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JULY 08, 2021

Beyond the Hype: Cryptocurrency and Blockchain Technology

Cryptocurrency has been touted as a revolution in currency, a great investment and a breakthrough technology. It’s also been vilified as both a haven for criminal behavior and an environmental disaster. Whatever the case, it’s not likely to go away, especially as central banks begin to explore digital possibilities.

To get a handle on this fascinating and complex subject, I recently spoke with Lamont Black, associate professor of finance at DePaul University and the academic director for the school’s Keeley Center for Financial Services. Previously, Dr. Black served as an economist at the Federal Reserve Board of Governors in Washington.

Following are highlights of our discussion.

 

A brief overview of cryptocurrency

It’s hard to believe that Bitcoin, which is synonymous with cryptocurrency in many people’s minds, has been around for more than a decade. The Bitcoin White Paper was published in fall 2008 at the height of the financial crisis. It’s essentially a digital currency, albeit one without government backing or banking system support.

"It's entirely decentralized, supported solely by the Bitcoin network on the internet, and it was created as a way to transfer value on the internet,” Black said.

To understand how cryptocurrency works, you need to understand blockchain, the technology that drives it. As Black explained, blockchain is a decentralized record keeping ledger through which participants can confirm transactions without the need for a central clearing authority.

"Typically, we would rely on banks to do all of that accounting,” Black said. “Blockchain is a distributed ledger, so all of the participants are looking at the same ledger. And then there's a network that updates that ledger, which is the process called mining. Miners are basically validating transactions and adding new blocks or transactions to the blockchain record.”

 

Where to start, how to buy

Bitcoin is hardly the only cryptocurrency available. Ether, Binance and Dogecoin are just a few of the thousands in circulation, and it can be difficult to get a handle on where to get started. Black recommends starting with the largest cryptocurrencies by market capitalization, such as Bitcoin, Ethereum and Tether, since they’ve demonstrated relative longevity and stability. Black suggests coinmarketcap.com as a resource to find crypto listings by market capitalization. As of late June, the site listed more than 5,400 cryptocurrencies in its tracker. The cryptocurrencies with smaller market capitalization tend to be newer entrants. While those offerings can be innovative, they also come with more risks.

When it comes to purchasing and trading, Black recommends newcomers use a cryptocurrency exchange. Coinbase, for example, is a U.S.-based exchange. And as a publicly traded company—it was recently listed on NASDAQ—Coinbase is subject to federal regulation and transparency requirements.

“You can just go to their website, create an account and then purchase cryptocurrency through that website,” Black said, adding that you’ll have to provide “quite a bit” of personal information to create an account. Because companies like Coinbase and Gemini are U.S.-based exchanges, they must comply with Know Your Customer (KYC) regulations. Once you’ve created an account, however, Black said it's easy to connect the cryptocurrency exchange to your bank account or credit card to transfer funds between the two.

One interesting point to note is regarding ownership. When purchasing cryptocurrency through an exchange, you don’t technically own that currency. What you have is a custodial wallet; the exchange owns the coin directly.

“Any account on the Bitcoin blockchain has both a public key and a private key,” Black explained. “Unless you own the private key, you don't officially own that wallet. In a custodial account, Coinbase owns the private key for the [cryptocurrency] on the exchange.”

Many cryptocurrency investors would prefer to manage their own noncustodial wallets, meaning they own and control the private key for executing transactions on the blockchain. Black cited MetaMask, a wallet for the Ethereum blockchain, as an example. Managing your own wallet eliminates the risk of being exposed to a hack on an exchange, but it puts the burden on the user to secure their accounts.

Many of these wallets will issue what’s called a seed phrase, a random list of words (usually 12 to 24) that are used to recover funds in case a user loses the wallet’s password. If you lose that phrase, you lose access to the account, and there have been several stories about people who lost their passwords and access to cryptocurrencies.

“Digital wallets come with more responsibility,” Black said. “But the benefit is you own the wallet, you have the private key and so you can send or receive funds out of that digital wallet.”

 

What can you do with cryptocurrency?

So, once you own cryptocurrency, what can you do with it? Many people think of it as an asset where the benefit is a rise in price. But Black points out that there are more ways investors can put cryptocurrency to work, including decentralized finance or, DeFi, which allows for executing traditional financial instruments without financial providers. “This is banking without the bank,” Black said. “With some cryptocurrencies, you can now lend out and earn interest on that cryptocurrency.”

Black pointed out that while Bitcoin was designed to be a new form of money, the benefits of some of the newer cryptocurrencies go beyond monetary purposes. The Ethereum network, for example—which operates the cryptocurrency Ether—is a platform for building decentralized applications. These  “dapps” use smart contracts, which execute rules regarding when money can change hands based on when a set of predetermined conditions are met. Smart contracts eliminate the need for third-party intermediaries.

"We're used to financial institutions buying, lending and borrowing,” Black said. “What we're seeing now in the crypto market is an evolution of algorithms that provide those types of services. The code is totally public and transparent, and then it simply executes those transactions, whether you want to buy and sell, or borrow and lend.”

