In 2008, digital currency was invented. Known as cryptocurrency, it is a virtual way to pay for peer-to-peer transactions. Over the past decade, it has gained popularity and is often mentioned in the media. Today, cryptocurrency is a well-known term among investors, and many want to own it simply due to FOMO (Fear of Missing Out). However, many people are not exactly sure what it is, how it works, or something they should have in their portfolio.
As of January 2021, there were over 6700 cryptocurrencies. Bitcoin is the most widely known, but it is just one of many. “Bitcoin” is often used to describe cryptocurrency, like “BAND-AID” is used to describe bandages.
Digital currency derived its name from the technology used to create it. Blockchain technology is the complex encrypted computer code that keeps track of cryptocurrency. It is a database or ledger distributed across a peer-to-peer network that supports all types of transactions. Cryptocurrency is stored in a “digital wallet” on the holder’s computer or phone or in the cloud. This wallet serves as a virtual bank account.
Unlike the money in your local bank account, cryptocurrency cannot be universally used to purchase goods. For example, you cannot use it to pay for groceries or at the local fast-food drive-thru. There has been a lot of promise that it will take off as a form of payment, but there has been little progress at this point. In fact, the price volatility makes cryptocurrency unfeasible for many transactions.
Cryptocurrency is bought and sold directly on crypto exchanges, crypto brokerage platforms, and brokerage kiosks. The price of each cryptocurrency is in constant fluctuation, and while many have experienced recent growth, they can also experience significant losses. One crypto experienced an 83% loss in one year.
Investors need to know that these digital currencies are not a commodity, asset class, or currency, even though they do share some of the characteristics. Unlike stocks and bonds, cryptocurrencies lack intrinsic economic value and generate no cash flows, such as dividends or interest payments. Stocks are purchased to participate in the growth of a company based on the products they make or the services they provide. Cryptocurrencies do not have a central authority to manage them – there is no regulation. They are speculative in nature and generally purchased for potential appreciation.
The five biggest risks of investing in cryptocurrency:
- Volatility. Prices are subject to wide fluctuations.
- Liquidity risk. It may be difficult to liquidate quickly at a reasonable price.
- Lack of regulation. They are not overseen by any government or central bank.
- Pricing volatility. No central market for pricing.
- Cybersecurity risk. Exchanges and platforms are subject to breaches.
This information is provided for educational purposes only and is not a recommendation to buy or sell any type of investment. If you would like additional information, please reach out to our wealth management team.
Source: Vanguard, Cryptocurrency | A quick guide to usage and risks