It seems like just about everyone has been talking about cryptocurrencies lately. Uber drivers are talking about them. Mates getting together on the weekend are talking about them. More importantly, a number of my clients have called me up and talked about them, so I feel a bit peer-pressured into talking about them as a professional accountant.
First and foremost, I am not a licenced financial planner, so I can neither endorse nor denounce, nor can I provide any financial advice in relation to cryptocurrencies as a financial investment. However, that doesn’t mean I don’t have a view on them, which is the subject of this article.
Are cryptocurrencies a legitimate investment?
As an accountant, outside the context of a business, an investment is by definition something that is likely increase in value over time. Therefore, unless your next iPad is likely to become an antique a century from now and you are still alive and kicking then to sell it for a profit, , I am generally reluctant to characterise it as an investment, at least for you.
There are generally three ways an investment can increase in value – it may produce an income stream, it may increase in capital value itself, or it may be a combination of the two because income and capital form a ‘feedback loop’ (ie, the more income an investment can produce, the more someone is willing to pay for it, which in turn increases its value).
Applying my definition of an investment to cryptocurrencies, unless I am wrong, cryptocurrencies do not produce an income stream. It’s not like you can deposit cryptocurrencies into a special account and someone will pay you interest on them. This leaves the remaining criterion that cryptocurrencies must be capable of increasing in value on their own before they could be an investment in my book.
There is little doubt that cryptocurrencies can indeed increase in value on its own accord. All you have to do is to look at all the Bitcoin billionaires out there!
So I will give you this – as far as I am concerned, cryptocurrencies as an asset class can be a legitimate investment in my view.
What kind of investment is it?
Just because something is, an investment doesn’t necessarily mean it is a great investment.
In the accounting world, things are simple - like the laws of gravity and curvature of space are governed by Einstein’s theory of relativity, the financial market is largely governed by the law of risk and return. The higher the risk you are willing to take, the higher is your potential return – or loss.
In fact, this universal law seems to spill over to other aspects of life as well. For instance, going to an exotic location that is drastically different from home for a holiday may arguably be more adventurous and fun but places you are not familiar with are probably more risky and if things go wrong, you could be much bigger trouble than if you have gone somewhere ‘vanilla’ … you get the picture.
When it comes to cryptocurrencies as an investment, I tend to focus on one thing – what is the driver behind its value? In other words, what makes their price go up or down?
We have already talked about cryptocurrencies not producing an income stream before, so that mustn’t be what’s underwriting their value.
Based on my somewhat limited understanding (which should be an alarm bell in itself), here are my thoughts:
I have no doubt that the Blockchain technology behind Bitcoin, for instance, is a ground-breaking innovation that has the potential of changing life as we know it. A transparent currency that is free from tampering and fraud sure sounds like the advent of macro-economic utopia (as soon as we have figured out how to keep hackers from stealing it). However, buying cryptocurrencies may not be the same as buying the technology behind it, not to mention that more advanced technology may crop up tomorrow to render the previous technology obsolete. It is already well known that the original technology behind Bitcoin is too slow for real life transactions, which is why all alternative ‘coins’ like Litecoins are flooding the market.
Storage of value
Another feature that may be underpinning the current value of cryptocurrencies is their potential ability to store value and function as alternative currencies. Like the fiat currency in your wallet or purse, the material that makes up the currency itself (eg, the copper in fiat currency, the energy expended to create a Bitcoin, etc) may only have limited value but it is the trust that people put in the currency for it to be an acceptable medium of exchange of goods and services in the economy that gives it value.
To that end, cryptocurrencies may be seen to be an alternative safe storage of value, especially as a ‘Plan B’ if a particular fiat currency collapses, which has happened throughout our economic history (eg, google ‘currency collapse’ if you suffer from insomnia).
However, at this stage, given the price volatility of cryptocurrencies, it is very hard for anyone to establish an ‘exchange rate’ between the relevant cryptocurrency and the goods and services one can exchange with it.
For instance, 1/1000th of a Bitcoin may be worth $10 today but it may be worth $15 an hour later. So unless suppliers for goods and services are prepared to keep adjusting their Bitcoin exchange rate as its price fluctuates, Bitcoin is probably not a practical medium of exchange for the time being. The price fluctuations mean that not a lot of people would accept Bitcoin as payment for their goods and services, which in turn limits its value (yes, we are going back to the idea of people’s trust in a medium of exchange as a prerequisite condition for that medium to hold value).
