Chapter 28: Crypto Money

Riley Poole: “Will someone please explain to me what these magic numbers are?”

– National Treasure (2004)

In 2008 a mysterious author using the name Satoshi Nakamoto invented Bitcoin. In a short technical paper, he described a computer program that would keep track of imaginary “coins” as they were created and exchanged among people. The program did away with the need for a bank or central database to store account balances; instead, anyone could inspect all transactions and how many coins were held by each account (though the account owners remained anonymous). Through some cryptographic tricks, once transactions were processed they couldn't be changed. The program grouped transactions in “blocks” for processing, making the Bitcoin program the first “blockchain” or “distributed ledger.”

Having gotten Bitcoin off the ground, Satoshi Nakamoto disappeared in 2011 and has not been heard from since. But the Bitcoin blockchain has been running on thousands of computers, updating for new transactions every few minutes. If you want, you can download the whole thing and see all transaction going back to Nakamoto’s original transmission of 50 coins. Meanwhile the dollar value of a single Bitcoin started near zero, and, through gut-wrenching ups and downs, reached about $65,000 in November 2021.

Soon after Bitcoin, other blockchain programs were launched. Today Bitcoin’s major rival is Ether, a cryptocurrency tracked on the Ethereum blockchain. But there are thousands of others. As I write this, the top ten currencies by dollar value are: [71]

Coin	Symbol	Value
Bitcoin	BTC	$1.18 trillion
Ether	ETH	$538 billion
Binance Coin	BNB	$94 billion
Solana	SOL	$74 billion
Tether	USDT	$72 billion
Cardano	ADA	$68 billion
XRP	XRP	$53 billion
Polkadot	DOT	$52 billion
Dogecoin	DOGE	$35 billion
USD Coin	USD	$32 billion

Blockchains can be used to record other kinds of digital information, not just “coins.” For example, they can track files, including documents, pictures, and even other computer programs. Recently “non-fungible tokens” (NFTs) have become popular. NFTs are unique electronic tags [72] that represent ownership of just about anything real or imagined—an image, a song, a virtual object, a piece of text. On a blockchain NFTs can be bought and sold for other coins (often Ether because the Ethereum blockchain is popular for this purpose).

Are Cryptocurrencies Money?

The short answer is no, at least not yet.

On the one hand, they are just a bunch of electronic entries, not unlike most regular, so-called fiat currencies. The difference is that popular cryptocurrencies are not controlled by a central government. No central bank determines the amount in circulation. You can’t use them to pay your taxes. Governments don’t issue bonds in crypto.

Recall the three key roles of money from Chapter 1. Let’s see how the largest cryptocurrency, Bitcoin, stacks up.

First, as a unit of measurement it hasn’t made many inroads. Very few people earn income in Bitcoin, and prices for real-world goods and services are by and large set in traditional currencies, even if they are converted into Bitcoin.

Second, Bitcoin is limited as a medium of exchange. It can be used in some stores, in virtual settings, and it's popular for crime, but you can’t use it for most daily transactions. On top of that, transaction fees for paying in Bitcoin are very high.

Third, even though its dollar value has increased dramatically since it was first introduced, Bitcoin isn’t a great store of value. It simply is too volatile. Have a look.

Data source: Coindesk

The bottom line: for now Bitcoin can’t stand side by side with fiat currencies such as the dollar. This is one reason for the rise of so-called “stablecoins.” These are cryptocurrencies whose goal it is to always be exchangeable one-for-one into U.S. dollars. (Tether and USD Coin are the most prominent.) Don’t confuse stablecoins with real dollars. It’s not certain that they will be able to live up to their promise through thick and thin. And there is no FDIC insurance if they become unstable.

Investing in Crypto

If they aren’t money, perhaps we should we think of cryptocurrencies as investments? People have gotten wealthy owning them. A whole financial ecosystem is growing up around them. Major financial institutions are jumping in with both feet.

To crypto-skeptics this is all a fad—a bubble that will eventually burst. They argue that when you buy cryptocurrencies you own nothing. Nobody has an obligation to pay you back, as they do when buy own a bond. You don’t own a piece of a business that generates earnings, as you do when you buy a stock. You don’t own something that has practical or aesthetic value, as you do with gold. The only people who make money from crypto are those who find a “greater fool” to sell it to at a higher price.

On the other hand, crypto enthusiasts argue that we are entering a new era. It's the era of Web3 and meta- omni- and multi-verses. An era comparable to the rise of the internet, where blockchains enable new businesses, new types of commerce, new art, entertainment, and markets. The currencies of this new era will be virtual. The profits will flow in Bitcoin, Ether, and other coins, including some yet to be invented.

Any given cryptocurrency may end up being a great investment or a terrible one. This uncertainty means that you should not invest money in it that you are not prepared to lose. It also suggests that crypto should at most be a small slice of your total portfolio. As a point of reference, consider that the total value of all crypto combined is about the same as the market value of Apple Inc.

If you do decide you want to invest some of your savings in crypto you should first understand its risks. Then you have to decide which cryptocurrencies to buy and how to buy them.

Risks of Crypto Investing

A lot of buying and selling in cryptocurrencies is short-term trading, often with leverage. [73] This causes huge price fluctuations. I don’t discuss (or recommend) trading in this book. My focus is on investing for the long term (meaning years!) to help you achieve your financial goals.

In addition to volatile prices, there are specific risks and costs of investing in crypto. I will focus on Bitcoin; other cryptocurrencies share these and may have other risks.

