- Does this year’s run-up in cryptocurrency prices have you interested in bitcoin investing?
- Central bank digital currencies are emerging, complicating the crypto landscape
- Merchants amounted to just 1% of crypto transactions between mid-2019 and mid-2020
Since bitcoin’s creation a decade ago, it has survived several boom-and-bust phases — generating large gains over short periods of time for some people, but also significant losses just as quickly for others.
2021, however, has so far been a banner year for bitcoin. The cryptocurrency has surprised even its skeptics by not only recouping its 2018 losses, but also rising well above its previous all-time highs.
Plus, over the last year a growing number of publicly traded companies have not only begun accepting bitcoin for payment but have also purchased the digital coin using cash reserves from their treasuries. The growth of the cryptocurrency landscape has also been supported by consumer-facing exchanges, which allow retail users and institutions to buy or sell bitcoin using different currencies.
As bitcoin becomes more mainstream, many investors are asking themselves if it should have a place in their portfolios.
Bitcoin’s future in question
To some investors, this year’s run-up in cryptocurrency prices validates the long-term case for investing in bitcoin. After all, a large part of bitcoin’s valuation is derived from its proponents’ conviction that it will eventually replace government-backed fiat money and displace banks (as bitcoin’s underlying peer-to-peer blockchain network could render financial institutions obsolete).
But while there are numerous benefits to the blockchain’s decentralized-ledger technology, it’s likely that the technology will reinforce the current financial ecosystem rather than replace it. That’s largely because several downside risks, which may not be “priced-in” to bitcoin’s current market value, could get in the way of bitcoin’s large-scale adoption.
For one, governments derive significant benefits from the ability of their central banks to manage the supply of money.
Additionally, the process of creating money represents a source of revenue for governments, which generate billions of dollars each year in seigniorage – that is, profit made by issuing currency. In a scenario under which alternative currencies like bitcoin compete directly with national currencies, seigniorage benefits would be reduced and central banks’ ability to use monetary policy would be significantly constrained.
Thus, as cryptocurrencies gain widespread acceptance and use, governments may view them as a threat to their national authority and enact regulations to control (or entirely ban) them. In fact, Saudi Arabia, Bolivia, Iceland, Ecuador, Vietnam, and Turkey are some countries that have already made it illegal to own bitcoin. (Turkey noted bitcoin’s lack of regulation, supervision mechanisms, or central regulatory authority, combined with the potential for criminal activity and high volatility, as significant risks.)
Countries also define its tax implications in different ways. In the U.S., the Internal Revenue Service views bitcoin as property, making it subject to capital gains tax. Thus, if one person uses bitcoin to buy a product, it is similar to selling an investment asset to do so, triggering the need to report its cost basis and any potential gain or loss on the digital currency. This is one reason bitcoin is mostly being used as a store of value, rather than a medium of exchange.
Enter central bank digital currencies
In response to growth in the crypto space, some nations are contemplating launching their own digital currencies. Similar to bitcoin, these central bank digital currencies (CBDCs) would only exist digitally and would help reduce service and security costs (since creating a digital coin is cheaper than printing a bill).
However, CBDCs would be electronic versions of fiat currencies, preserving central banks’ monetary policy capabilities. Although the largest central banks haven’t rolled out official digital currencies yet, several smaller institutions have begun testing prototypes designed to extend financial services to those sectors of society currently lacking access to banking institutions.
The Central Bank of the Bahamas, for example, has rolled out the Sand Dollar — a digital version of the Bahamian dollar. By deploying this virtual currency, policymakers aim to extend financial services to people and businesses in the archipelago, whose complex geography of 700 islands and islets and over 2,000 cays in the Atlantic Ocean makes it challenging to securely collect and circulate physical cash. Other nations, such as Cambodia, have also taken steps to issue their own digital coins, which are expected to increase financial inclusion particularly in the developing world.
China, too, is already working on a CBDC system as it races toward an entirely cashless society. In turn, the Fed has stated that it will tread very carefully into the digital currency space, given the important role the U.S. dollar plays in the global economy and the lack of an urgent need to shift to CBCDs.
Bitcoin’s negative effect on the environment is another area of governments’ and regulators’ attention. Mining bitcoin is extremely energy-intensive because verifying, processing and recording bitcoin transactions and maintaining the blockchain network require calculating complex algorithms that demand a lot of computing power and electricity.
Scientists believe that the growing energy consumption and associated carbon emissions of bitcoin mining could potentially undermine global sustainability efforts, with projections by the scientific journal Nature Communications estimating bitcoin mining in China to generate more than 130 million metric tons of carbon emissions by the time the technology’s energy consumption peaks in 2024.
Compared to other existing systems of payment, bitcoin also ranks very low from an environmental perspective — a single bitcoin transaction consumes more than four times as much energy as 100,000 Visa transactions. Therefore, companies that are looking for ways to reduce their carbon footprint and improve their environmental, social and governance (ESG) standards are likely to avoid transacting or investing in bitcoin.
At present, bitcoin is almost entirely used as a speculative investment despite its innovative underlying technology.
As of today, very few companies have approved bitcoin as a payment method, given that its sharp price swings make it difficult to use as a measurement of value. A report by Bloomberg concluded that bitcoin is still far away from becoming a common medium of exchange, with merchants amounting to an estimated 1% of crypto transactions between mid-2019 and mid-2020. The Visa network, for example, handles over 5,000 times more transactions a second than the bitcoin mempool (where all the valid transactions wait to be confirmed by the bitcoin network). This could be a risk to bitcoin’s current price levels, given that valuations appear to reflect the future expectation that bitcoin and its related technology will eventually become a mainstream mechanism for payments.
For these reasons, the price of bitcoin is likely to remain highly volatile and prone to move sharply for quite some time. That said, investors still looking for exposure to bitcoin could have a small place for it in their portfolios. Investing in cryptocurrencies can be done through digital exchanges, open-ended funds, or private passive funds.
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