Many wonder if cryptocurrency is a bubble waiting to burst or a legit form of currency here to stay. And, while we sort that out, should our investment portfolios include digital currency?
With cryptocurrencies taking center stage in financial world news, Finance Professor Vivek Singh weighs in.
Singh has a history of questioning financial investment trends — his research in the late 1990s focused on the dot-com bubble (before it had a name). He hypothesized that major financial institutions were driving up the price, which was an unpopular theory at the time. Most financial researchers believed the price surge came from the ignorance of the average retail investor. “When the bubble burst in 2002, I was able to prove what I was theorizing in real time.”
Bitcoin has been around for more than a decade — news continues to report mostly favorably on cryptos despite a recent dip. And a Financial Planning Association report released June 1 reveals that more financial advisers are recommending their clients have cryptocurrency in their portfolios.
So what’s an investor to do? Here’s what the UM-Dearborn financial expert (and sometimes skeptic) has to say about cryptocurrency.
Singh: “It’s a currency created by a secure network of computers using cryptography, making it so the currency is nearly impossible to counterfeit. A feature of cryptocurrency is that there isn’t one institution responsible for it, so it’s decentralized and exists outside of the control of government and central authorities.
In contrast, fiat currency — like the American dollar or the Euro — is government issued and managed by centralized banks. Bitcoin launched in 2009, and many others (Ethereum, Litecoin, Cardano, etc.) have since followed. You don’t physically own cryptocurrency. For example, a Bitcoin balance is kept on a ledger and stored on the Bitcoin network. Users can track their own Bitcoin activity by addresses created privately by each user’s virtual wallet."
Singh doesn’t get into the different types of cryptos available, but you can read more about that here.
Singh: “Economist Charles Kindleberger has a quote: ‘There is nothing so disturbing to one's well being and judgment as seeing a friend get rich.’ This leads some people to FOMO (fear of missing out). We’ve all heard stories about average people becoming millionaires off of Bitcoin they bought years ago. Maybe you even know someone. I think that’s a factor in what’s causing this surge in cryptocurrency interest. It has been aggravated by almost zero yield on bonds and related asset classes, easy access to online trading in cryptos, and perhaps people working from home with lots of time to play around with some free money (stimulus checks).
So what’s a rational approach to something that feels like it could be a bubble? Don’t expect to get rich quick — realize that what goes up like a rocket, comes down like a stick too. But also don’t entirely dismiss a risky asset like cryptocurrency. I need to be honest. Like many finance researchers, I am skeptical about the viability of cryptocurrency. But I also know that cryptos deserve some investment attention with the cryptocurrency market cap now exceeding $1.5 trillion. It is almost the same size as junks bonds, where even smart institutional investors invest despite the gargantuan risks.
My advice? Despite a neutral position on Crypto, portfolio theory demands that we put a very small amount in this proportional to its size in the investable universe.Talk to your financial adviser about investing a small chunk of money in cryptocurrency — 1 to 2% of your investment portfolio, realizing that 2% may be a bit on the speculative side — for hedging purposes and to have diversification of risk. Fixed income assets like treasuries and bonds offer almost next to nothing as a return. Your highest risk assets, like cryptocurrencies, are where the money is when you get it right."
Singh: “The cryptocurrency market soars and falls too quickly for it to be used in major consumer transactions — it’s too volatile. Since we make money in dollars, there is no natural hedge either. Imagine taking a home loan in Bitcoin and making money in dollars. If Bitcoin soared in value your mortgage loan would be astronomical. Under the circumstances, would you take a loan in bitcoin? On the reverse, bankers would think twice about loaning in a currency that might tank.
It has gone up and down by 20% within an hour on many days. In day-to-day dealings, by the time a transaction processes cryptocurrency to dollars and it’s settled, no one knows what the converted amount will be.
A lender or seller doesn’t want to accept a form of payment that may crash by the time they get it — too risky. And, if it rockets in value during that time, buyers give more than they agreed the item was worth. Given the current technological bottlenecks underlying cryptos, transactions may take a long time to go through with significant fees too.
Outside of the mostly irrational demand that created the more recent spikes in price, the value in cryptocurrency is really in its potential long-term use. However, we aren’t going to know it’s true value for years.
In a decade or so, we’ll have a better idea. By that time, if still around, cryptos values should be stabilized and financial institutions may see it as a valid unit of currency. But that would happen only if cryptos can overcome the significant regulatory headwinds, competition from central banks with their own digital currencies, its current technological limitations (that are deflationary by design),and undesirable environmental impact.”
Singh: “The technology that cryptocurrency operates on, called blockchain, has a lot of potential. People are already using it and it is on the cusp of adoption worldwide. (Here’s how blockchain and cryptocurrencies like Bitcoin are connected: Cryptocurrency is mined by computers verifying the blocks that make up the blockchain — when validated, the cryptocurrency is created. It’s like the reward for getting it right.)
The data contained within the blockchain is immutable, meaning once it’s written it cannot be edited or changed. The blockchain technology can authenticate trades or financial transactions so people get what’s promised. Smart contracts — which are like any financial contracts but exist on the blockchain — can remove unnecessary paperwork and human error, and increase efficiency.
In addition to security, the appeal of blockchain is that it runs on a peer-to-peer system of computers that hold and verify the information. The system is maintained by people like you and me. This essentially eliminates the cost of a middleman, resulting in financial transaction fees that are far lower than what big exchanges or banks charge. The benefit of transactions costing less is that it can lead to more economic activity for everyone.
Blockchain is a transformative technology that will change the way we do things. Even if the cryptocurrency bubble bursts, blockchain technology is here to stay.”
Interview by Sarah Tuxbury. If you are a member of the media and would like to speak with Professor Vivek Singh about this topic, please contact [email protected].
