The Lessons of Crypto

February 16, 2023

Written by Paul Stringer, Managing Director and Chief Investment Officer of Equities at Prio Wealth

After a plunge in the price of Bitcoin last year and the popping of the speculative cryptocurrency bubble, it is instructive to review the original drawbacks of cryptocurrency and examine what lessons were learned from the crash.

Despite its initial promise, there have always been a multitude of drawbacks to cryptocurrency, including the following:

• Governments can severely restrict (e.g., India) or outright ban (e.g., China) its use.

• It was largely unregulated by the Securities & Exchange Commission (SEC), creating a fertile opportunity to commit fraud (e.g., FTX).

• It is vulnerable to theft via hacking, scamming, phishing, SIM swapping and URL hijacking. According to blockchain data platform company Chainalysis, $42.5 billion in cryptocurrency was gained through illicit means from 2017 to 2021.

• Because there are no identity checks, cryptocurrency is a haven for criminals. Cryptocurrency is used to commit crime in three ways:  1) to engage in financial transactions tied to crimes, such as buying and selling illicit drugs, weapons on the dark web, prostitution, child sex exploitation, paying kidnapping ransoms, leasing servers to commit cybercrimes, or terrorist activity; 2) to engage in money laundering or shield otherwise legitimate activity from taxation; and 3) to steal cryptocurrency from exchanges through hacking or using the promise of cryptocurrency to defraud unwitting investors.  It is also used by communist countries such as North Korea to evade American financial sanctions.

• It has excessive price volatility. There are many sources of volatility:  When mining costs exceed the prices of cryptocurrencies, prices decline as people are less incentivized to mine cryptocurrency; when the Federal Reserve raises interest rates or reduces the growth of the M2 money supply; when countries announce new bans or regulations on cryptocurrency; when investors grow more fearful of the future and speculate less; when cryptocurrency exchanges experience security breaches or fraudulent activity.

• It has unlimited supply. Although Bitcoin fans like to point out that, unlike fiat currencies, Bitcoin has a finite supply of 21 million Bitcoins, Bitcoin was created using open-source software and therefore a potentially endless number of cryptocurrencies can be created.  In fact, CoinGecko, one of the largest cryptocurrency data aggregators, currently tracks 12,353 cryptocurrencies – double the number in 2021.

• Cryptocurrency owners who forget their private keys (passwords), lose access to their money. The common phrase in the crypto world is, “Not your keys, not your coins.”  The New York Times reported that Stefan Thomas, a German-born programmer living in San Francisco, had two guesses left out of ten to figure out a password to his digital wallet that will allow him access to his 7,002 Bitcoins, worth $261 million (now worth $163 million).  According to Chainalysis, around 20% of the Bitcoins in circulation ($89 billion) appear to be in lost or stranded wallets.

• Future innovations such as quantum computing could make cryptocurrency obsolete because the private keys might be easily cracked by quantum computing technology.

• Creating new cryptocurrency through mining consumes a lot of electricity, contributing to carbon emissions. For example, the University of Cambridge estimates Bitcoin’s current annualized electricity consumption is 110 terrawatt-hours (TWh).  That compares to Switzerland’s 2019 annual electricity consumption of 56 TWh.

• Bitcoin is “not actually usable” for retail transactions because of high costs and the inability to process chargebacks (Nicholas Weaver, a researcher quoted by Bloomberg). Long transaction times are also a problem because a new group of accepted transactions (a new block) are added to the blockchain only every 10 minutes.

These are the important lessons investors learned, or re-learned, in the wake of the implosion in cryptocurrency markets:

• Investors should only invest in what they understand. Many people today still do not really understand how cryptocurrency works.

• The wisdom of the crowd is often wrong. Cryptocurrency got swept up in a mania that created a massive speculative bubble that engulfed many people looking to get rich easily and quickly.  While the S&P 500 rose +114% from the pandemic-induced bottom on March 23, 2020, Bitcoin rose an astronomical +965%.

• When paid celebrities get involved, that is often a ‘red flag.’ Cryptocurrency ensnared multiple celebrities such as Tom Brady, Kim Kardashian, Matt Damon, Spike Lee and Larry David, all of whom did commercials touting cryptocurrency.  In Spike Lee’s commercial for CoinCloud, he said, “A currency is not currency.  Old money out.  New money in.”  In Matt Damon’s commercial for Crypto.com, he said, “Fortune favors the brave.”  Larry David’s commercial for FTX ended with, “Don’t miss out on the next big thing.”

• Although FOMO (Fear Of Missing Out) is a powerful emotion and hard to resist, eventually the business fundamentals of a given investment security will take over. In the case of cryptocurrency, it has never produced revenue, earnings, cash flow or dividends.

• The performance of risky assets like cryptocurrency is often inversely correlated with a higher Federal Funds Rate. For example, twice now, in 2018 and in 2022, when the Federal Reserve was raising interest rates, the price of Bitcoin crashed 70-80%.  Moreover, Bitcoin was created to reject government overreach and currency debasement by unelected central bankers.  In fact, Bitcoin’s founder, Satoshi Nakamoto, mined Bitcoin’s starting blockchain block (known as the ‘genesis block’) with the following embedded text:  “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”  Indeed, the price of Bitcoin could be viewed as a barometer for how irresponsibly central banks are managing their currencies.  When central banks are raising interest rates, however, that strengthens their currencies, which weakens Bitcoin’s original purpose and reason for existence.

The cryptocurrency bubble follows a long history of financial market bubbles that preceded it – the 1600s Dutch Tulip bubble, the 1720 South Sea bubble, the 1920s U.S. stock market bubble, the 1980s Japanese stock market and real estate market bubbles, the 1990s Dot-Com bubble, and the 2000s U.S. housing bubble.  Fundamental and timeless elements of human nature such as fear and greed will always exist and therefore financial market bubbles will continue to be blown.  Hopefully, investors will be better prepared for spotting and avoiding the next one.