A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.[i]
I couldn’t be any clearer than Investopedia. Remember to refer to that site whenever you get confused. See how good it is?
There are many different cryptocurrencies on the market and many more will arrive in the future. The biggest, of course, is bitcoin. The second largest is Ethereum. Each is based on a different algorithm and works in a different way.
Risk: At the moment the risk of cryptocurrencies is very high – any of them could crash to a value of zero. In the future the risk might be lower, as we will discuss.
Return: At the moment there are potentially high, unpredictable returns, but this is also likely to change as the concept matures.
Cryptos are not just for drug dealers, terrorists and geeks. Normal people can use them for safe, online transactions [edit: and as an alternative to cash as a place to keep savings. Some call it ‘digital gold’].
Like cash and precious metals, cryptocurrencies are a store of value rather than a productive asset. Mining cryptos is productive but holding them is not. [Bitcoins do not breed and create baby bitcoins, nor is ever increasing value guaranteed.]
Hang on, my reader might ask. Why are cryptos under Cash and Equivalents, supposedly the safest, most defensive asset? There was that time in 2017 when they soared in value – at one point, bitcoin rose 1,900% and some other cryptos went even higher! And didn’t those cryptos then crash way back down, afterwards? Why am I categorizing cryptocurrencies as a cash equivalent rather than as a risky growth asset?
These are fair points. At the moment, the value of most cryptos is bouncing around all over the place and they don’t look very defensive at all. The reason for this is that they are new – people are speculating on them, which is causing bubbles, and some individuals hold huge percentages of the total cryptos in existence, meaning that if they sell, there can easily be a flash crash.
The problem is that cryptocurrencies are not yet being used primarily as intended; that is, as an easy way of buying and selling things. [In the second edition I will modify this section. Read this original text then see how my opinion has changed at the end.]
Imagine a primitive society where everyone trades by barter: I’ll give you a dozen apples for that ax, and so on. One day the government has the bright idea of using money to get around the problem of people’s apples rotting before they can be traded, or the tricky problem of trading big things like houses that cannot be divided up into small change.
However, the people start to think that this new thing, ‘money’, might rise dramatically in value as it becomes more popular, so they start speculating on it instead of using it to make transactions. One dollar goes from being worth an apple, to a hundred apples, to half an apple seed, in the same year.
If people actually used the money to buy and sell things, the value would stabilize and it would turn into cash as we know it today.
That’s what’s happening with cryptocurrencies. In the future, as people start using them as a way of doing business and the value starts to settle down, cryptos are likely to be a fantastic complement to conventional cash and gold as a defensive asset for preserving wealth and staying liquid. They cannot be printed by undisciplined governments, meaning they should not suffer from inflation like conventional money. It is easier to store than gold, being not nearly so heavy.
[Since writing this I have come to realize that many cryptocurrencies, particularly bitcoin, are not so suitable for online transactions as I thought. They tend to be clunky and use up a lot of energy. Some cryptos were designed to be easier to transact with than bitcoin but how well they actually do this remains uncertain. Further experience is required.
If the value of cryptos stabilizes, however, they may end up being suitable as a store of value, like gold. Or we may have a situation where some are good for storing and some are good for transacting. At the time of writing the situation is too flux for me to make a firm call. They definitely have huge potential but, as noted, there’s no guarantee any cryptos currently in existence will the ones that survive and flourish.]
I don’t presently hold any crypto because I have no plans on using it for transactions in the foreseeable future, but as soon as I do have some use for it, I’ll buy it.
Crypos are a brilliant idea that I hope will eventually bring down the cost, and increase the safety and convenience, of online transfers and transactions.
For now, cryptocurrencies are the Wild West of investing, but over the next decade we are likely to see conservative investors holding some as part of their overall cash and equivalents part of their portfolio for convenience and as a hedge against inflation and currency fluctuations.
It is also possible that private companies or governments might issue their own cryptocurrencies, but it is too soon to discuss this at the time of writing.
[Further edits: There is also some risk that government regulation might adversely impact cryptos. On the other hand, regulation in Japan increased the popularity of bitcoin as it became legitimized in people’s minds.
The idea that governments cannot control cryptos might be overconfident because they can control the entry and exit points into fiat currencies, i.e. normal money. That is, they might make it harder for you to buy and sell cryptos for cash. In addition, banks and other institutions might crack down for one reason or another. See recent Woke closing of dissident accounts.
A further topic of discussion since the time of writing is, are cryptos a bubble? They sure look like it, except they’ve been going for many years now and always seem to bounce back stronger after every crash. Anyone telling you the certain future of cryptos is either lying or kidding himself.
My suggestion for the second edition: get some crypto for extra diversification of cash and equivalents if you like, or as a bit of a fun speculation, but INVEST NO MORE THAN YOU CAN AFFORD TO LOSE.
This section will certainly be the most-revised in the book as it is a rapidly-changing field. I’ll have to check how the various laws described next end up evolving, too.]
Cryptocurrencies and the Law
Note: legislation and policy in this area change very quickly because governments are only just catching up with the new crypto craze. The information provided here was correct at time of writing but always double-check for yourself, especially regarding taxation.
‘Legal tender’ means the currency approved for use in a particular jurisdiction. For example, you can’t go into a 7-11 in Japan and try to buy distasteful manga with Chilean pesos or with rare postage stamps. You have to use yen. This is why some countries specify that cryptocurrencies are not legal tender – you can’t use them for ordinary transactions within the country . . . yet.
Australia – legal. At time of writing, the government is implementing regulations to make the use of cryptocurrencies more secure and to prevent money laundering and the financing of terrorism. Make sure you pay GST and capital gains tax as you would with conventional money.
Canada – legal but not considered legal tender. GST applies to transactions made in cryptocurrencies. Profits made by actively trading cryptos is considered income while those from long-term investments are classed as capital gains. British Columbia registered the first ever crypto-only investment fund. Further regulations are planned that will keep cryptos in line with other Money Services Businesses.
New Zealand – legal. This is the first country in the world where you can pay salaries in cryptocurrencies! Various rules apply. Cryptos are considered securities. New Zealand’s IRS is currently leaning on tech giants to help them catch crypto users who’ve dodged tax, so make sure you’re paying what you’re supposed to.
United Kingdom – there are no specific laws about cryptocurrencies, but they cannot be used as legal tender. Gains and losses are subject to capital gains tax. New guidelines and regulations are planned soon.
United States – legal. Regulations vary by state. Not considered legal tender. The IRS considers cryptocurrencies to be property and taxes them as such. Cryptocurrency exchanges seem to be a gray area, with different agencies variously considering them to be commodities or securities. New regulations seem to be coming soon.
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