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INSTITUTE Research INSTITUTE Research April 2018 Handle with Extreme Care! Our Take on Cryptocurrencies KEY ELEMENTS Cryptocurrencies are digital assets designed as a medium of exchange and are not controlled by central governments. They work through blockchains, which are public transaction databases that act as distribution ledgers. There is no shortage of interest in cryptocurrency, driven in part by strato- spheric returns in 2017: Bitcoin rose 1,318% and another cryptocurrency, ripple, an incredible 36,018%. The implementation of blockchains show promise, as do alternative forms of currency decoupled from central governments. But Callan does not recommend our clients invest in cryptocurrency strate- gies due to concerns over asset security, liquidity, unclear tax implications, and heightened volatility. “The old maxim—there is no free lunch—remains true for cryptocurrency.” Mark Wood, CFA Global Manager Research Knowledge. Experience. Integrity. Cryptocurrencies like bitcoin are a hot topic in investor circles, driven by the exponential increase in their prices and the exotic nature of this new type of asset. Investors are understandably excited by bright, shiny objects with excess return potential, and cryptocurrency is no different. By the fall of 2017, more than 120 hedge funds had sprung up solely focused on cryptocurrencies, trading along with thousands of individual investors worldwide. We at Callan—like you—have been following these developments with great interest, and in this paper we provide a brief overview of cryptocurrencies and evaluate them in the context of our long-established approach to assessing industry trends. In addition, we address primary considerations for potential inves- tors (individual or institutional) interested in plunging into the space. Spoiler alert! Callan does not recommend our clients allocate to cryptocurrency investment strategies due to concerns over asset security, liquidity, unclear tax implications, potential government and regulatory scrutiny, and heightened volatility. A cryptocurrency What exactly are cryptocurrencies and what is a “blockchain”? wallet stores the public A cryptocurrency is a digital asset designed to work as a medium of exchange, and it uses cryptography and private “keys” or to secure transactions. Such a currency is implemented with a system that controls the creation of addi- “addresses,” which can be tional units and verifies the transfer of assets. used to receive or spend the cryptocurrency. Cryptocurrencies use decentralized control. In centralized banking systems, like the Federal Reserve System, governments control the supply of currency. In a decentralized system, cryptocurrency is pro- duced by the entire cryptocurrency system. Most cryptocurrencies are created (or “mined”) at a rate that is defined when the system is created and that is known in advance to every participant. The decentralized control of each cryptocurrency works through a blockchain, a public transaction database that acts as a distributed ledger. Thus, no single entity owns the ledger. What makes this type of ledger special? A blockchain is a growing list of records, or blocks, linked and secured with cryptography. Every block includes an encrypted pointer to the previous block, a date and time stamp, and information about the transaction. Because of this design, information cannot be altered once it is added to the chain. This system provides participants with transparency (since it is public) and transac- tion security (since it is encrypted). Cryptocurrency exchanges let customers trade cryptocurrencies for other assets, such as fiat money1 or other digital currencies. These businesses can act as market makers, taking the bid/ask spreads as transaction commissions, or charge fees as a matching platform. A cryptocurrency wallet stores the public and private “keys” or “addresses.” With the private key, it is possible to write in the public ledger, effectively spending the associated cryptocurrency. With the public key, others can send currency to the wallet. Because wallets are associated with the keys, and not an individual, cryptocurrencies provide anonymity for their owners. 1 https://www.investopedia.com/terms/f/fiatmoney.asp 2 Bitcoin, Bitcoin, developed in 2009, was the first decentralized cryptocurrency to gain widespread trac- tion, succeeding where predecessors DigiCash and eCash failed. Since then more than 1,000 currencies have been developed; ethereum, litecoin, and ripple are some of the best known. There is no shortage of interest in cryptocurrency from individual investors, driven in part by stratospheric returns in 2017. Bitcoin rose an incredible 1,318%—a robust performance, to be sure, but easily outpaced by ripple (+36,018%), ethereum (+9,162%), and others (Exhibit 1). Ripple 36,018% Exhibit 1 NEM 29,842% Now That’s a Bull Ardor 16,809% Market Stellar 14,441% 2017’s biggest cryptoassets Dash 9,265% ranked by performance Ethereum 9,162% Golem 8,434% Binance Coin 8,061% Litecoin 5,046% OmiseGO 3,315% Bitcoin 1,318% Source: coinmarketcap.com But the old maxim—there