The economy is up, the broad markets are up and many investors are happy about how the end of 2017 is wrapping up. However, other investments have done so well that the growth in the markets looks unimpressive in comparison. Bitcoin, for example, is up a little more than 1,400 percent in 2017. By any standards, that’s impressive. Each bitcoin is worth about $16,432. With such astronomical growth, it’s dizzying to think that the currency was only begun in 2009.
The investing landscape is constantly changing. Learning how to navigate new frontiers of investing requires, as Tacitus said, considerable patience and research.
While bitcoin is the most well-known cryptocurrency, it’s only one of the 1,000-plus cryptocurrencies available. The way these currencies are traded is through a technology called blockchain. Blockchain removes the need for a central banking system to verify and execute transactions. Put simply, blockchain is an open ledger, a history of all the transactions recorded in code. The fascinating aspect of this technology is that anyone with a computer and an internet connection can contribute to a blockchain. These individuals can become nodes that use algorithms to verify transactions, and confirm that no one is spending more coins than they have.
The people who use their computers, servers and fancy computer gismos to verify transactions are often called “miners.” A miner is rewarded financially for verifying transactions. The challenge is that as the currency gains popularity, the blockchain become too long and unwieldy for a simple computer to handle processing the data, hence the need for seriously expensive and powerful servers and processors. High-capacity servers and processors use a lot of electricity and generate a lot of heat. According to Vice.com, a bitcoin transfer uses as much electricity as an average American household does in a week. And therein lays the Achilles’ heel of bitcoin. As bitcoin becomes more mainstream, a point will be reached where the amount of energy required to verify transactions is too expensive, as well as being too damaging to our planet’s health.
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So far, it’s unclear how the people who invented blockchain are going to address the issue of energy consumption. Another factor that might affect the future of the current technology and cryptocurrencies like bitcoin is that others are trying to develop new cryptocurrencies with new methods of verifying transactions. Bitcoin has weathered significant challenges in the past, however, including hacking and the fact that it was a currency of choice for nefarious people. Given the current price of a bitcoin, the cryptocurrency has obviously adapted well to these challenges.
Another investment practice that is gaining popularity — and has had a longer history than cryptocurrencies — is peer-to-peer lending. Many businesses have started offering people the ability to borrow money at lower rates than credit cards. The money is raised by many different people who are willing to lend money at a higher rate than other forms of lending, like bonds. An example of peer-to-peer lending would be: If someone wanted to borrow $1,000, instead of borrowing that from one person, they would borrow $25 from 40 people. The facilitator would organize the transactions and charge a fee for doing so. Depending on the credit worthiness of the person borrowing, the interest earned by a lender can vary from 5 to almost 20 percent. The business that facilitates the transactions has a vested interest in making sure that those who borrow pay back the funds. If enough people never repay their loans, the system collapses. These loans aren’t “covered” by collateral so without payment lenders would quickly lose trust and decide not to participate. A lender can diversify their risk by limiting the amount of money they lend to each person, but if a good percentage of borrowers can’t pay back the loan there isn’t much recourse for the lender.
Notice how in both cryptocurrency and peer-to-peer lending, an attempt is made to remove the central entity that acts as the source of trust in the transaction. The central entity is then replaced by a large number of people. While a great concept, I’m not convinced that the central entity — which benefits most from the transaction — is actually removed. What I think is taking place is actually an attempt to reshuffle power.
In the case of cryptocurrency, the power is in the hands of those who invented the currency. An arms race will ensue, which ensures that there are several dominant currencies vying for the most number of users. Along with the miners who have invested millions of dollars on warehouses full of servers trying to mine as much of the data as possible to generate as much fees as they can.
In the case of peer-to-peer lending, the central power may not technically be a bank, but for all intents and purposes performs the same functions as the bank. The facilitator’s duties may have changed and the process may be simpler, but there’s still someone charging a fee to set the loan parameters.
In order to properly assess the risks involved in these new ways of investing, we must be able to either reasonably predict the future of the services and technologies, or evaluate past performance of the services and technologies. And unfortunately, at least with cryptocurrency and peer-to-peer lending, we can’t do either reliably. Guessing how these new technologies will take hold in the future is highly speculative. But more importantly, the technology is so recent that we don’t have the ability to look back and see how these services have performed in a crisis.
By crisis, I don’t mean crises that are unique to these technologies. A global recession would be a good test for these new financial tools. Before we consistently rely on them, it would be prudent to see how these services would perform in a 2008-like financial crisis, or even a recession. Only time will tell if investing in these new technologies is worth the risk. Until then, the prudent thing to do is learn as much as possible about these new developments.
Ash Toumayants is the founder of Strong Tower Associates, a Retirement Planning firm dedicated to helping clients in all stages of life prepare for retirement.