Custody

In its purest form, owning Bitcoin means knowing a long, complicated password called a “private key.” Anyone who knows the private key can “spend” the coin. Without the private key, the coin can’t be accessed. Sorry, no password resets. This means that custody (safekeeping) of private keys is really important. Stories abound of people losing their private keys, being hacked, or having them stolen. By some estimates, about 20% of Bitcoins are irretrievable. [74]

Private keys are stored in wallets: these can be anything from an encrypted file stored in the cloud or on a dedicated flash drive, to a piece of paper in a safe. Hot wallets are those that are connected to the internet and thus ready to send or receive cryptocurrencies. Cold wallets are not connected to the internet and generally considered more secure.

Many people buy crypto through intermediaries who maintain wallets on behalf their customers. Some intermediaries commingle all customers’ crypto and keep track of who owns what in an account database. Others provide individual wallets for their customers to let them make their own crypto transfers. Regardless, it’s critical that you trust whoever keeps your crypto. There is no deposit insurance or regulatory guarantee to bail you out if something goes wrong with your custodian.

Expenses

When you buy or spend crypto you incur much higher expenses than you do with the stock or bond investments discussed in Chapter 13. You can buy and sell stocks, bonds, low-cost mutual funds, and ETFs commission-free. The price is generally quite close to the one quoted on large, public exchanges, and will be very similar at Schwab, Fidelity, Vanguard or any other brokerage firm, all of whom are legally required to try and find you the most favorable price.

Not so with crypto. Most intermediaries charge fees for each transaction. Blockchains themselves charge fees to validate transactions. And unlike stock exchanges, crypto trades 24/7, with each exchange setting its own prices to match supply and demand. Your exchange or platform has no obligation to try and find a better price and may or may not disclose an additional mark-up to the price. As a result it is hard for the average individual to know whether they are getting a good deal.

Regulation

As more money has flowed into crypto, financial regulators have become increasingly concerned about abuse. Some countries have taken draconian steps—most notably China, which in September 2021 outlawed all cryptocurrency transactions. [75]

Regulations in the U.S. are evolving. The risk for investors is, on the one hand, that heavy-handed regulation will squash innovation and growth in crypto, making it a lousy investment. On the other hand, weak regulation means investors could end up losing money to market manipulation and fraud.

Taxes

The IRS considers cryptocurrencies property, not money. This creates tax complications. Any time you use crypto to pay for something the IRS treats it as though you sold the crypto for dollars and used the dollars for the payment. This means you must calculate a capital gain or loss on each crypto transaction. NFTs are more complicated still and are subject to additional tax rules.

Leverage

Many exchanges offer the ability to use leverage when investing in crypto. Leverage involves borrowing funds by using crypto as collateral and using those funds to buy more crypto. Chapter 27 explains the general risks of leverage. There are additional risks when leveraging crypto. One is that many of the exchanges that offer it are outside the U.S., which means there is even less recourse if your crypto disappears. Another is that if the price of a cryptocurrency falls rapidly, your coins may be sold automatically by algorithms. Without human intervention, this automatic selling can drive prices down further, causing a spiral of more selling. Large losses can be rapidly locked in. Don’t use leverage when buying crypto.

Which Crypto Should You Buy?

If you decide to invest in crypto, what should you buy? There aren’t many ways to objectively compare different currencies, let alone surmise which will be “winners.” It definitely makes sense to diversify. Unfortunately, unlike with stocks, there is no low-cost, simple way to buy a broad universe of cryptocurrencies.

A diversified crypto portfolio should almost certainly include Bitcoin and Ether, the top two coins by market value. These are the most established, well-understood coins with the most tested blockchain programs (though even in these programs potentially costly errors and vulnerabilities have been discovered). After that, the top coins by value change regularly. Many are heavily promoted by parties who have a vested interest in driving up their prices. Some are outright scams.

One possible way to diversify is to buy coins with different functions and a reasonable amount of trading activity. Of course, stablecoins aren’t long-term investments since by design they won’t do better (but could do a lot worse) than keeping cash under the mattress.

What about crypto funds?

The crypto space is “hot”, which means it offers mouthwatering fees for financial companies. Expect to see lots more products, many with dubious benefits. There are already all kinds of funds with “crypto” in their names and marketing lingo. But so far regulators in the U.S. haven’t allowed any real crypto funds to be sold to small retail investors—that is, funds which actually own cryptocurrencies on your behalf. Also remember that funds which invest in a single cryptocurrency don’t provide any diversification over buying the cryptocurrency directly.

There are some real crypto funds targeted at wealthier or more sophisticated individuals (accredited investors). They include offerings from Grayscale and Bitwise. These companies handle the trading and storing of coins in exchange for annual fees that range between 2% to 4% of the fund’s value, but also come with additional risks.

You may come across several Bitcoin exchange traded funds (ETFs) introduced in late 2021. These ETFs don’t buy Bitcoins; they buy Bitcoin derivatives (futures) [76]. Futures strategies only approximate the price of actual bitcoins and can fail spectacularly.

Other crypto-sounding funds don’t invest in cryptocurrencies at all, but rather in the stocks of companies that are in some way connected to the crypto industry. Remember that broad-based stock index funds also include these companies in proportion to their size in the market, typically with lower expenses.

Where to buy crypto

A simple way to get started is through a platform such as Venmo, Paypal, Robinhood, or SoFi. These companies make it almost too easy to buy and sell Bitcoin, Ether and some other established coins. That means it’s super important to follow a well-defined plan. Each transaction will set you back by a fee and/or mark-up, so they are most appropriate when you plan to hold your crypto for many years.

For access to a wider selection of cryptocurrencies you'll want to open an account at a dedicated crypto exchange such as Coinbase or Gemini. Costs at these exchanges are high and can include trading commissions, annual custody fees, and “administrative fees” for things like getting your money out. Coinbase also offers a popular wallet if you don’t want your crypto commingled with that of others.