Whether you follow markets tick by tick or ignore them altogether, there’s a good chance you’ve had a conversation about cryptocurrency recently.
That’s because there’s a ton of excitement brewing around cryptocurrencies and the blockchain tech that they are built upon. Crypto bulls (people who are optimistic about the technology’s future) envision a day when intermediaries, such as banks and data processers, are no longer needed for two people to execute a transaction. They envision systems that process and store smart contracts without a mountain of paperwork and lawyers. They envision a global currency and store of value that’s detached from central bank policies or local political turmoil.
If even half of these predictions happen, they could rejigger the financial system and business as we know it. That’s why investors, speculators, a certain spacefaring CEO and newbie investors who are just plain curious have piled into crypto markets. Indeed, cryptocurrencies could, perhaps, establish themselves at the center of an economy 2.0.
But they could also become utterly irrelevant in 10 years’ time. And let’s be honest: There are over 10,000 cryptocurrencies on the market … there are going to be a lot of losers.
“Both outcomes are equally viable, and that’s part of the challenge with crypto,” says Brent Schutte, chief investment officer at Northwestern Mutual. “At this point, anyone’s guess is just as good as anyone else’s. For now, it’s riding on a lot of hopes for future adoption, which is why even a single tweet can send its value soaring or into a tailspin.”
If you are thinking about adding some crypto to your portfolio or have friends who are talking about it, it is important to keep a foundational investing rule in mind: Always know what you own. And with crypto, there’s a lot we don’t know.
Before diving into crypto, here are a few things to consider.
With any investment, this is the best place to start. This also happens to be hardest step for cryptos.
“Unlike other asset classes, there’s nothing really supporting the value for cryptocurrencies other than people wanting to buy cryptocurrencies. There are no cash flows, assets or earnings,” says Schutte. “Is Bitcoin worth $500,000 or $50? The answer is yes because traditional valuation techniques don’t really apply here.”
Traditional asset classes are a bit easier to price. A stock, for example, entitles you to a share of profits from a company. Analysts can value that stream of profits using formulas to predict the value of future cash flows and dividends and arrive at a fair value for the company. Analysts can also draw on the past performance of the company through various cycles to make reasonable inferences about its performance.
Or take commodities. Oil or soybean prices are based on demand (crypto prices are, too), but these commodities are purchased and used as inputs in products people consume. In other words, they’re inputs for productive assets. They’re critical for life as we know it. That gives crucial commodities a basic, utilitarian value to humanity. There are no underlying cash flows with cryptocurrency, and (at least right now) they are not used to feed or move people or make things we need.
“Gold is often compared to Bitcoin as two ‘stores of value,’ but even gold has uses beyond sitting in a vault, and that drives demand and value. It has a long history of being a means of exchange, for example,” says Schutte.
IT’S A CURRENCY?
As the name implies, cryptocurrencies are lauded as alternatives (or even replacements) to the dollar or other global currencies. Cryptocurrencies hold the same relative value wherever you are in the world, and the distributed ledger technology allows you to transact with anyone, without a bank or processing company in the middle. A person in the U.S. can do business with someone in Nigeria and not worry about currency risks or foreign transaction fees if they are exchanging Bitcoin.
But cryptocurrencies have a long way to go before they are widely used as a currency.
“For starters, the prices of cryptocurrencies are incredibly volatile, which makes it pretty difficult to use them in transactions, especially large transactions,” says Schutte. “Bitcoin is also a pretty slow, computer-intensive network. Think about this: If Bitcoin were a country, it would rank 30th in total energy consumption.”
While other cryptocurrencies may be more efficient, there are thousands of coins aiming to fill a niche. Will a single standard emerge, or will merchants need to accept 2,000 different forms of payment? Keep in mind, there are tax consequences each time you spend (or, more accurately, sell) your crypto. Crypto is taxed as property in the U.S., so the government gets a piece of your profit based on short- and long-term capital gains.
