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Introduction to Cryptocurrencies

In this article, Prof Aaron Gilbert explains new asset classes including cryptocurrencies and non-fungible tokens, and its impact on global markets.

Introduction to Cryptos

  • The development of new financial technologies, known as Fintech has created among many things’ new investment opportunities for individual investors.
  • The best known of these opportunities are cryptocurrencies which have gained rapid notoriety and more than a little criticism.
  • Cryptocurrencies have been described as “having no unique value at all” by Warren Buffet and Jamie Dimon, CEO of JPMorgan Chase.
  • Crypto’s have become immensely popular and investors have made, and lost, substantial amounts from trading in cryptos.
  • From an investment perspective, investing a portion of a portfolio into crypto’s may increase returns and hedge against inflation. But it is definitely an investment best undertaken with eyes wide open.

What are Cryptocurrencies

Digital or virtual currencies

  • Have many of the same properties as traditional ‘fiat’ currencies
  • Act as store of value
  • Can be traded for goods and services
  • Hard to counterfeit or double spend
  • Unlike traditional currencies, they are not controlled by central banks/governments.
  • Records are decentralised using blockchain technology. Near impossible to control or fake
  • Transfers between parties can be made directly without involving financial intermediaries. That is cryptos can be traded online directly between individuals rather then transferred via banks

Bitcoin (BTC) example

  • Most well known Crypto is Bitcoin (BTC)
  • As of Aug 2021 there are 18.8 million BTC in circulation
  • Currently value as at 30 Aug 2021 – $USD46,993.70 per BTC
  • Bitcoin can be traded in 1/100,000,000th ‘s of a BTC – called a Satoshi after BTC’s creator
  • The total number of BTC’s is capped at 21 million – expected to be reached in 2140

How are new coins created?

  • A process called mining. Cryptos require processing and validating transactions via decentralised network. Requires sophisticated computers solving complex computational problems
  • To reward people and compensate for the costs involved – must have verified at least 1 MB of transactions and be first person to solve a complex ‘hashing’ puzzle
  • Currently 6.25 new BTC created every 10 mins! Creation rate halves every 4 years!

BTC Prices over time

BTC Prices Over Time

  • Altcoins
  • BTC was the first and is the best known crypto
  • Currently there are estimated to be over 6000 different cryptos available
  • Contrast with traditional currencies – 180 currencies worldwide!
  • Popular altcoins include: Ethereum, Litecoin, Cardano
  • Some companies looking to create their own crypto’s – Facebook planning a crypto called Diem (was Libra). JPMorgan Chase (one of the worlds largest investment banks) is planning a crypto. Mitsubishi UFG Financial Group has launched MUFG Coin in 2020

Cryptocurrencies as an Investment

  • Currency vs Investment – an ongoing debate as crypto’s are only just been seen as legitimate mediums of exchange, i.e. a way of paying for something. On 7th September 2021, El Salvador became the first country to make BTC legal tender.
  • Crypto’s are extremely volatile – lets re look at the price chart for BTC

Cryptos as an Investment

  • High 52,634.5 Low 51,036.73 In ONE DAY!
  • Since inception – 75% annual Std Dev. Same last 12 mths
  • High Risk but High Reward

Price of a Crypto

  • Based largely on the demand and supply for the currency. Supply is largely inelastic – capped number, fixed rate of creation of new coins
  • Demand however is wildly volatile thus seen as a speculative market
  • Critics argue crypto’s have no ‘intrinsic value’. Valuable only as long as people want to or can use/own crypto’s. In May 2021 China cracked down on crypto’s sending BTC prices down 30%
  • Can be heavily influenced by sentiment – Elon Musk has driven BTC and Doge prices based on tweets alone

How to Trade Crypto’s

  • Easiest way is via an exchange. Brings together buyers and sellers of cryptocurrencies
  • A fee is charged for trading. Often charged as a percentage of the value of the trade.
  • For instance Binance charges between .02% and .1% per trade. The greater the trading activity (past 30 days) the cheaper the fee. Also, cheaper if you pay fees with Binance Coin
  • Separate fees for Makers and Takers. Makers put limit orders (providing liquidity) into the market , cheaper fees in some cases, and Takers use market orders (taking liquidity). In addition, often charged deposit or withdrawal fees

Risks

  • Price risk – extremely volatile, even within a single day. The average daily volatility is around 4%. Extreme movements also seen up to 30-40% movements within a day
  • Security Risks – apart from lost or forgotten passwords, there are unique risk for Crypto currencies. Crypto exchanges have been hacked – to date over $USD2.5 Billion in cryptocurrencies have been stolen.
  • Unregulated risks – Exchanges are not regulated as Stock Exchanges, therefore has resulted in ‘fake’ exchanges defrauding investors.

Issues with Crypto’s

  • New Technology – most coins are less then 10 years old and technology itself is still developing. It requires much greater mainstream acceptance to become a legitimate medium of exchange.
  • Environmental Concerns – mining is a power hungry business. It consumes around 91 Terawatt hours of electricity annually, about .5% of worldwide electricity use. As prices rise, more people are attracted to mining thus increasing consumption. Much of that electricity is coming from non-renewable sources. Tesla stopped accepting BTC due to environmental concerns
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