In continuing down my punch list of technologies I’ve ignored, I’m on week two of a cryptocurrency deep dive. During this time I dove into blockchain, studied the different approaches to proof-of-work / proof-of-stake, researched the market, read the various cryptocurrency white papers, constructed my own balanced portfolio, made buys, and even coded a bare bones blockchain (JoeCoin will be the reserve currency within my household for the next six weeks). In other words: watch out world, I am running with scissors now.
In full transparency, I am not fully a novice investor. My introduction to cryptocurrency came in 2012 when my Bitcoin-mining nephew told me about digital currency. I will confess my mind was blown reading the Bitcoin paper. While I was confident cryptocurrency would remain a niche market for techies, when it started to get mainstream attention in 2015, I decided to create my first wallet and mine a little LiteCoin. But then I promptly returned to ignoring this market, believing that if cryptocurrency was an alcoholic beverage, it would be two parts hype and one part fraud. Well, $1.7T+ in market cap later, I am not too proud to admit: I totally missed this one. So here are my (mostly) new investor thoughts on approaching this market:
Central Bank Digital Currencies Are Here
If there are Five Stages of Cryptocurrency Grief, governments across the world are finally moving beyond denial and anger and into the bargaining phase. The long awaited Central Bank Digital Currencies (CBDCs) - digital money issued by sovereign nations - is finally here. China launched the pilot for its digital currency on January 4th, and while the US seems to be moving much more slowly, it is inevitable they will be forced to follow suit.
The pushback against cryptocurrencies is not surprising. Governments rely on the ability of their central banks to manage monetary policy - increasing supply during economic downturns, and decreasing supply when an economy is overheating. By working outside the control of central banks, cryptocurrencies threaten the very foundations of these systems. But while CBDCs are becoming a reality, there is a long list of unanswered questions about how they will work - e.g. privacy protection, legal tender, interest bearing, use of intermediaries, restrictions to protect the financial system, and more.
As a new investor, I am pricing in the impact of CBDCs. I believe that within 15 years, 100% of money will be digital, and that if CBDCs are designed well - a big if of course - these will be the digital currency of choice for most consumers. While CBDCs will likely not place the same value on anonymity, privacy, and freedom from intermediaries we see in cryptocurrencies today, I believe a majority of consumers will be willing to make some tradeoffs for ease of use and stability.
But It Still Won’t Stop Cryptocurrency
That said, I also believe it’s too late for governments to stop or slow the cryptocurrency movement. Its 10+ years untethered from oversight has allowed it to innovate at the speed of light. Today’s crypto is not just a currency. It is a speculative asset, a way to automate business contracts, the next-generation of the web, a movement to free the world from centralized authority, a platform for distributed apps, a technology to eliminate inequity, and much more. While some of these innovations will fall flat or be mainstreamed on top of CBDCs - others will still escape to disrupt the global financial system. So I am still bullish on cryptocurrency in the long term.
The Bubble Will Pop… Soon
Last week’s market volatility was a healthy reminder to us all that while the crypto market can giveth, it can also taketh. Within a few days Bitcoin was down almost 45% from its November high. While this could be the start of a shake out in the market, it is more likely a brief pull back that will be followed by more exuberance. But sooner or later, the economic bubble we are in will pop. The signs are all around us that the sustained quantitative easing since the 2010s, combined with the Fed and Treasury pumping money into the pandemic economy, has created an environment of excessive exuberance. In the Dotcom Boom we used to call what we were doing the “New Economy”, since we were convinced we were breaking free of the old rules and creating new ones. We stopped using that phrase after the market crashed in 2001 and we realized: there are no new rules.
While the incredible speculation in cryptocurrency is a symptom and not a cause of this bubble, my short term bearish-ness on this market is based on a more basic concern: in a world in which we have 180 fiat currencies, it seems implausible to believe mainstream early majority consumers will want or need the 16K+ cryptocurrencies available today. I realize each coin / token offers different features / functions and has different intended use. But this level of choice seems less a reflection of customer need, and more about what is possible when venture investors pour the gas on a market. Sooner or later, all emerging markets must obey the laws of gravity and be powered by business fundamentals instead of speculation.
I’m Hedging My Country & Currency Exposure
By now the risks of cryptocurrency are well known - e.g. new technology, immature organizations, market volatility, fraud, hype. But the single biggest risk this market faces is government regulation & restriction. Cryptocurrencies have been banned and/or restricted in several countries. While right now the likelihood of a ban is directly proportional to how authoritarian a government is, it seems the pace of regulation / restriction is showing no signs of slowing. As a result, I’m minimizing my risk by limiting myself to no more than 50% exposure to a single country (e.g. the non-profit driving Ethereum is based in Switzerland).
I’m also limiting my portfolio to no more than 25-35% of a single currency. While I know it’s popular to double down on Ethereum and Bitcoin today, I see great risk in this approach. For years I have been hearing that Bitcoin is the new gold: an inflation proof digital currency that should be held long term and used only for large purchases. But what if instead of being the new gold, Bitcoin is really just the new coal? When you look at the raw computational power we are throwing at the problem of distributed block creation / verification - e.g. Bitcoin’s 190 million terahashes per second - it’s hard not to admit this is a staggering waste of energy. In a world confronting dramatic climate change, this almost seems borderline criminal when viable alternatives to Double Spend now exist. What if world governments decide the rapidly growing energy consumption of Bitcoin and other expensive proof-of-work currencies needs to be regulated like smokestack emissions? Similar risks may exist for the currency with the second greatest market capitalization: Ethereum. While the “consensus layer” - the network upgrade formerly known as Eth2 - will migrate Ethereum to a proof-of-stake model, this transition may prove to be harder and take longer than many of us expect. Technology upgrades are fraught with risk, and given the Ethereum network is already experiencing substantial scalability issues - i.e. slow performance, high gas prices - they may not be able to hold competitors at bay for much longer.
My first boom-bust experience was the Dotcom Bubble in the mid/late 1990s. Like crypto, that market was a frenetic bundle of hype and potential. When the market correction came, some of the early movers like Pets.com and WebVan went bankrupt quickly since their businesses were not based on sound fundamentals. Others like Amazon and eBay not only survived the downturn and intense investor scrutiny, but went on to produce incredible returns over the next two decades. And in spite of a market correction, the disruptive innovation of the internet was unstoppable, and continued to roll like a tsunami across the industry.
So as a new investor, yes I believe we are in a bubble. And yes, I also believe this bubble will likely pop soon. But even a bear can be greedy enough to realize: you can afford several Pets.coms if you can find the next Amazon.com.