Bitcoin & Cryptocurrencies’ Biggest Risk

Bitcoin & Cryptocurrencies’ Biggest Risk

Bitcoin and cryptocurrencies have been an amazing invention and have provided the market with a new type of asset class.

But most in the bitcoin and crypto market still have a healthy fear of the risk they’re taking on if they own bitcoin or crypto in any material quantity.

Everyone is aware of bitcoin’s lack of intrinsic value. It has imputed value. And there’s bitcoin’s infamous volatility.

Bitcoin has been known to swing up or down 10 percent in just one day. This means bitcoin will need to have more price stability before it becomes safe for the average person to keep it as a significant portion of their portfolio. Not many can trust it as something great for long-term investing, especially those nearing retirement.

And there’s the cybersecurity risk. Hackers are always looking for loopholes in systems. Bitcoin is no exception.

Many bitcoin users have feaered or experienced crypto cyber theft in one form or another. To make matters worse, bitcoin and crypto holders don’t have the same protections as regular bank account holders when it comes to potential theft. There are no government agencies to turn to for help in recovering bitcoin or any other type of cryptocurrency that may have been stolen.

So bitcoin users will be left on their own to try and recover stolen bitcoin.

The bitcoin market is still too young for mainstream, traditional financial institutions such as banks, stock brokerages, and most big investing institutions to get involved with bitcoin directly.

That means they cannot offer bitcoin accounts or allow bitcoin transactions in the same way they do regular bank accounts and the buying, selling, or trading of stocks and bonds.

That’s a huge detriment because many people want that layer of security that comes from working with someone they trust: a regulated, insured institution where bitcoin and cryptocurrency transactions can take place under the oversight of government agencies like FINRA.

Until bitcoin has more regulatory oversight, it won’t appeal to more conservative institutional and retail investors. These entities will want assets in their portfolio that are more stable and reliable rather than something speculative like bitcoin. Until then, they will either avoid it or will choose to own it in a smaller quantity.

 

What is the biggest risk in the bitcoin and cryptocurrencies market?

Most likely, the biggest risk against cryptocurrencies is that they become a victim of their own success. If they become too successful, governments will want to crack down on them.

Therefore, the biggest risk bitcoin and cryptocurrencies face, in all likelihood, is regulation by governments.

Governments can shut down bitcoin exchanges, which are digital marketplaces where people trade bitcoin for national currencies (like the dollar or euro) using various types of internet-enabled devices. They could also ban the production of new bitcoin or even outlaw bitcoin ownership altogether.

As a medium of exchange (one of the basic ideas behind a currency) it would be virtually shutdown.

For cryptocurrencies to maximize their value, people need to use them so they can buy and sell goods and services with them. When bitcoin is banned altogether or outlawed, no one can effectively use it. It ceases to have value as a type of cash or transactional medium.

One of the greatest powers a government has is to control all the money and credit within their borders so they’re allowed to control policy.

They want the money and credit they produce to be the best choice for their own citizens, not forms of money that are privately created and/or privately held.

On a limited scale, there have been countries like El Salvador (a dollarized economy since January 2001) that have introduced bitcoin as legal tender. But that’s very different from a larger, reserve-currency country taking that step.

 

Crypto in the historical record

If you put crypto into the historical record of private forms of money, gold has periodically been banned by governments looking back thousands of years when people were using it to store wealth off the record rather than putting it into forms of credit.

Gold was banned in the US from 1933 to 1975 (some restrictions loosened in 1964) for this reason (excluding jewelry, industrial applications, and a few others).

Many governments are looking for ways to do something similar with bitcoin and crypto (in contrast with El Salvador and a few others). China has already cracked down.

That could mean banning it completely or at least severely curtailing its use.

Governments don’t want people using any currency but local currency for buying and selling goods and services. When people are using bitcoin or other forms of private money, they’re operating outside the traditional banking system. It reduces the central bank’s influence on interest rates and economic policy.

Bitcoin’s Privacy Advantage

One advantage bitcoin has over many national currencies is that it offers privacy features, something that could appeal to some investors and make bitcoin more attractive in certain circumstances.

But by having these advantages, bitcoin is also creating an intrinsic problem for itself as far as regulators are concerned.