is no free lunch—remains true for cryptocurrency. In the following Q&A we outline some of our top concerns associated with the nascent asset class. SECURITY: How safe are cryptocurrency exchanges and wallets? Mt. Gox, a bitcoin exchange based in Tokyo, launched in July 2010. By 2014, it was the largest bitcoin intermediary and the world’s leading bitcoin exchange, handling over 70% of all bitcoin transactions world- wide. In February 2014, however, Mt. Gox abruptly suspended trading, closed its website and exchange service, and filed for bankruptcy protection from creditors. Following the closure, Mt. Gox announced that approximately 850,000 bitcoins belonging to customers and the company were missing and likely stolen, an amount valued at more than $450 million at the time (approximately $7.6 billion at current valuations). The coins were stolen by hackers who gained access to the system through a security flaw in the coding and were able to siphon off coins undetected until it was too late. Unfortunately, this was not an isolated incident, and additional attacks on exchanges remain prevalent as sophisticated hackers continue to find security flaws. Due to the security issues with online exchanges and wallets, the best advice for storing cryptocurrency is, paradoxically, to keep it offline in “cold storage,” in crypto-parlance. In this case, holders of cryptocurrency transfer coins and private keys to a so-called hardware wallet. The USB-looking device keeps the digital coins off the internet, making them less vulnerable to hackers. Further, many experts suggest storing the hardware wallet in a safe or in a safety deposit box at a brick-and-mortar bank. Knowledge. Experience. Integrity. 3 Another risk, more remarkably, is simple human memory: Owners of cryptocurrency might simply forget the password to access their online wallet. Since no centralized resource to recover this information exists, the tokens are inaccessible. According to blockchain tracking company Chainanalysis,2 more than 3 mil- lion bitcoins have been lost this way. Bitcoin was created with a finite supply (21 million). There are 16.9 million coins in circulation, meaning that approximately 17% of the current market capitalization (and 14% of the potential supply) could be “lost” for good. LIQUIDITY: How easily can I convert cryptocurrency into plain old cash? One measure of liquidity is the ability of an asset to be converted into cash readily on demand; there is no premium or discount attached to buying or selling, making it easy to enter or exit a position. By that standard, cryptocurrencies are not very liquid. For example, the price of bitcoin (the most liquid cryptocur- rency) may fall hundreds of dollars before a user can fully sell out of a position if there is a massive sale. Why is liquidity constrained? There are multiple technical reasons related to how the bitcoin blockchain functions with high transaction volume, but suffice it to say that the significant growth in total bitcoins, from only 50 in 2009, has not translated directly into increased liquidity. That illiquidity is a headwind to institutional investment. TAXATION: How are cryptocurrencies treated by governments? If cryptocurrency is to upend the traditional system as we know it today, countries will have to agree on how to classify and tax the emerging asset class. The Internal Revenue Service (IRS) has ruled that cryptocurrency is property rather than currency and is subject to capital gains tax. As such, each time you sell or transfer a digital coin for goods and services— cashing out bitcoin for dollars or even to buy a cup of coffee—is a taxable event that must be separately recorded and accounted. So far there is no clear global consensus on how to regulate or tax cryptocurrencies; some countries have banned them outright. And the ramifications of tax decisions grow with every transaction. A recent article in The New York Times highlighted the issue:3 Complicating matters even more, the timing of last year’s cryptocurrency boom made for some extra tax headaches. The price of Bitcoin rose more than 1,500 percent last year, with most of the gains coming during the last two months of the year. High prices caused many traders to sell Bitcoin in 2017, in order to lock in their profits. But instead of cashing out into dollars, many traders put their 2017 profits into new cryptocurrency investments, most of which have lost money in this year’s market slump. That decline has left some investors short of the funds they need to pay the taxes they owe on last year’s gains. (One accountant) said she had seen clients with cryptocurrency gains as large as $400,000 who did not withhold taxes during the year and subsequently lost money trading. “Now they’re stuck with these huge tax bills, and they don’t have the capital to pay it.” 2 Darryn Pollock, “Up To Four Million Bitcoins Gone Forever.” Cointelegraph, Nov. 27, 2017. https://cointelegraph.com/news/ up-to-four-million-bitcoins-gone-forever 3 Kevin Roose, “Think Cryptocurrency Is Confusing? Try Paying Taxes on It.” New York Times, March 21, 2018.
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