Caroline, at the age of 10, amassed a fortune of $100 from her gifts and allowance. Rather than keep a bunch of small bills, she traded her $1s for $20s and ultimately her $20s for a $100 bill. Looking carefully at her newly gotten $100 bill, she opined, “You know, Mom, a $100 bill isn’t really worth more than a $20 bill. It takes the same amount of paper and uses the same amount of ink.” When a currency is not backed by anything tangible, what is it really worth? This 10-year-old is now in her 20s, and her generation is thinking what is a dollar really worth if more of them can be created at any time?

Enter a never been seen individual, Satoshi Nakamoto, who wanted to find an alternative to currency controlled by governments. In 2009, he devised ‘an electronic payment system based on cryptographic proof instead of trust’. The digital currency, Bitcoin, would be set up to gradually grow to a predetermined amount of 21 million coins, after which no more supply could be created. Therefore Bitcoin, unlike fiat (government issued) currencies, has the advantage of limited supply. As governments around the world substantially increased their money supply, both after the financial crisis and after the pandemic, investor interest in Bitcoin and other cryptocurrencies exploded (now Litecoin, now Ethereum, now Tether and Dogecoin).

Bitcoin is “the most widely distributed asset in history outside of the Dollar and Euro; 140 million people own some Bitcoin. And it’s easily stored and transported, unlike gold. Stores of value are social constructs – they have value because we believe they do. There has never been a more successful brand created in such a short period of time.” [1] While our general analysis applies to other crypto currencies, we use Bitcoin to explain how a cryptocurrency works.

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‍How is Bitcoin Created?

Today, most financial transactions are centralized through financial institutions such as banks and brokerage firms. In contrast, once Bitcoin has been mined, future transactions happen on a distributed digital record called a blockchain. All the details of each transaction are stored in a discrete block with a unique identifying code. These block entries are strung together in chronological order literally creating a digital chain of blocks. Records of these transactions are accessible to anyone, which act as a public ledger of cryptocurrency transactions, making them difficult to reverse or fake.

Bitcoin and other cryptocurrencies can be purchased directly through an account at Coinbase and other cryptocurrency exchanges, or it may be held indirectly at major brokerage firms in Grayscale Bitcoin Trust (GBTC), or in the recently created Canadian ETFs.

The U.S. Government treats cryptocurrencies as an asset, and realized gains or losses are subject to capital gains tax treatment.
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A Store of Value?
Over history, a store of value provides a fallback asset when investors are unsure about the state of the world and the safety of conventional assets or fiat money (i.e. events like war, government confiscation of money, high inflation). To date, gold has served as the primary store of value across cultures.  

In the past, “all important non-yielding stores of value developed real uses before becoming investment assets. For instance, gold was first used as jewelry to signal permanence, commitment or immortality. The economic problem was a need to signal permanence, and gold’s durable and inert elemental properties solved that problem.”[2] 

“Given the importance of real uses in determining store of value, [Ethereum] has a high chance of overtaking Bitcoin as the dominant digital store of value. The Ethereum ecosystem supports smart contracts and provides developers a way to create new applications on its platform… For example, individuals can store and sell their medical data through Ethereum to pharma research companies."[3] 

Although Bitcoin’s limited supply is appealing, it is demand, not scarcity that drives the success of stores of value. For example, gold has remained a store of value despite annual supply growth of about 2% for centuries.  

‍A Medium of Exchange (Currency)?
‍Calling cryptocurrency a currency is a misnomer. “Currencies must have four qualities: they must be a unit of account, a means of payment, a stable store of value, and act as a single numeraire. Bitcoin and most other cryptocurrencies have none of these features. It's not a unit of account; nothing is priced in Bitcoin. It's not a scalable means of payment; the Bitcoin network can only complete seven transactions per second, versus the Visa network that can conduct 65,000. It's not a stable store of value for goods and services; even the crypto conferences I've attended don't accept Bitcoin for payment because the price volatility could wipe out their profit margin overnight. And the crypto universe doesn’t offer a single numeraire in which the prices of different items can be denominated because there are thousands of tokens and thus limited price transparency.”[4] As demonstrated in the chart below, the biggest challenges to Bitcoin’s use as a currency are its acceptability (as a unit of account, means of payment or stable source of value) and its durability.
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A medium of exchange requires widespread social adoption. In modern society, younger people accustomed to online commerce can be more attracted to a digital ‘currency’, which in turn may turbo charge participation in crypto and digital currencies. Visa, PayPal, and Square have announced willingness to accept cryptocurrency for payment. However, the current volatility of cryptocurrencies makes them impractical as a medium of exchange.

An uncorrelated asset?
‍Academic studies have shown that cryptocurrency combined with gold and stocks provided a better risk adjusted return over recent history. The short and volatile time frame of bitcoin trading make it far too soon to say it provides beneficial portfolio diversification.
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“Bitcoin and other cryptocurrencies also aren't assets. Assets have some cash flow or utility that can be used to determine their fundamental value. A stock provides dividends that can be discounted to arrive at a valuation. Bonds provide a coupon, loans provide interest, and real estate provides rent or housing services. Commodities like oil and copper can be used directly in different ways. And gold is used in industry, jewelry, and has historically been a stable store of value against a variety of tail risks, including inflation, currency debasement, financial crisis, and political and geopolitical risk. Bitcoin and other cryptocurrencies have no income or utility, so there's just no way to arrive at a fundamental value.”[8] 

If we can’t determine a fundamental value, be prepared for a wild ride!
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