If bitcoin catches on too much with the wider public, governments will crack down on it because they think it’s being used heavily for purposes of a lot of bad activity, like money laundering, terrorism financing, tax evasion, and so on, which incentivizes policymakers to do something.

Governments can also kill crypto by getting rid of the on and off ramps. If banks aren’t allowed to connect to exchanges so people can’t get their money in and out, that’s one avenue.

But crypto can serve as a long-term store of value if they’re allowed to exist. In that case, bitcoin would remain a store of value like gold.

And bitcoin is difficult to regulate by design. No government in the world can fully control bitcoin or cryptocurrency exchanges because no person or entity is in charge of it all.

It’s decentralized and peer-to-peer (P2P), meaning transactions happen directly between users without going through a regulatory body, bank, or another entity. This makes tracking bitcoin and other cryptocurrencies difficult for regulators.

The bitcoin blockchain is designed in a way where every transaction is recorded publicly. So the history of bitcoin ownership is known to everyone on the internet who wants to participate in bitcoin transactions. But it can’t be easily traced back to any single individual or entity unless they’re revealed by that person willingly (like when they send themselves bitcoin at an address).

 

Why people take the risk investing in crypto and bitcoin

First, there’s the obvious speculation element.

When things like Shiba Inu coin (SHIB) can return over 1,000,000x in one year, there are many people willing to swing for the fences, who will take on large risk for the prospect of high return.

But there are also more institutionally driven reasons.

There’s a lot of debt and money creation by governments to fill in the gaps with their bad finances.

This is driving people out of cash and bonds – because they lose their value in these circumstances – and into various other stores of value.

That includes things like commodities, certain types of stocks, land and real estate, hard assets, and various forms of private money.

Bitcoin and its competitors can help fill that gap and the growing need in the market in terms of the type of assets that are wanted.

Bitcoin and other forms of cryptocurrencies are like a long-duration option on a store of value with a highly unknown future, hence all the volatility.

While regulation can be a “crypto killer” there needs to be more public oversight for more institutional acceptance of cryptocurrencies. At the same time, the lack of regulation is what a lot of its holders like about it.

And for large institutions to hold bitcoin and others in their portfolios, there also needs to be sufficient liquidity for trades to be conducted in size without destabilizing the market.

Emerging markets and how bitcoin or crypto fit in

There’s a lot of interest in bitcoin and crypto from countries with unstable economies that are experiencing their own forms of inflation and capital controls.

In these cases, there’s not enough money in the system or people don’t have access to funds even though they want their assets denominated in something stable, like dollars or euros.

Therefore bitcoin is attractive because they can take control of how much bitcoin they own, and bitcoin can help them hold their own assets without having to take on the sovereign risk of their own currency. Or simply when there’s a lack of money to transact in.

For example, in many poor societies, they still heavily use a barter system. One person’s goods and services are exchanged for another’s. But that’s cumbersome, so crypto provides one avenue to get around those constraints where there’s a lack of money to meet the demands of trade.

Bitcoin is also conceptually attractive for technologically advanced emerging markets who want to benefit from blockchain technology without getting into bitcoin itself (or other cryptocurrencies) because bitcoin may pose additional policy risks that they don’t want.

So in places like China, which has more centralized control, they’ll work to enforce the banishment of bitcoin and other cryptocurrencies.

In place like the United States and western Europe, they’ll give them a longer leash. But they’re still likely to crack down if they become successful to a point where they interfere with their ability to direct economic policy.

 

Bitcoin and crypto’s role in the new monetary paradigm

In the paradigm that we’re living in – with many government bonds no longer offering the same yields or diversification characteristics as they did before, and currencies facing greater risk of depreciation with all the money and credit creation – this could propel the development of alternative stores of value faster than might otherwise have been the case.

Bitcoin and crypto ETFs and futures also help legitimize bitcoin as an asset class. These can increase their popularity among a larger group of traders and investors that wouldn’t touch them otherwise. They can trade them directly through their broker without having to go to a dedicated crypto exchange.

Some will still not like crypto on any level because they don’t pay a yield on an outright basis, like gold and various other hard assets that don’t produce cash (or aren’t rented out).

But this matters little when yields on other assets (cash, bonds, even stocks) have collapsed because of the compression of short-term and long-term interest rates.

