In December 2017, Bitcoin reached over US$19,650 before crashing down to approximately US$3,200. More recently, Bitcoin is back hovering near US$18,000 at the time of writing (November 20th).
Bitcoin is not alone. Other so-called digital or cryptocurrencies are enjoying similar momentum. Ethereum or Ether has more than quintupled in value since 2018 (about US$80 to US$460) but remains far from its 2017 peak (US$1,300). Although these popular cryptocurrencies have floating values, other so called “stablecoins” aim to reduce volatility by pegging value to some other asset (like the U.S. dollar). Libra (pending the resolution of regulatory concerns) from Facebook, which promises full backing by assets like bank deposits and short-term government securities, is likely to be less volatile. Tether is another good example.
With all the associated headlines, I’m often asked these three questions: Are cryptocurrencies actual currencies? Do they represent a good investment opportunity? And how will they impact the global financial ecosystem?
Are cryptocurrencies currency? Sort of, maybe, it depends
The Oxford dictionary has a very simple, but narrow definition of what a currency is: A system of money generally used in a particular country. Merriam-Webster has a somewhat broader definition speaking to a “medium of exchange” or a “common article for bartering.”
Using the Oxford definition, cryptocurrencies such as Bitcoin would not be deemed currencies. Although a few businesses are starting to accept them as valid forms of payment – you’ll continue seeing the odd story of someone buying something like a house with Bitcoin – no particular country generally accepts cryptocurrencies as a form of tender at this time.
Using the broader definition, cryptocurrencies can be used as a medium of exchange and/or used in barter. The exercise is simple but with floating cryptocurrencies, the situation is a bit more complex. What makes a currency successful in the exercise of exchange is stability, the ability to retain value, and recognition as legal tender (when both parties accept the currency, understand its value, and trust that it will be worth more-or-less the same tomorrow vs. today, the transaction can happen more smoothly), characteristics that currently do not apply to Bitcoin and most other cryptocurrencies.
Speculative investment is probably a better description
At this time, cryptocurrencies are probably best described as an investment – a highly speculative investment to be more specific. Jerome Powell, Chairman of the U.S. Federal Reserve described Bitcoin as “speculative store of value" much like gold.
The recent increase in the value of Bitcoin and Ether is due in part to two factors.
First, investors around the world have been looking for an alternative to the U.S. dollar throughout 2020. These investors often turn to gold (the shiny yellow metal has also fared very well during this time frame) and other currencies like the Euro or Renminbi. Interestingly, Bitcoin has more than tripled in value since March and its return correlation to gold as a “safe haven” asset has increased quite a bit, reaching 70% recently, an all-time high.
The second factor providing a boost to cryptocurrency values at this time, is the creation of new solutions seeking to unlock the benefits of cryptocurrencies and backing from major players such as PayPal. It’s also interesting to note the similar environment/sentiment prior to the previous peak in 2017. Bitcoin is cool, bitcoin is hip, as with anything cool and hip, it saw tremendous growth in 2020.
An all-digital future? Maybe, but it will be a struggle
The world is slowly embracing digital currencies. Sweden is close to being a cashless society and is considering the e-krona as legal tender. Another example is the Chinese Digital Currency Electronic Payment (DCEP) framework, sometimes referred to as the digital yuan, which could be launched soon. This raises an important nuance – digital currencies backed by a country’s central bank and others like Bitcoin that are private in nature.
Looking at China, alternative digital wallet or payment systems such as Alipay or WeChat Pay are prevalent and there will be tension between countries issuing their own currencies and private businesses engaging in alternative payment systems and currencies. Some even speculate that the postponement of the Shanghai portion of the ANT Financial IPO by China’s regulators was in part a move to keep control of its own currency and financial landscape.
Currencies remain a very important tool for countries to exert some control over their economies through monetary policy. Widespread adoption of private networks and currencies outside of central bank control would undoubtedly make things more difficult for central banks and policy makers.
Cryptocurrencies are not going away but expect a tug-of-war between central banks and private issuers which may put some pressure (and increase volatility) on the likes of Bitcoin, Ether, and other cryptocurrencies. The way we pay for things is evolving but unfortunately there’s no way to predict how things will turn out. For now, some caution is warranted as these investments have already demonstrated just how volatile they can be.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.