 

Going mainstream

Earlier this year, the People’s Bank of China unveiled the digital yuan, its national digital currency. Other central banks, including the U.S. Federal Reserve and the European Central Bank, are exploring their own digital currencies. "They recognize that our financial system is digitized, and they're trying to figure out to transition from paper-based currency to digital currency. They are recognizing they have to adapt and innovate. Even five years ago, many central banks wanted to pretend that crypto was going to go away, and it hasn't.”

The IRS is getting in on the act, too, treating cryptocurrency as property that’s subject to capital gains taxes. On the other hand, while China is getting into the cryptocurrency game, the government is cracking down on Bitcoin mining. Authorities in China’s Sichuan province and other mining-intensive regions ordered cryptocurrency miners to shut down and required electricity providers to cut power to any mining operations.

 

Energy concerns

Energy consumption is a major concern. Bitcoin mining requires a decentralized network of computers to generate new coins, as well as verify and record new transactions. That requires a tremendous amount of electricity. According to the University of Cambridge Bitcoin Electricity Consumption Index, Bitcoin miners consume about 130 tera-watt hours of energy per year. To put that in context, that’s roughly the same consumption of nations like Sweden and Argentina, or about one-quarter of Canada’s annual consumption. As Black said, "That's just not acceptable.”

Black pointed out that some blockchains are more efficient than others, and that he expects a greater focus on improving efficiency. He also puts cryptocurrency in historical context, noting that the Industrial Revolution—with its soot-emitting factories—was notoriously harmful from an environmental standpoint.

“The history of our economy has been the progression from dirty production to cleaner production,” he said. “With cryptocurrency, we are still in the early phase where it is not efficient. But that does not make it a bad idea. It's simply the first phase of other phases to come, and now we need to all work together to figure out how do we do this new paradigm, but do it better and greener.”

 

Security and regulatory challenges

Black acknowledged that the criminal element associated with cryptocurrency is troubling to a lot of people, and it raises difficult questions about its unregulated nature.  A recent high-profile case involving $4.4 million in ransomware being paid in Bitcoin did not help cryptocurrency’s image. The fundamental tension between decentralization, government regulation and institutionalization will be crucial regarding the future of this space.

“These aren't just new forms of money,” Black said. “This is a paradigm shift where the network runs itself rather than a corporation or government doing it on its behalf. Depending on how you feel about that paradigm shift, that's going to affect whether you view this as a good thing or a bad thing.”

Black explained that while cryptocurrency itself is unregulated, any transaction between cryptocurrency and fiat currency creates an intersection that can be subject to regulations. Cryptocurrency exchanges, for example, are highly regulated financial service institutions, and U.S. regulators can restrict access to certain exchanges and restrict certain activities.

For Black, the current regulatory uncertainty is contributing to the current market volatility. "I would argue that regulatory clarity can be good for financial markets, so I think we're going to see some stabilization of crypto prices as regulations become more clear.”

 

Always evolving

By late June, Bitcoin lost about half its value since reaching a record high of nearly $64,000 in April. Black said much of that can be attributed to environmental concerns—including a high-profile company announcing it would no longer accept Bitcoin as payment, citing its high energy consumption—and China’s recent crackdown.

But Black noted that there is a shift in investment philosophy from placing a value on a currency like Bitcoin, which has no intrinsic value, to placing a value on an underlying business model, such as DeFi. “These newer models are providing a service, and if more people use that service, then it's going to increase in value,” Black said. “That becomes more of an investment proposition.”

As Black pointed out, cryptocurrency is not for the faint of heart. "These are not blue-chip stocks,” he said. These are new ideas and some of them take off, some of them don't, and some of them are straight-up fraud, so you do have to be careful.”

For those interested, it’s about assessing your risk tolerance. For Black, his own enthusiasm for the future of cryptocurrency comes down to literacy and comfort.

"I feel like I have learned a lot about cryptocurrency over the last 10 years, but it is changing constantly,” he said. “To me, that's exciting because it shows growth, development and potential.”

 

Investment Implications            

While Professor Black provided a fantastic cryptocurrency overview during our discussion, I also offered some considerations for investment portfolios. It is important to note that we share the Professor’s excitement on the space overall, but are less enthusiastic about the investment proposition for any particular currency. Today’s winners may not prevail as more service-based systems, governments and associated coins come online. From an investment perspective this suggests a flexible, diversified approach would be most prudent. But because the SEC has been slow to approve any crypto-tracking products, there are currently limited options available for achieving exposure in traditional investment portfolios. In addition, the available options tend to be expensive, narrowly focused, and/or subject to price variation relative to underlying currency movements. However, things are evolving rapidly. Some mutual funds have begun to incorporate cryptocurrency holdings into their strategies, and the SEC may yet rule on several ETFs in 2021. This is an area we are watching closely, and while we are not recommending any specific investments at the present time it remains one of our top focus areas.

Michael Stritch
Michael Stritch, CFA
Chief Investment Officer BMO Wealth Management, U.S.
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