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The cryptocurrency revolution

By Andrew Lawford - Topics: Bitcoin, Blockchain, Cryptocurrency, investment diversification, Investment Risk, Italy
This article is published on: 29th July 2021

29.07.21

Hodling and the cryptocurrency revolution

Are you hodling? No, that’s not a typo – it is millennial-speak for what you do if you are a true believer in the cryptocurrency revolution. Look it up. I wouldn’t describe myself as old, but I’m certainly old enough not to be automatically in tune with what motivates millennials. However, you can hardly open a newspaper these days without some notable individual passing comment on cryptocurrencies, and they even seem to be going mainstream now that bitcoin has been made legal tender in El Salvador – you can buy residency there for 3 bitcoin. It seemed therefore like a good moment to try and get at least a vague understanding of what cryptocurrencies are, as I suspect that many of the readers of this newsletter will be as confused as I am on the topic, so let’s see what we can discover. I will be focussing particularly on bitcoin, as the main example of a cryptocurrency, but do be aware that bitcoin is only the most prominent out of the estimated 10,000+ cryptos out there.

Everything you don’t know about money, combined with everything you don’t know about technology

This was a tongue-in-cheek definition of cryptocurrencies that I heard not so long ago from an asset manager, but it kept coming back to me every time I saw cryptos mentioned in the press.

Once upon a time, “money” essentially meant some amount of precious metal, generally in the form of a coin which was easily recognisable. Then we evolved to a situation in which we used banknotes to represent an underlying amount of precious metal, and finally we arrived at where we are today, where any link with precious metals has been definitively severed in favour of fractional reserve banking and “fiat” currency controlled by sovereign states – the “fiat” is Latin, meaning “let it be done”, and is the essential expression of our concept of legal tender: something is money not because it has any intrinsic value, but because the law says it is. These fiat currencies rely on trust in the good economic management of the issuing countries, and we can all think of notable examples of where bad management has left fiat currencies broken. I have a 100 trillion dollar note issued by the Reserve Bank of Zimbabwe in my office as a reminder of the importance of sound currencies.

Cryptocurrency

Not many of us could properly explain a fiat currency system and the interactions between bank deposits, bank lending and central bank reserves and, as a result, many find it tempting to say that even major currencies like the US dollar and the euro have little intrinsic value due to the fact that their supply is essentially unlimited. To a certain extent, cryptocurrencies were born out of a lack of trust in fiat currencies (even the “good” ones) and the desire to make money something more regulated (not in the sense of having more government oversight, but rather of wanting precise rules and limitations on the amounts of currency in circulation). In order to be worth something, so the reasoning goes, the supply must be limited and it must be difficult to create – hence the parallels that are sometimes drawn between cryptocurrencies and precious metals.

A lump of gold sitting in a vault somewhere has value simply because we think it has value; up until the time that you find a practical use for that gold, its value is dictated by that vague idea that come (almost) what may, at least it will always be there. Not an amazingly intelligent argument, it must be said, but better than many things that finance has come up with over the years. The basic reason for abandoning the link between money and precious metals was that the supply of commodities like gold or silver were subject to vagaries that had little to do with the overall economic situation, so bullion failed to keep up with our economic growth.

Bitcoin in your investment portfolio

As far as bitcoin is concerned, it is very clear that scarcity is central to its functioning given that it has been set up to have a maximum number of 21 million units. As of today, there are roughly 18.7 million bitcoins that have been created, but the number effectively available for transactions is much lower, due to the fact that many people hodl, and also due to the fact that a large number of coins have been lost (I have read estimates of 20% of the total in existence). You see, if you have a bitcoin, you better make sure you keep hold of the codes that allow you to access it, because there is no “lost password” function if you don’t. Losing the codes is the digital equivalent of throwing your gold bars into the Mariana Trench; they don’t cease to exist, but you will find it all but impossible to recover them. It is worth noting that whilst the scarcity value of bitcoin may be beyond doubt, the fact there are so many other cryptocurrencies around should give pause for thought about the scarcity of the category as a whole.

The creation of bitcoin is one of the things that I struggle with the most – it is commonly called “mining”, in an evident attempt to draw a parallel with precious metals, even though the mining in the case of cryptocurrencies is entirely digital. Essentially, they are discovered by computers contributing to the distributed ledger that monitors all bitcoin transactions. The only explanation of bitcoin mining that has made some sense to me so far is to consider it in terms of a triple-entry accounting system: There are two parties who record a transaction and this is then sealed into bitcoin transaction records by a third party that verifies it through its mining activities (and receives a reward for doing so). Mining, in the world of bitcoin, is technically called a “proof of work” and allows a participant in the network to be rewarded by participating in the distributed ledger and crunching the enormously complicated numbers that guarantee the transactions that have been recorded. This ledger, also known as the blockchain, belongs to everyone and no-one, rather like the internet itself, and it exists in order to eliminate the risk of someone being able to spend the same bitcoin twice. No, I don’t really understand it either.

