Decoding cryptocurrency

Is bitcoin the wave of the future or an investment bubble? And if it’s the latter, should you rush into it or other cryptocurrencies before the bubble pops?

Those are questions that some investors are asking as they watch the volatile prices of these currencies zigzag upwards, with the total value of all cryptocurrencies rising some 400 percent last year. Gains like that certainly sound appealing, but experts caution that you should research the asset class before buying either shares in a security linked to a cryptocurrency or digital coins themselves. And some advisers suggest avoiding cryptocurrency altogether until it’s less volatile and government regulators have agreed on how to treat it. At the moment, it’s not clear which of the thousands of cryptocurrencies will survive long enough for you to recoup an investment.

“It’s hard to figure out who’s going to be winners, who’s going to be losers, who’s going to be disruptive,” says Michael Casey, a senior adviser at the MIT Media Lab’s Digital Currency Initiative.

Like many people, you might not yet even be dealing with the question of whether or not to invest; you may simply be asking, “What the heck is cryptocurrency?” Answer: it’s a side effect of something called the blockchain, which is a decentralized digital ledger that allows for transactions that don’t have to be verified by a central authority. Instead, each transaction has to be confirmed by people on the network, working independently.

After they verify it, and solve some complicated math puzzles, they receive cryptocurrency as a reward. Because transactions can’t be changed, there’s no possibility of disputes about them. And because transactions are anonymous, they can’t be tracked by the Federal Reserve or any other central authority.“Once we keep a log of transactions—it doesn’t have to be money; it can be exchanges of value in many forms, like our data on the internet—we can start to take charge of our data and our assets,” Casey says.

Because information recorded on the blockchain is immutable, experts think this technology could reinvent the way we manage rights, permissions, and payments. Potential applications for blockchain are unlimited, ranging from online privacy to land records in the developing world.

The biggest and best-known cryptocurrency is bitcoin, which launched in 2009, during the global financial crisis. Today there are about 2,000 cryptocurrencies, all of which are designed as rewards to enable the functioning of a network that does a specific thing, such as Filecoin, which allows people to spread digital files across the internet.

Cryptocurrency systems use cryptography—think spy codes based on complicated math—to generate the coins. (That’s why they’re called “cryptocurrencies”—not, as some people think, because they’re not really currencies.)

Once a niche idea, cryptocurrency has become the subject of rampant hype as companies rush to figure out what blockchain might mean to the economy. While most mainstream financial advisers don’t hold them on behalf of their clients, some investors are trading cryptocurrency, particularly bitcoin, on their own.

For some, blockchain has become their singular focus. Consider Nithin Eapen, chief investment officer at Arcadia Crypto, a New York City fund that backs new token issues and cryptocurrency-related startups: he sold his entire investment portfolio, liquidated his retirement accounts (paying penalties to do so), and put the balance into bitcoin. The only major asset he has aside from bitcoin is his house, he says. The plan is to use his firsthand knowledge as a cryptocurrency holder to learn more about the market.

“You have to be in the space to know what is happening, or you’re going to miss the whole revolution,” he says.

Few financial advisers would recommend anywhere near this degree of investment in cryptocurrency. They worry that risks abound, even beyond what’s expected in the securities markets.

A major danger for investors is that, unlike securities such as stocks and bonds, cryptocurrencies aren’t regulated. The agencies that supervise financial markets have yet to agree on a framework for which of them will regulate which aspect of cryptocurrencies. The Commodity Futures Trading Commission has said it thinks cryptocurrencies should be considered commodities, the Securities and Exchange Commission has said initial coin offerings may be regulated as securities, and the Internal Revenue Service taxes cryptocurrency holdings as property. The uncertainty and overlapping jurisdictions can be confusing, and potentially risky, for investors.

If you wish to get involved in cryptocurrency investing despite all the caveats, you can choose from several methods. Buying digital coins is the simplest, although getting access to the tokens can be difficult, and so can storing and trading them.

You can trade existing cryptocurrencies on online exchanges. Stick to well-known markets with strong trading volume or your trades might not execute quickly. Be prepared to pay higher fees than you would for stock trades.

If you want to hold cryptocurrencies directly, you’ll need to safeguard your digital wallet, the place you store the digital keys, or passwords, to your crypto holdings. Anyone who gains access to these keys will be able to steal your money. You may want to keep those keys on a hard drive and place the drive in a safe-deposit box, says Richard Levin, the chairman of the fintech and regulation practice at Polsinelli, a Denver law firm.

If you prefer to invest in a security linked to the price of cryptocurrency and subject to securities regulation, one option to consider is buying shares in a private placement. You’ll need to hold the shares for 12 months before you can trade them legally, Levin says.

