What are Cryptocurrencies?
Cryptocurrencies, like Bitcoin, have been a hot topic in recent years. Still, they haven’t become relevant in client portfolios just yet. In this month’s FinPlan Friday conversation, Joe will highlight what financial advisors need to be aware of when it comes to cryptocurrencies.
In our video blog series, FinPlan Fridays, Covisum® Founder, and President Joe Elsasser, CFP®, offers his take on the issues financial advisors see every day. Joe is a practicing financial planner with a unique perspective on the challenges Covisum provides technology solutions. Join us on the first Friday of every month for FinPlan Fridays and get helpful tips to grow your financial planning practice.
Hi, this is Joe Elsasser, CFP®, President and Founder of Covisum, and I’m also a practicing financial advisor. Welcome to another FinPlan Friday. Today, our topic is cryptocurrencies. We’ll talk a bit about what they are and why they may become relevant in client portfolios. We’ll also talk about some of the things that keep them from being relevant in current client portfolios, specifically at the retail level. And then finally, we’ll close out with some of the ways you can use our tools to help you model crypto in client portfolios overall.
How Do Cryptocurrencies Work?
So, let’s start with a little bit of a primer on cryptocurrency. I remember being introduced to crypto, specifically to Bitcoin, from 2010 to early 2011, having read the Bitcoin white paper. At that time, there was a whole lot of concern, specifically about inflation, about fiat money. (The word fiat means “make it so,” so fiat money is money that the government can create out of thin air, and in theory, it’s backed by the full faith and credit of whatever government issues the currency. Ultimately, it means that they said that the money exists.) Now Bitcoin was unique in that it promised a limited supply–21 million is the absolute maximum number of Bitcoins that can ever be created according to the algorithm.
Further, it promised a fully transparent method for token creation. Each Bitcoin that would be created would take a certain amount of computer power/mining power. As more coins are made, it becomes more expensive to power the computer. It does the operations that create a new Bitcoin such that it’s perfectly predictable. It’s a predictable trajectory to reach that 21 million. So, there were two use cases at the time, and there are still are two use cases for all cryptos. I talk primarily about Bitcoin because it’s the grandfather. Still, each of the other coins that have emerged in the crypto space appeared to solve some problem or perceived problem that Bitcoin had.
Two Use Cases for Cryptocurrency
- Store of Value—Fiat money is a problem because when governments inevitably overreach and print too much money, they enter hyperinflation, where the cash goes to a zero value. That’s a fear. We’ve seen it play out throughout countries all over the world. So, this idea of a stable and predictable number of coins at any given time is the argument that Bitcoin represents a store of value or digital gold.
A lot of the people that subscribe to the philosophy of Bitcoin as a store of value use the term HODL (hold on for dear life), and the reason is that crypto has inevitably wild swings. When you run GBTC (the ticker symbol for the Grayscale Bitcoin Trust) through SmartRiskTM, you’re going to see about an 88% risk level. In other words, it’s possible to lose 88 cents on the dollar. And we’ve seen dramatic slides up and down with Bitcoin over the years, So that store of value philosophy is a long-term view. It’s the idea that at the point that we’ve reached saturation in the markets. People understand the crypto space and Bitcoin in particular. They’ll recognize that that limited supply puts a stable value on the exchange. In other words, if I build a fence for you today, and I say, “I’m going to charge you X dollars.” Still, X dollars can no longer buy what I planned to buy with it between today and tomorrow. Those dollars weren’t an excellent mechanism for exchanging labor. And the argument is that when Bitcoin is fully mature, it will be a very stable means for exchanging labor. That’s the core argument that underlies the store of value.
- Rapid Electronic Peer-to-Peer Payments—As we’ve seen Bitcoin develop over time, we’ve seen transaction speeds that are just not fast enough to be able to have real-time payments, and so you’ve seen all kinds of other coins emerge to try to solve that problem–Ethereum being the most prominent coin in that space. The Ethereum blockchain does a lot of different things. It enabled smart contracts. It allowed this ability to effectively program contracts into the blockchain where they’re fully transparent, verified, and distributed so that no one can modify those contracts once they are created. That’s a second use case that stems out of this use case of a fast payment structure. You see all sorts of other coins that are promising quicker ways to process transactions. Two core promises of the original Bitcoin and various currencies have cropped up to create speedier transaction times to create a global peer-to-peer, decentralized payments network.
So, if those are the two use cases, store of value or medium of exchange, then you might ask, “why on earth would you see prices that are all over the place?” In the last two months, we’ve seen the Bitcoin price slide over 50% from its most recent high of around $65,000. The reason is that this is a huge transition period. This is a period that is marked by upgrades to the network. We recently saw the Taproot upgrade being voted by the Bitcoin miners across the world as becoming part of the process. It’s also still early adoption. We just had the first country, El Salvador, decided to make Bitcoin an official legal tender for all transactions in that country. Now, any of these things could go wrong. It’s still possible that that happens and that we never reach a global mainstream acceptance of cryptocurrency. Still, it’s also very likely that things continue to go right. There are now enough stakeholders that it may be a situation where we’ve already crossed a threshold, and we don’t yet know it.
Cryptocurrencies in Client Portfolios
Earlier I mentioned a ticker symbol GBTC, and it’s one way of buying Bitcoin in a seemingly traditional vehicle. It’s a company that holds Bitcoin in a trust and then issues shares, so it has a familiar tax reporting structure. It can be held in IRAs. The challenge for many is that this ticker can trade at a significant premium or discount to the net asset value. If Bitcoin fluctuates, GBTC can fluctuate even more than Bitcoin. So, the challenge as a fiduciary is incorporating an amount that is prudent in a vehicle that is an accepted vehicle for client portfolios, and that’s why I think we don’t see it as much as I believe we will see it in the future.
Now, this video is not investment advice. It doesn’t represent an endorsement of anything that we’ve talked about here, but what you should take away from it is that it makes sense to become knowledgeable on cryptocurrencies because it is likely that we will see them in client portfolios. It’s expected that we’re going to need to plan for them, or at least be able to plan around them.
How We Can Help
SmartRisk needs about six months of daily price history to come up with a reasonable estimate of the downside exposure in a given security. For example, with GBTC, when you run that through, you’ll see an 88% downside exposure, but when you pair a small portion of that with other assets often see a little bit of a diversifying effect.
Regardless of which financial planning software you use, when you model a ticker like GBTC in a financial planning application, the vast majority of financial planning applications determine rates of return based on the asset class. Most do not have a cryptocurrency asset class because there are very few traded tickers today for crypto. And so typically, what they’ll correlate back to is either domestic stock or foreign stock, which means that in a financial planning application, they’re commonly being assigned a rate of return that is commensurate with a diversified portfolio of US stocks. You can see how that could be a dangerous assumption. If you have a heavy weighting to cryptocurrency, it’s unlikely that it will realize anywhere near the mean. It’s either a boom or bust situation.
So, hopefully, we’ve been able to give you a little bit of background on the use cases for crypto, the reasons why we don’t see them in client portfolios today. Still, we may begin to see more and more of them in client portfolios in the future. And a couple of things to think about as you’re incorporating cryptocurrencies into your client’s financial plans.