Are Cryptocurrencies Indeed Currencies?
One of the most interesting arguments of the modern age of financial investment is that between the opponents and supporters of digital money. On one side, those against cryptocurrencies contend that Bitcoin and other such digital currencies are a scam and that people who are “fooled” into buying them will soon pay the price for their gullibility, while supporters contend that it is a legitimate asset.
However, the reason why the issue is so divisive is simple: both sides cannot really agree fundamentally on what exactly digital currencies are. The most compelling argument is that the likes of Bitcoin are not cash-generating assets but instead are currencies with features similar to commodities. This means that they cannot be valued or invested in, only priced and traded.
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Understanding Assets, Commodities and Currencies
To better understand the classification of cryptocurrencies, we have to examine the following three groups of investments:
The value of a commodity comes from its utility as a raw material that meets a particular human need, such as energy, food or shelter. Although an estimate of this value can be made by examining the commodity’s supply and demand, they both have long lead times, making them more difficult to evaluate than cash-generating assets. Possibly the best illustration of the similarity between cryptocurrencies and traditional commodities is its analogy with gold. When viewed as hard assets, they both have important characteristics in common, namely scarcity, finite supply and inherent value, all of which show that digital coins are not only an asset, but a viable medium for trade.
A currency is defined as a medium of exchange which is a store of purchasing power and can also be used to denominate cash flows. Viewed in isolation, currencies cannot be valued and do not have any cash flows. However, they can be priced by comparing them to other currencies. In the long term, any currencies that are widely accepted as a medium of exchange and can also maintain their purchasing power will see an increase in their price when compared to those which do not have these characteristics. However, in the short term, there are other forces which determine the price, including manipulation of exchange rates by governments. Like any other currency, you can readily exchange most of the major cryptocurrencies for goods or services as they are accepted worldwide as viable modes of payment. These digital currencies are not endorsed by any municipality or country as official currencies. In this respect, cryptocurrencies can be viewed as more of an article for barter than actual legal tender.
- Cash Generating Asset
An asset is something that currently generates cash flow or is expected to generate cash flows in the future. When you own a business, it is an asset, and the same applies to any claim you may have on the business’ cash flows. These claims could be contractual (in the form of debt or bonds), residual (equity) or contingent (options). The thing that all assets have in common is that their cash flows have a value whereby any assets that have low risk and high cash flows, are valued higher than those with more risk and low cash flows.
As mentioned before, cryptocurrencies do not feature cash inflows and cannot – as currencies – be valued in isolation, therefore they cannot be classed as cash-generating assets.
Investing vs. Trading Cryptocurrencies
This is a point made in the previous part of this article, and one that is worth revisiting. If you are to invest in an asset, you have to assess its intrinsic value and then compare it to its current price.
You may then act on the basis of that comparison, buying the asset if its price is less than its value, or selling it if the price is higher.
Conversely, trading is much simpler; you set a price, make a decision on whether the price you have set is going to be higher or lower at the end of a particular time period, then you invest or wager on that price.
Although you may be successful at both trading and investing, they require different tools and skill sets since the characteristics of a good trader are far different from those required from a successful investor.
The table below clarifies the essential differences between trading and investing.
|Trading (Price)||Investing (Value)|
|Underlying Philosophy||In trading, you can only really act on price. It is impossible to determine the value of a traded asset, such as a digital currency.||All assets that you can invest in have a true or fair value attached to them. This value can be estimated, with the price eventually converging on the value.|
|How it Works||When you trade, you are essentially guessing the price movement of the asset. To get ahead, you need to guess correctly, often, and make an exit before a shift in the pricing trend.||Investment involves estimating the value of an asset, buying if it is undervalued or selling when it is overvalued. To get ahead, you must be right about the true value and the market should be moving toward that value.|
|Main Drivers||A traded asset’s price is determined by the forces of demand and supply, both of which are effects of momentum and sentiment.||Value is established by understanding the asset’s cash flow, risk and growth potential.|
|Effect of Information||News stories and rumours shift market sentiment and affect the price in the short-term, as we have seen with regard to Bitcoin in the past year, even if the stories do not really have a long-term effect.||The only information that can affect the value of an asset when investing is altered cash flow, slowed or increased growth or changes in risk.|
|Tools||· Technical indicators|
· Price charts
· Investor sentiment
|· DCF valuation (discounted cash flow)|
· Ratio analysis
· Accounting research
|Time Horizons||Trading in assets, like cryptocurrencies, is often short-term (as little as a few minutes) to medium-term periods of a few weeks or months.||Investment is usually a long-term game.|
|Essential Skills||You need to be able to assess shifts in momentum or sentiment ahead of the market.||In spite of uncertainty, you must be able to place a value on the asset, then act on that value.|
|Main Personality Traits||· Gambling instincts|
· Market amnesia
· Quick action
|· Immunity from peer pressure|
· Faith in the market
· Faith in an asset’s value
|Biggest Danger(s)||Quick momentum shifts could quickly wipe out months of continuous profits.||Even if you correctly value an asset, the price may fail to converge on this value.|
|Delusional Player||The trader bases actions on the assumption that the asset (cryptocurrency) has an intrinsic value.||An investor assumes that all market movements are rational and reasonable.|
What’s Next for Digital Currencies?
While the first part of this article argued that Bitcoin and other digital currencies are currencies, they are not really acceptable ones yet, since they are too volatile to be used to store value and have only limited acceptance as a medium of exchange. Moving forward, there are three possible scenarios that could unfold for these digital currencies:
- A Global Medium of Exchange:
This is the best-case scenario, which would see cryptocurrency gaining universal acceptance all over the world and becoming a widely used medium of exchange. For this to occur, the cryptocurrency needs to stabilise (in relation to fiat currencies), governments and central banks should accept its use, and the shroud of mystery surrounding digital currencies must fade. If this scenario unfolds, then a cryptocurrency like Bitcoin will compete with traditional currencies, justifying its high price.
- Gold for the Millennial Generation:
In this case, cryptocurrencies could act as a safe haven for people who do not trust fiat currencies, governments or central banks. This scenario would see digital currencies take on the role that has been played by gold as a store of value for people who have no trust in centralised authority. Interestingly, the world of cryptocurrencies is filled with references to mining, so it is clear that the pioneers of these currencies seem to share this vision for their creations. Bitcoin’s fixed cap of 21 million coins would seem to fit in more with this case than the first scenario. If this scenario comes to pass, with currencies like Bitcoin showing the same staying power that gold does, then it should be expected to act as gold does; its price rising when there is a crisis and falling in sanguine times.
- The 21st Century Financial Bubble:
This is the worst-case scenario for the future of cryptocurrencies. In this case, the leading cryptocurrencies would be like shooting stars, drawing in more money from people who consider it a way to make quick and easy profits, with its price rising dramatically. However, they would quickly flare out when traders decide to move on to a new and different asset, with Bitcoin holders left with something worthless after putting in a lot of their money.
The Final Word
In the end, nobody can really invest in a cryptocurrency, they can only trade it. This is because they lack an essential ingredient that is necessary for any investment – an intrinsic value. In order to successfully trade cryptocurrencies, it is important to recognise that any price movements that you see have little or nothing to do with market fundamentals. These are movements that can be attributed to momentum and sentiment, with large price shifts possible due to incremental information.
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