U.S. tax forms included a new question in their capital gains section this year: “At any time during 2021, did you receive, sell, exchange or otherwise dispose of any virtual currency?” Nothing says there might be some investment value in cryptocurrency like the IRS taking notice. Being called out as an investment worthy of notice certainly gives crypto a certain credibility, but is it right for the typical investor? Should advisers be thinking about adding a bit to their clients’ portfolios? Or is it still too new and esoteric for all but the most adventurous (or least excitable) investor? Afterall, the IRS also taxes gambling winnings.

THEORETICALLY SPEAKING …

Although cryptocurrency might not be a true currency in the traditional sense of the word, it’s not entirely dissimilar, either. We can, thus, use aspects of the financial system that we already understand (currency, credit cards, foreign exchange rates, etc.) to make it easier to visualize what cryptocurrency is, and exactly what an investor is investing in.

Bitcoin can be viewed potentially as the next step in the evolution of payment for goods and services that started with using shells or stones, moved on to precious metals — such as gold and silver (which are precious only because people decided they were precious) — and then to paper and coins representing the value of those metals. During the Nixon years, we decoupled the dollar from gold, so now the U.S. dollar is worth what it is worth simply because everyone has agreed that’s what it’s worth. There is no agreement on Bitcoin’s value at the moment, and that has led to the volatility and speculation the asset is known for.

Cryptocurrency was launched in 2009 to pay for digital assets in a digital world (e.g., the internet and metaverse) just as dollars are used to pay for items in the United States, pounds are used in the United Kingdom, the yen in Japan, and so on. Instead of being physical money carried around and exchanged, cryptocurrency payments exist as digital entries to an online database known as “blockchain” that tracks, describes and records specific transactions. This isn’t terribly different from online shopping, where the buyer keys in a credit card number that connects to a bank account, which authorizes the sale without any tangible currency being exchanged. However, unlike a credit card purchase, which is approved by the individual bank issuing the card, the blockchain ledger is stored and duplicated on interlinked servers around the world, so the system is decentralized, just as the internet is.

“If you own cryptocurrency, you don’t own anything tangible,” explains Brad Updike, a partner at Mick Law. “What you own is a password (i.e., also referred to as a key) that enables you to move the digital money from one person to another without the involvement of a financial intermediary.”

Some terrestrial-based entities also accept specific cryptocurrencies to pay for terrestrial goods and services, just as some businesses accept specific foreign currencies. For example, stores near the border in Mexico and Canada will accept U.S. dollars, stores in Sweden will accept euros, stores in Slovakia will accept Czech crowns. In the same way, Home Depot, Starbucks, Whole Foods, Expedia, the Dallas Mavericks, AT&T and a slew of other traditional, name-brand companies now accept Bitcoin or a similar cryptocurrency in payment for goods and services. Your digital wallet lets you choose which account to use — Bitcoin, Visa, PayPal, your bank account, or whatever other payment method you have in the wallet — and the store credit card reader accepts the payment. If you choose Bitcoin, there will often be a small fee, similar to a foreign exchange fee, added.

But here is where the analogy falls apart. Although Bitcoin and other cryptos were intended to be used to pay for goods and services, people really aren’t using them that way. Instead, they are seen as a speculative investment, which is the opposite of how most people view adding foreign currency to their portfolios.

CRYPTO AS AN INVESTMENT

There are three main parts to the cryptocurrency world — currency, such as Bitcoin; blockchains, such as Ethereum; and currency exchanges, such as Coinbase. There are a variety of ways for investors to invest individually in one or more of these aspects, but because one cannot function without the other, the parts are typically grouped together under the umbrella of cryptocurrency.

Since it was launched, the value attached to cryptocurrency has behaved much more like a commodity than a currency. Even the term “mining,” which is used to denote the creation of bitcoins, brings to mind commodities.

“One could argue that a cryptocurrency’s value and function are like that of precious metals,” notes Updike. “Both are limited in quantity and have select use cases. Precious metals, like silver, gold and platinum are used in industrial applications, while blockchain, the underlying technology supporting cryptocurrencies, also has discovered applications across multiple economic sectors [such as financial services, travel and entertainment].”

So, cryptocurrency exhibits many of the characteristics of precious metals, even if it is intangible. In other words, we get the essence without the mass. “Cryptocurrency is gold’s spirit animal,” asserts Charlie Morris, CIO of ByteTree Asset Management.

Another way to look at cryptocurrency investment is to think of it as investing in a new disruptive technology. Just as Amazon disrupted retail, crypto could disrupt finance.

“This is what we call the Web3 argument,” says Mark Bell, partner and head of family office services and private capital at Balentine. “We have now developed a decentralized payment layer, which is the third iteration of the development of the web. In this sense, you can think of the price of Bitcoin as owning the ‘stock’ of a protocol and a piece of the oldest, most decentralized of these networks.”

Finally, for those who only add new sectors to their portfolio if it will add diversity, cryptocurrencies appear to be uncorrelated to other investments.

