Few financial topics divide opinion like cryptocurrencies.
Two years ago, an influential committee of British MPs likened crypto (or digital) currencies to “the Wild West”, warning that regulation and investor protection were non-existent in this sphere.
They weren’t alone in their concerns. The UK’s City watchdog, the Financial Conduct Authority, is blunt when it comes to cryptocurrencies, describing them as “very high risk, speculative investments”.
“If you invest in cryptoassets,” it warns, “you should be prepared to lose all your money.”
Stark messages like these, however, are at odds with growing support for this form of digital asset, which is completely virtual, has the same value in every country, and is out of the reach of governments.
Payments giant PayPal, for example, has announced a service allowing its US customers to buy, hold and sell cryptocurrencies through their accounts. A Facebook-backed digital currency called Libra is due to launch in 2021.
Mainstream investors are also taking more than a passing interest in cryptocurrencies.
In what it referred to as a hedge against monetary and market risks, investment firm Ruffer recently spent about £550 million (equating to 2.5% of the £20 billion it has under management) on buying Bitcoin. This is the oldest and largest of all the cryptocurrencies.
But what are cryptocurrencies – and should you be taking a closer look? Here’s an overview…
What is a cryptocurrency?
According to the trading platform eToro, a cryptocurrency is a digital currency that uses cryptography as a means of security. With a track record going back over a decade, cryptocurrencies are more than just a fad.
Indeed, Dan Schulman, president and CEO of PayPal, paints a rosy future when he says “the shift to digital forms of currencies is inevitable, bringing with it clear advantages in terms of financial inclusion and access”.
Most cryptocurrencies operate without the backing of an authority, such as a central bank or government. This fundamentally differentiates them from traditional currencies, such as the pound or the dollar.
Instead of governmental guarantees, the way cryptocurrencies work is underpinned by something called blockchain technology (see below).
Rather than existing as a physical stack of notes or coins, cryptocurrencies are confined to the internet. Think of them as virtual tokens, whose value is determined by market forces generated by the people who want to buy or sell them.
Nowadays hundreds, if not thousands, of cryptocurrencies exist. Bitcoin is far and away the largest, with a market capitalisation of around $400 billion, according to platform provider Coindesk.
The market capitalisation of a cryptocurrency equates to the unit price of a currency, multiplied by the number of units in existence. Other major cryptocurrencies include Ethereum and Ripple, with market caps of around $73billion and $55billion respectively.
Cryptocurrencies can be bought with traditional cash such as sterling and can then be used themselves to buy an expanding array of day-to-day goods and services. Cryptocurrencies have the same value in each country, making person-to-person transfers around the world easier, while negating the issue of exchange rates.
Only a limited number of Bitcoins actually exist – both it, and other cryptocurrencies, are likened to a digital form of an asset such as gold, where a perceived store of value is then subject to the laws of supply and demand.
Currently, this is the main appeal of cryptocurrencies: that they are able to be traded on exchanges similar to the way stock market investors buy and sell shares and other commodities.
How have cryptocurrencies performed?
The performance of cryptocurrencies can be notoriously volatile with roller coaster peaks and troughs. Currently, however, Bitcoin is experiencing something of a purple patch. In 2013, an individual Bitcoin was worth just a few dollars. In December 2020, its price broke through the $20,000 mark for the first time.
Over the past year alone, Bitcoin’s price has gained by around 150%, topping $20,000 in December.
Why is Bitcoin performing so well?
Can this good run continue? The truth is, no one really knows, although mainstream support is on the upswing currently.
For example, despite cautioning, as recently as three years ago, that Bitcoin “possesses many of the characteristics of a speculative bubble” Waverton Investment Management is one of a number of mainstream investors that admits the investment case for Bitcoin has noticeably strengthened during this time.
The company suggests several reasons for this, including the recent appetite of large US companies, such as MicroStrategy and Square, to invest hundreds of millions of dollars in the cryptocurrency. Waverton also cites the backing of Bitcoin by major hedge fund luminaries.
In a recent opinion piece for the Financial Times, Morgan Stanley Investment Management’s chief global strategist, Ruchir Sharma, suggested that a cryptocurrency might one day even challenge the status of the mighty dollar as the world’s reserve currency: “Do not assume… that traditional currencies are the only stores of value, or mediums of exchange,” he wrote.
How are cryptocurrencies governed?
The simple answer is that they aren’t, outside the confines of blockchain technology, which we’ll come to later.
Even more fundamentally, the current legal status of cryptocurrencies varies considerably from one country to another. While the use of cryptocurrencies is unfettered within the European Union, specific countries, such as Algeria and Morocco, prohibit their operation.
The FCA is the UK’s financial regulatory watchdog. Its stance is clear-cut when it warns investors that “if you buy… cryptoassets, you are unlikely to have access to the Financial Ombudsman Service or the Financial Services Compensation Scheme”.
The FSCS is a lifeboat arrangement which comes to consumers rescue in the event of a financial calamity such as a provider going bust.
In December 2020, the FCA also advised customers of cryptoasset firms to check the status of their providers and to ensure that they were allowed to carry on trading as per the watchdog’s revised rules on registration.
For providers who can’t confirm they are operating under the new rules, the watchdog advised customers to withdraw their holdings.
How do you buy cryptocurrencies?
The most common places to buy Bitcoin and other cryptocurrencies are on specialist exchanges. This includes a range of online trading platforms, mobile apps and websites that allow investors to buy Bitcoin using either traditional currencies and/or other cryptocurrencies.
According to research by the FCA, about three-quarters of Brits who had bought a cryptocurrency did so through an online exchange.
To open an account, would-be traders are typically asked to provide passport details, a phone number and an email address. The costs of trading can vary from one exchange to another. Some providers impose a flat fee per trade, while others will charge a percentage of the overall transaction amount.
UK appetite for cryptocurrencies
In the summer of 2020, the FCA published research into the UK’s growing appetite for cryptocurrencies.
The FCA estimated that nearly two million adults owned cryptocurrencies, although the findings suggested that about three-quarters of consumers held cryptocurrencies to the value of £1,000 or less. The most popular reason for holding cryptocurrencies, said the FCA was ‘as a gamble that could make or lose money’.
What is blockchain technology?
In essence, a blockchain is a type of database. Blockchain first came to prominence as the technology that underpinned Bitcoin when the cryptocurrency was originally mooted in a paper on peer-to-peer electronic cash systems in 2008.
The paper was credited to Satoshi Nakamoto, thought to have been a pseudonym for either an individual or group of people. Part of the cryptocurrency’s design meant that there would only ever be 21 million Bitcoins created.
The blockchain is essentially a public ledger of every Bitcoin transaction that takes place. A record gets distributed across numerous computers and cannot be tampered with or changed retrospectively. According to supporters of cryptocurrencies, blockchain transactions are more secure than traditional payment mechanisms.
A short Bank of England video demonstrates the blockchain process in more detail and also explains how ‘mining’ works, the mechanism through which new units of currency such as Bitcoin are produced.
What happens next?
Even before the upheavals of 2020, cryptocurrencies were surrounded with questions about their security, practical use and long-term viability. Hence the stark and repeated warnings from financial regulators that people should approach investments in this area with extreme caution.
If more mainstream investment houses dip their toes in the cryptocurrency waters, we may see digital assets improve in value, with their usage normalised and more widespread. But in the uncertain times in which we live, it is also possible that the entire concept may prove vulnerable or unsustainable in the face of as yet unforeseen challenges.
To paraphrase the regulators, “buyer beware”.