One of these private placements, Grayscale’s Bitcoin Investment Trust, trades at a premium to bitcoin’s price, says Michael Sonnenschein, managing director of the firm, which oversees investment trusts based on cryptocurrencies. Grayscale, which has been trading since 2013, also offers shares of trusts linked to other cryptocurrencies, including bitcoin cash, ethereum classic, ethereum, litecoin, ripple, and zcash.

Grayscale charges a 2 percent annual management fee, and investors will also pay a trading commission of 1 to 2 percent to the brokerage firm they use, Sonnenschein says.

Because the companies that issue cryptocurrencies are mainly still private, it’s not possible to buy shares in a public market. You could invest in venture-capital funds that back cryptocurrency startups and those in related industries, Casey says.

Another investment strategy is to buy shares of public companies that stand to profit from a blockchain explosion. IBM and Microsoft are among the fastest movers in this area, Casey says, although their exposure to blockchain is only a small part of what the companies do. Also poised to benefit are businesses like Nvidia that make high-powered graphics processing chips, which cryptocurrency miners use to soup up their computers.

The type of cryptocurrency investment that has received the most attention recently is initial coin offerings, or ICOs, of which some 2,000 have been held. Despite the name, this is nothing like an initial public offering, in which a company sells shares on a public stock market. Instead, a company is selling tokens of its own new cryptocurrency, often before the blockchain system that uses this token as a reward mechanism is even built.

“When you’re buying in an ICO, you’re not investing in a company; you’re buying the utility token those companies will use to operate their system,” Sternberg says. If the company turns out to have a useful system, the tokens you buy may have value one day (as bitcoin does), but there’s no guarantee. If not, your investment will be worthless, since it doesn’t represent the debt or equity of the company.

“Failure is a likely outcome here because you’re looking at highly speculative, startup-type ventures,” says R.A. Farrokhnia, a professor at Columbia’s business and engineering schools and the executive director of the Fintech Initiative there.

Another risk: although ICOs are typically sold without any government regulation, the SEC has said it may regulate them as securities offerings, which could invalidate these sales or result in the imposition of penalties.

“Most will likely get hit with SEC actions because they’re looking like they’re unregistered securities,” Casey says.

One thing you shouldn’t do, experts say, is become a bitcoin miner yourself, joining the network to verify transactions and receiving cryptocurrency as a reward. When bitcoin first started and the reward for verifying transactions on the network was higher than it is now, mining was an easy way to make money. But it’s impossible to make a profit from mining today without understanding what hardware to buy and how to join a mining pool, a collective of miners around the world that splits all profits, says Joseph Sternberg, an adviser to several blockchain and security companies.

There’s also a high risk of getting scammed—for instance, by buying an expensive mining-specific computer that the seller surreptitiously uses himself nonstop for several weeks before shipping it to you, wearing out the processor faster, he says.

If you do make an investment in cryptocurrencies, you should include information in your estate documents about how your heirs can find your digital wallet or other crypto assets, says Mindy Stern, an estate-planning attorney at Schwartz Sladkus Reich Greenberg Atlas in New York City.

Cryptocurrency may be how we’ll pay for things in the future, but it’s a risky way to make money now, Farrokhnia says. He recommends investing only what you’re comfortable losing and being prepared to wait five years or longer to realize returns.

“For crypto to enter the mainstream, it will take some time, certainly beyond the investment horizon of many accredited investors,” he says.    

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Bitcoin in the Sky

The blockchain boom has come to business aviation.

Someday, jet owners and operators might use blockchain to keep track of aircraft registrations, fractional-ownership shares, and flight plans. But it’s already possible to pay for at least some flights with cryptocurrency.

Monarch Air, a charter and fractional-jet-share jet company based in Fort Lauderdale, Florida, started accepting bitcoin and ether in November as payment for flights. So far, it’s a curiosity, not a trend: fewer than 10 flights have been booked with cryptocurrency, all by American customers, says executive director David Gitman.

Clients choose a flight on the company’s app or by phone, and don’t pay extra fees for using cryptocurrency, Gitman says.

Having clients pay for flights in bitcoin signifies a change in the market, Gitman says: “Now you have people who are buying cryptocurrency and using it to get real value, as opposed to just waiting for it to go up so they can sell it.”

But the volatile price of bitcoin means that there’s only limited interest in spending it, rather than holding onto it in hopes that its value will rise. Monarch clients’ desire to use cryptocurrency as a payment mechanism waned after the value of one bitcoin dropped from a high of $19,783 in December to a low of less than $6,500 at presstime.

“If you’re holding cryptocurrency, you think it’s going to go up, so you’re not going to sell it now,” Gitman says. Most clients who hold cryptocurrency would rather pay for their flights in dollars, rather than sell out of bitcoin at a relatively low valuation, he says.  —C.R.S.