Returns on bitcoin have been wild rides with a lot of volatility, but bitcoin has outperformed most asset classes over recent history.

As a result, bitcoin and cryptocurrencies could be seen as a viable alternative to traditional financial assets under certain conditions.

They may not have ideal diversification properties – at least not how bonds or gold might do a better job of diversifying stock and risk asset exposure – given their speculative nature.

But there may be some place for a smaller amount of crypto in an asset allocation.

In terms of bitcoin’s role when interest rates come back up from their present compressed levels – especially as real yields go from negative to positive again – it’s likely to become less attractive as cash and bonds become more viable.

Bitcoin as a gold-like alternative

Bitcoin is the most developed of all cryptocurrencies, so it’s the closest thing to a gold-like alternative.

In terms of market share: Gold is about a $5 trillion market (excluding central bank ownership and jewelry) and bitcoin is around $1 trillion (with much higher volatility).

So there’s about a 5:1 split between gold and bitcoin if you take out central banks (who don’t want to own bitcoin as a source of reserves).

So if you think about how much bitcoin to own relative to something like gold in a portfolio to stay balanced, it’s only about 20 percent before you factor in the volatility factor.

And gold itself is a small percentage of a balanced portfolio because it’s just an alternative form of cash. Its long-run real (inflation-adjusted) return should be around zero.

So if gold were to be about 10 percent of a portfolio, bitcoin might be at a 2 percent baseline before volatility considerations.

Then taking into account the factor that bitcoin is about 10 times as volatile as gold, you’d probably want bitcoin to still be under half a percent of your portfolio thinking purely from a “balance” perspective.

Any more than that it ventures more into speculation than owning a balanced allocation of assets.

 

Can bitcoin rise another 10x?

Going back to the market share argument, if bitcoin were to rise by 10x that means you have more money in bitcoin than in gold.

That’s probably unlikely.

But the absolute level that bitcoin rises going forward also depends on what’s going on with national currencies and how much of those go into the various alternatives and cause their prices to rise.

 

Price risk

Bitcoin, like any volatile investment, faces the risk that you could lose 80 percent or more of your money.

Bitcoin could also be displaced by other types of cryptocurrencies that have characteristics that are better for those who wish to hold and transact in them.

Just as there’s been the evolution of top companies (e.g., look at the Dow Jones component over the years) and the evolution of sovereign currencies, there will be the evolution of cryptocurrencies.

Looking through financial history, of the national currencies that existed since 1700 – about 750 – 80 percent of them no longer exist. The remaining 20 percent have all been significantly devalued at one point or another, even the most credible ones like the US dollar.

“Printing” currency is the ultimate way out of having too much debt. It’s the easiest and most discreet way of alleviating debt crises. Interest rates in developed markets are around zero and they’re printing a lot of it to relieve debt burdens.

Policymakers want to keep a currency “hard” (have it bear interest and ideally yield positively in real terms). But debt crises force their hand so they never keep it hard in the long run. They push “printing” policies as far as they can until they see constraints in the form of intolerably high inflation, currency problems, and/or asset bubbles.

Then you have other types of currencies and stores of value in the mix that people want when currencies are being devalued.

Bitcoin is one of those newer alternatives.

Bitcoin can be transacted in to some extent and has limited supply. So as long as the demand goes up faster than the supply, its price goes up.

 

Conclusion

What happens to bitcoin will come down to how regulators view it around the world.

Governments don’t want alternative currencies. It impacts their ability to control policy if they have other private currencies competing with their own currency and credit.

One scenario is bitcoin could be relegated as a store of value like gold, which would diminish its importance in day-to-day transactions but increase its allure as an alternative store of value at times when confidence in national currencies falls.

Basically a type of inverse money. Gold is the most common example of this concept. But things like real estate, equities, commodities, and hard assets also share “inverse money” characteristics in varying forms as well.

Bonds and cash do not because of their fixed return characteristics and are the assets that suffer most when money and credit are being devalued from highly stimulative policies.

Another long-term possibility is bitcoin becomes so widely accepted by mainstream society that it becomes more integral to daily transactions.

But if bitcoin becomes too material, many governments will try to clamp down because bitcoin threatens their power over currency and credit policies.

 

 

 

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