“We think that we’ve got an asset here that is inflation sensitive, with weak correlations to other sectors,” says Morris. “For example, we recently saw the European stock market go up 9 percent and gold go down 2. That same day, Bitcoin went up 10 percent. If you just look at this year-to-date, gold is up approximately 10 and Bitcoin is down approximately 10. You have this very clear risk-on/risk-off relationship, and it is very apparent that Bitcoin is kind of a pure play on risk.”

While cryptocurrency is quickly gaining in popularity, it is still a relatively small market. For example, Bitcoin has a market capitalization of roughly $835 billion, gold has a market cap of roughly $12 trillion, and the global equity market cap exceeds $125 trillion. This means that even small moves can cause outsized fluctuations.

Even investors who feel comfortable that they understand the crypto world can be put off by its volatility. In the past five years, there have been 38, 24-hour drawdowns of 10 percent or more, according to Balentine. Even in bull markets, Bitcoin has experienced drawdowns of more than 20 percent with white-knuckling regularity. At the end of 2021, Bitcoin lost 30 percent of its value in one day. This is not an investment for the faint of heart.

“Like commodities, it has a fixed supply, but demand is all over the place,” explains Morris. “Those who have followed Bitcoin are quite used to the ups and downs. It tends to double more than it should, and so sometimes it just gives back a double.”

Anthony Scaramucci, founder and managing partner of SkyBridge Capital, was recently on CNBC explaining why people should be more sanguine about cryptocurrency’s gyrations. “Amazon has dropped more than 50 percent eight times since inception,” he said. “But if you had invested $10,000 on its IPO, it would be worth $22 million today. It’s about buying quality and recognizing that Bitcoin is not a store of value at this moment, it’s not technically a currency at this moment. It’s an early-adoption technology story. With that is going to come a lot of volatility.”

GIVING CRYPTO ITS DUE DILIGENCE

The challenge of investing in cryptocurrency (whether it is Bitcoin, Ethereum, Coinbase or an ETF that does the choosing for you) is that it doesn’t have a long enough track record to do traditional due diligence. There are no bricks to kick or historical rent rolls to study. There is no performance data through multiple cycles, and what data we have is distorted by speculation based on things out of left field, such as Elon Musk’s tweets. There is no way to know what to expect over the long term. And, while crypto is becoming popular and can be accessed by a number of investment methods, it is a sector wrought with promoter activity and fraud.

“Complicating the problem is the fact that many crypto distributors don’t view their currency offerings as securities, even though they most certainly are,” says Updike. “As such, some currency distributors are skating the rules by not registering their securities with the SEC.”

That means investors need to be very careful (no one wants to invest in the next Pets.com) but there are ways to find the diamonds or spirit animal among the dregs.

“Most of it is rubbish,” says Morris. “So, it’s more of a private-equity approach where you need good, detailed research to determine if a particular investment serves a purpose. I think that with Bitcoin, the real value is the network. Never before have we been able to put a price on a network. Now we’re measuring networks, and networks have never mattered quite so much. Without blockchain, we couldn’t do this.”

Despite the complexity of crypto, there are measures people can employ to vet crypto investments and underlying projects. The first step begins with an education on blockchain and its potential economic applications. Due diligence should also include a review of the currency distributor’s written business plan (referred to as a “white paper”) and prospectus in an effort to confirm the people managing the projects, as well as economic need for the project and its “value creation potential” to the blockchain ecosystem. Certain areas of inquiry that speak to the legitimacy of a currency in terms of substance and suitability might include the following:

• What is the tone of the crypto distributor’s white paper, website and other promotional materials (i.e., is it educational in terms of its presentation of the business plan, or does it use a lot of emotion-driven content about outsized returns)?
• Can the character and credentials of the distributor’s managers and personnel be confirmed through the white paper, prospectus and further research?
• What economic problem can the distributor’s development of blockchain solve, and is the developer’s project really needed by the public?
• How will the money raised by the developer be used to solve the economic problem and ultimately generate revenue?
• How does the revenue ultimately enrich the blockchain ecosystem participants (i.e., those that hold the currency, as well as the distributor)?

BOTTOM LINE

Investors who are able to go with the flow and ride out cryptocurrency’s growing pains might very well find this an opportunity to get in on the ground floor of a truly revolutionary sector. It is foolish to think it will have a straight-line, 45-degree growth pattern, but that’s part of the fun. And frankly, investing in emergent asset classes, such as cryptocurrency, could be viewed as fun.

“We do not think that cryptocurrencies are part of a balanced diet,” says Bell. “However, people are increasingl99y living a digital life, and it would be foolish to ignore that fact. So, for our clients who have a speculative bucket, investing in cryptocurrency might be interesting. If you’re willing to spend a few thousand dollars a year in Las Vegas, cryptocurrencies may make sense as a better speculative outlet. We would encourage those clients to view cryptocurrency as something they want to learn about and understand, versus something that is an investment that is going to help them reach their financial goals.”

Many investors still view real estate as an alternative, risky investment. These are not the investors who should be looking at cryptocurrency. But if zen is part of your vocabulary, cryptocurrency could well be part of your portfolio.

Sheila Hopkins is a freelance writer in Auburn, Ala.