Cryptocurrency is in the headlines enough that it may pique your interest. Some swear that it’s the wave of the future for money and finance. But should it be part of your comprehensive financial plan checklist?
To evaluate whether or not it should, let’s look at what cryptocurrency is.
What is Cryptocurrency?
The answer to what it is lies hidden in the name itself: it’s a currency!(1)
Like U.S. dollars, Euros, or other currencies, cryptocurrencies can theoretically be used to purchase goods or services, as long as two significant criteria are met: 1) the vendor of the good or service must accept cryptocurrency and 2) cryptocurrency must be legal in the jurisdiction where the purchase is done. Cryptocurrency is not legal in all countries: it is in the U.S., for example, but not in China.
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But cryptocurrency is also profoundly different from currency like dollars or Euros in highly significant ways. First, it is an entirely digital currency. You can purchase cryptocurrency on exchanges, and must generally set up a digital account where your purchase will be stored in a digital “wallet.” All transactions are digital.
Second, currencies like dollars and Euros are backed by governments and central banks. Dollars, for instance, are backed by the U.S. government and the U.S. Federal Reserve, our central bank. But cryptocurrency is not backed by any government or central bank. Cryptocurrencies are developed by individuals and companies.
Third, cryptocurrencies are investable and tradable assets whose price fluctuates. In fact, over the roughly 12-year-plus history of cryptocurrencies, prices have been extremely volatile.
In late 2017, for example, Bitcoin, one of the most widely known and used cryptocurrencies, sold for $20,000. A year later, in 2018, it sold for $3,200. In late 2021, the price had risen again, to $65,000.
Why Was Cryptocurrency Developed?
Cryptocurrency was born out of the sweeping transformations that computers and digitization have caused in many sectors. Again, it is entirely digital; buying, selling, trading, and investing are all entirely done on digital devices such as computers and smartphones.
Digital transformation was disruptive of many sectors and institutions. Lyft and Uber, for example, disrupted the taxi industry by moving the hailing operation to an app and a digital device rather than a whistle and a wave on a crowded city street (or a taxi stand).
Proponents of cryptocurrency believe that the banking and financial industry is ripe for an analogous disruption, via cryptocurrency. They argue that banks and financial institutions are cumbersome and overly regulated.
The argument goes like this. Financial transfers taking place within banks, such as credit card payments and checks, take a certain amount of time to fully process. A credit card payment, for example, may go through quickly on the purchaser’s end but is not fully processed to the vendor until several days go by.
In addition, government regulation affects transactions, such as the amount of cash that can be withdrawn on any given day.
Cryptocurrency exchanges, however, have virtually no processing time – just the time it takes for the digital exchange to complete. Plus, because there is no government or central bank regulation, there are no restrictions or rules on amounts of money that can be withdrawn or exchanged.
Proponents also argue that cryptocurrency is actually more secure than mainstream banks and financial institutions. Why? Well, because cryptocurrency exchanges take place via blockchain,(2) a distributed ledger system that records all exchanges and distributions.
Like cryptocurrency, blockchain is entirely digital, and proponents believe it is more secure than physical locations or physical records. Physical locations, like banks, can be broken into, after all. Physical records can be lost or altered.
Those in favor of cryptocurrency essentially argue that cryptocurrency will digitize the financial sector, just as so many other sectors have been digitized.
Are There Any Drawbacks to Cryptocurrency?
Knowing what proponents believe about cryptocurrency is important because their beliefs are necessary to understand what cryptocurrency is and how it was developed.
But it’s important to understand that there are potential drawbacks to cryptocurrency as well.
First of all, as currency, even the most popular cryptocurrencies, such as Bitcoin, are not in wide use or widely accepted. In fact, a minuscule amount of people hold Bitcoin compared to how many hold dollars or stocks!
Again, cryptocurrency is not legal in all countries. Plus, history shows that the legal status within countries changes frequently. Cryptocurrencies used to be legal in China, for example, and now are not.
Second, cryptocurrencies are extremely speculative and volatile as investments. Don’t let an ad touting the percentage increase between 2018 and 2021 tempt you; it’s large because a 2018 price could represent a nosedive from previous levels.
Third, cryptocurrencies could have an association with criminal activities and/or underground activities. The lack of government regulation and oversight, combined with the digital nature of both cryptocurrency and blockchain, means that users can (potentially) hide or try to hide their identities and activities. That’s appealing to criminals. Crypto has been associated with money laundering, ransomware, the dark web, and more.
As a result, cryptocurrencies may be more subject to hacking than traditional financial accounts like bank or brokerage accounts. In other words, they could be less secure, not more.
Fourth, cryptocurrency has potential drawbacks for investors specifically. It is not necessarily easy or simple to purchase. There are roughly 16,000 cryptocurrencies publicly traded. Some can be purchased with dollars, but others require cryptocurrency itself to purchase.
The U.S. government classifies any cryptocurrencies citizens hold as financial assets. That means investors need to keep their potential tax picture in mind. The volatility of crypto can result in a large tax bite.
Finally, cryptocurrency may run into difficulty with wider circulation and acceptance as climate change becomes more visible and important. Why? Because the creation of cryptocurrency is done through a computer process known as “mining” that requires an enormous amount of energy.
The energy consumed is estimated to be more than some entire countries use. That may hamper any notion that it will be the wave of the future, and be important to concerned investors.
In short, any discussion of cryptocurrency needs to be taken into account by both proponent beliefs and its potential drawbacks. A financial advisor can help you evaluate whether the risks are worth the rewards and whether cryptocurrency should be considered as part of your comprehensive financial plan.
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- “What is cryptocurrency, what you should know” Authored by James Royal Ph.D. and Kevin Voigt. Published January 3, 2022. https://www.nerdwallet.com/article/investing/cryptocurrency-7-things-to-know
- “Cryptocurrency” Authored by Jake Frankenfield. Published December 20, 2021. https://www.investopedia.com/terms/c/cryptocurrency.asp