It is also said that bitcoins and their transactions are “immutable” – I suppose to the same extent that precious metals are immutable. But does this really make any sense? Aside from the apparent lack of ability to hack the blockchain today, can we really be confident that in a thousand (or a million!) years bitcoin will still be unhackable and attractive to a sufficiently large community of people? Perhaps this is more of a philosophical question than anything else, but us humans do get wrapped up in the idea that the big issues of today are the big issues for all time. I suspect our distant descendants, assuming the human race is lucky enough to survive, will become interested in many things beyond bitcoin or cryptocurrencies in general. In this context, the best parallel to draw is with technological innovation: today, not many people are interested in steam engines or dirigible balloons, once important technological developments, and the same may be true for bitcoin in a few decades. For bitcoin to enjoy any value at all, it is dependent on the bitcoin community continuing to support it through time. It would be highly unwise to think that nothing will ever come to supplant it, because human experience with other technologies suggests that better things are always on the horizon. The same cannot be said for precious metals, which may wax and wane in terms of community interest, but do not depend on community interest for their existence. My gold bar will still be there in a thousand years if it is kept safe, regardless of what people might think about it. What might happen to it over the course of a million years is a question I find rather difficult to ponder, but it’s probably fine for the next few thousand.

investment talk

In all of this, the real evolution may be arriving shortly, and it is not to be found amongst the many new variations on the bitcoin theme that have come into existence. Many have looked upon cryptocurrencies as a way of thumbing one’s nose at traditional financial structures – no more central banks and traditional bank accounts for me please! Yet the governments of this world are not going to give up the privilege of being able to issue national currency without a fight, and it could be that they will try to beat the cryptos at their own game. Some cryptos, known as “stablecoins” are backed by a given fiat currency, but it has been suggested that the most appropriate issuers of such coins are the central banks themselves. One idea is that each of us could end up, as of right, with our own account at the central bank of the nation we live in. If this were to happen, then bank runs would no longer be an issue and commercial banks would have to reinvent their business models, at least in part. Presumably physical cash would become a thing of the past. This is not speculation on my part – the ECB is publicly discussing the benefits of digital coins and the Bank for International Settlements – the central banks’ central bank – has even commented that this is “a concept whose time has come.” The full BIS report is available here for anyone who is interested.

Much has also been said about the potential of the blockchain – essentially the network that runs bitcoin – to revolutionise everything from banking to contracts. We’ll just have to wait and see how all of that shakes out, but it is clear that there are numerous technologies being developed and brought to bear on finance and commerce and it’s by no means clear that blockchain technology is the only answer. In any case, even if the blockchain network is valuable, this says nothing about whether any given cryptocurrency that relies on it has value.

As I suppose must be obvious by now, my research for this article hasn’t convinced me that cryptocurrencies are a good place to speculate (please let’s not use the term “investment” in this context!) – and certainly I see no reason why investment in this sort of asset should supplant traditional assets in an investment portfolio. As boring as it may sound, what really counts in investment is not jumping on that latest bandwagon, but planning one’s affairs properly whilst having a disciplined approach and a long-term view.

As a final point, for any Italian residents, please also be aware that bitcoin investments and gains deriving therefrom are subject to declarations and taxation in Italy – you may think your cryptos are 100% anonymous, but I wouldn’t be betting on it.

Bitcoin in your investment portfolio – what is Bitcoin, how to use it and what it will do

By Barry Davys - Topics: Bitcoin, Blockchain, investment diversification, Investment Risk, Investments, Spain, wealth management
This article is published on: 18th January 2021

18.01.21
Bitcoin in your investment portfolio

Love it or hate it seems to be the approach to Bitcoin. It will be the best investment ever or it is just a bubble controlled by the few people who can pull the strings, rumoured to be the Chinese.

Let’s start with “What is Bitcoin?”. Bitcoin is a piece of computer software with the ability to share pieces of the software with other people. Of course, the other people have to pay for their share of the software and the price varies according to supply and demand. In principle, there is nothing wrong with this. It worked for Bill Gates.

To get a better of understanding of Bitcoin it is worthwhile making that comparison with Microsoft. With Microsoft we know who owns the product, the products have set prices and perform a function that makes something happen, e.g. run our computer, allow us to write letters, make presentations and do our numbers on spreadsheets. Bitcoin has none of these attributes.

