary and Former Fed Chair Janet Yellen warning about “extremely inefficient” Bitcoin, and the Boston Fed President predicting the Bitcoin boom won’t last, you can bet there are headwinds cryptocurrencies will be facing going forward, which likely will result in more volatility in their prices
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