Crypto is still in the “show me” stage of being a useful currency. PayPal, for example, is allowing people to use crypto to purchase items. Other businesses have announced plans to allow Bitcoin or even Dogecoin purchases as well. For now, these are early, incredibly small experiments, and they in no way challenge the dominance of the dollar or other local currencies.
“Let’s be clear, I don’t think cryptos will ever replace the U.S. dollar as the U.S. currency. Sure, they may aid in some transactions in the future, but it's a near certainty the U.S. dollar will continue to be the currency that backs the U.S. economy indefinitely,” says Schutte.
In fact, the Federal Reserve is studying a digital dollar, and is expected to release some preliminary findings in June. A digital dollar could enable instant, person-to-person transfers which could make the financial system more efficient. The Fed’s Lael Brainard, for example, said a digital dollar would make it easier for the Fed to directly distribute stimulus or other financial aid to underbanked communities.
A digital dollar could also serve as a platform for “programmable money.” For example, your money could accrue interest simply sitting in your wallet rather than in a bank. Or parents could program money to ensure the cash they sent to their college-age child can only pay for books or rent. A programmable dollar could provide fertile ground for companies to develop new, tech-enabled financial products and services.
“You'll likely see a lot of interplay between the public and private sector, with the private sector building off the public sector’s foundation of a digital dollar,” says Schutte. “One could convince me that’s where some of the value may lie in a few cryptos in the future.”
IT’S A NONCORRELATED ASSET?
Another argument for crypto is that it’s a store of value and an asset class that is not correlated with stocks, bonds or commodities (i.e., they retain value whether or not other asset classes decline). That’s why people often compare Bitcoin to gold. That argument has picked up steam lately amid increased government spending and easy money policies from the Federal Reserve. Some argue these policies could trigger inflation and devalue the dollar, and cryptos, like gold, are viewed as a haven.
“The trouble is Bitcoin and other cryptocurrencies don’t have enough history to support some of the claims about their role as noncorrelated assets or hedges against other risks,” says Schutte. “Gold at least has a vast history of being valued in society, and it has proven itself through various economic cycles and environments to be a noncorrelated asset.”
So far, there’s simply not enough evidence to support these claims about cryptocurrencies. There has not been enough time for the asset class to have proven its mettle through recessions, depressions, inflationary periods, etc.
IT’S FREE FROM REGULATION?
We are quickly learning this is not the case. China has pledged to crack down on crypto mining (the computational process of executing transactions) and financial firms that engage in crypto trading and transactions. Here in the U.S., the Biden Administration is considering new tax rules and regulation regarding the sale of crypto. Due to its transactional anonymity, crypto has also been criticized because of its favored status as currency for hackers or other criminals.
“The regulatory environment is incredibly uncertain,” says Schutte. “There’s a lot of money circulating in crypto markets — and a lot of money being made. It’s hard to say what’s coming down the pike, but governments around the world are going to want more oversight here.”
SPECULATION VS. INVESTING
“There are just too many unknowns and risks for us to feel comfortable adding cryptocurrency exposure to the funds we manage,” says Schutte. “When I can’t value it and I don’t know what moves it from a macroeconomic perspective, I am not inclined to invest the funds we are entrusted with in it.”
Maybe the future is bright for crypto, but at this point there’s nothing more than optimism driving the price and that can vanish in an instant. Investors need to know what they own, and understand the difference between investing and pure speculation. Remember, a single investment is not a financial plan.
If you are thinking about more ways to invest for growth or to build a plan, a great first step is to reach out to a financial advisor to discuss your goals and how to get where you’re going.
The opinions expressed are those of Northwestern Mutual as of the date stated on this report and are subject to change. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or product.
Please keep in mind that high double-digit returns are highly unusual and cannot be sustained.
Prices at which digital assets (including cryptocurrencies) are purchased and sold are highly volatile and trading digital assets involves a high degree of risk, including risk of loss of principal. The past performance of any particular digital asset is not indicative of future results.