The way Bitcoin pricing works is much more like a commodity. If you go to Starbucks today and buy a coffee, let’s say you pay 4€. Next week you want a coffee. The same coffee now costs 5€. The coffee has not changed, only the price. The difference may be due to shortages, logistical difficulties during a pandemic, many more people wanting a Starbucks coffee, exchange rate movements etc. Bitcoin works in the same way. The price of Bitcoin is primarily set by demand as the supply is fixed. There are only so many Bitcoins in the World. At least you can do something nice with a coffee bean. Bitcoin’s primary purpose is just as something you can sell to someone else. It has no other purpose at the moment.

You would now have a valid point if you were to pull me up on this analysis. “You can use it to buy goods and services” is a fair comment to make, however, there is a ‘but’ that should follow that statement. Whilst the number of places you can use Bitcoin to make a purchase is increasing it is not widespread.

Bitcoin is super volatile, which is great on the way up and terrible when it falls after you have just bought it. Here are some important figures which tell you about Bitcoin’s volatility.

2009 – 2017 little price movement

Autumn 2017 the price rises

October 2017 $5,000

November 2017 $10,000

17th December 2017 $19,783

April 2018 $7,000

November 2018 $3,500

14th March 2020 $5,165

crypto currency

It has bounced again in recent weeks and is now at $40,714 as I write this article (9th Jan 2021). Institutional investors (fund managers, hedge funds etc) are now buying Bitcoin. Increased demand of a fixed supply commodity pushes up the price. Will this last? I do not know. Is it a bubble? Again, I do not know. However, what I do know is that institutional investors invest to a plan. They systematically take profits i.e. sell some of their holdings. They are disciplined. They manage risk by keeping a balance of different investments. Should these institutional investors take profits, other fund managers will follow and sell so as not to get caught out by a large price fall. Their careers depend on getting it right. The ability to feed their family depends on it. They analyse, have large teams doing research, watch and wait before buying and sound out other professional colleagues to ensure they sell in a timely manner. The field of behavioural finance has shown that as individual investors we use the part of our brain driven by emotion when making investment decisions, especially when there is a big price movement in an asset. This emotion based decision making often leads to poor decision making.

This is why it is beneficial to speak with a professional financial adviser who can be more analytical!

There is a body of opinion from Bitcoin exchanges and advocates that is putting forward the theory that Bitcoin is going to become a national currency in some countries and therefore the price is going to go ballistic (their phrase). It is unlikely that a non regulated, very volatile commodity will be used as a national currency.

Here is an example from me of the practical problems. A solicitor practice in Barcelona started to accept Bitcoin for settlement of their fees. It looked like a superb idea to show they were a forward-looking firm.

The problem comes with the volatility. Between issuing the invoice and payment by the client there is a delay. Having charged 1.03874 Bitcoins, for example, they had no idea how much they would get in the currency that would pay all the bills of the firm, such as their staff (Can we pay you in Bitcoins Mrs staff member? Ah, no!), electricity company etc. So having chosen 1.03874 Bitcoins as the fee because that would generate 4,000 in Euros, at the date of payment it could have been just €2,000 value. For this reason it is very unlikely that Bitcoin will become a national currency!

If you wish to invest in Bitcoins, it is worthwhile separating them from your primary investments. Bitcoins will then not influence your investment decisions on your main portfolio in the way that they might be if they are on the same investment platform. How much should you invest in Bitcoin? Set aside a percentage of your savings and only invest that much. Whether it is 1% or 10% will depend on your overall circumstances. However, with Bitcoin it is very worthwhile applying the rule that only invest what you can afford to lose. That way, if you lose it all it has not damaged your financial wellbeing. If it goes up 400% next week, you will be able to take some profit and perhaps spend your winnings on something frivolous.

Bitcoin profits will be taxed. Remember to put money aside from your winnings to pay tax. The amount of tax will depend on your country of residence. The annual declaration can be very difficult so keep track of all your transactions. A figure of 23% of the profit is a good guideline as the amount to put aside if you live in Spain.

investment idea

Practical Tip. A more mainstream alternative to investing in Bitcoin is the technology that Bitcoin is based on called blockchain. Blockchain has lots of uses and is good news. Uses include electronic voting in national elections, supply change management, payment systems, and anti-counterfeiting software. It can also allow companies to work together and share only what they need to for a specific project.

As an example of what is possible, there are also many Blockchain propositions for supply chain management for Covid 19 vaccines and contact tracing. For more information on blockchain, you could read “Blockchain Revolution” by Don and Alex Tapscott. You can already find many investments to include in your main portfolio such as ETFs and funds. For more information on these funds email barry.davys@spectrum-ifa.com

A final point on Bitcoin.  When someone sells a Bitcoin what does the buyer pay with? It is one of the major currencies. Sellers still want good old fashioned US dollars, Euros or Sterling when they part with their coin.  That tells us something!