Perhaps the price of cryptocurrencies may become sufficiently stable one day for them to become a credible storage of value but no one knows if and when that day would come.
Another reason for something to go up in value is scarcity. To that end, cryptocurrencies like Bitcoin may benefit from the fact that only a limited amount of a cryptocurrency will be issued (ie, the current protocol dictates that a maximum of 21 million Bitcoins can ever be mined for circulation), so the scarcity of cryptocurrencies may drive up their value.
Having said that, I find this concept mind-boggling.
Again, using Bitcoin as the scapegoat, if the price of Bitcoin goes up and I am accepting Bitcoin as payment for my services, I would simply accept a lesser fraction of a Bitcoin as an acceptable payment. To that end, depending on what is going to happen in the economy, there is nothing to stop any future changes to the protocol to provide for a larger supply of Bitcoins or increase its divisibility (currently, it is my understanding that dividing a Bitcoin beyond a ‘Satoshi’, which 10 to the power of negative 8, cannot easily be done – and fancy having your name being used as a unit of measurement).
Therefore, Bitcoin (and other cryptocurrencies) can’t really enjoy scarce status unless it completely de-couples itself from fiat currencies on a worldwide basis (which requires a global currency collapse or reset like the way the European countries adopted the Euro) and start bearing a meaningful relationship with the underlying goods and services in the economy. This may happen or this may not – nobody knows.
Driver of value
On the basis of the above, I am led to believe that the driver of value behind cryptocurrencies is this - people’s perception of the value of the specific technology behind the cryptocurrency they are investing in, its potential rise to the status of being a viable and stable storage of value, and its potential scarcity if fiat currencies across the globe collapse.
Other practical issues
Like most products that are new and novel, there are many practical issues associated with their introduction and cryptocurrencies are no different.
At this stage, the transaction costs of trading cryptocurrencies are high and the speed is slow, compared with, for instance, trading shares on the stock market.
Then there are regulatory risks as world governments try to grapple with the implications of cryptocurrencies on the financial markets. In fact, some governments have already expressed concerns over them and any attempt to restrict or outlaw them may erode or even completely neutralise their value.
As an accountant, I can see cryptocurrencies posing some curly problems for taxation purposes.
Before you even start calculating the gain or loss you make on the disposal of your cryptocurrencies, you need to work out how you are taxed.
The taxation treatment of any gain or loss you make on the disposal of cryptocurrencies will depend on your intention when you acquire them. If you purchase them with the intention of holding them until they increase in value and then sell them for a profit (regardless of how long you hold them), then the gain or loss you make on their disposal will be on income account or treated as a windfall gain or loss.
Generally, the gain or loss will be on income account where you trade cryptocurrencies in a business-like manner (similar to the rules around when you are treated as a share trader, eg, regularity of trades, amount of capital employed, etc) or a professional gambler. If you are trading cryptocurrencies in a business-like manner, any gain you make will be treated as assessable income and any loss you incur may be tax-deductible.
If you do not trade cryptocurrencies in a business-like manner, any gain or loss you make may be treated as windfall gain or loss, which may not be caught by the tax net at all, ie, you may effectively be treated like an amateur punter.
There may be a few situations where the gain or loss on the disposal of cryptocurrencies may be subject to capital gains tax. One situation could be where a cryptocurrency is being used as a medium of exchange to acquire or sell goods or services that are themselves on capital account or private in nature and the cryptocurrency was not acquired with the intention of making a profit. For example, you receive the cryptocurrency in selling a leisure yacht and you use the cryptocurrency soon after to purchase another yacht, then any gain or loss you make on the disposal of the cryptocurrency may be subject to CGT but you may be entitled to the 50% CGT discount if you have held the cryptocurrency for at least 12 months before its disposal.
There may also be other practical difficulties in calculating the tax impact on the disposal of cryptocurrencies. For example, it is not uncommon for holders of cryptocurrencies to exchange one type of cryptocurrency for another (which is usually expressed as a fraction of a whole cryptocurrency); assuming that the disposal of the original cryptocurrency may give rise to assessable income or allowable loss or, possibly a CGT event, you will need a valuation of the market value of the new cryptocurrency you receive in exchange to calculate the assessable income or capital proceeds and therefore the assessable income or loss or capital gain or loss on disposal. Given the price volatility of cryptocurrencies, their market value may vary from moment to moment, which could create a recordkeeping nightmare for tax disclosure and the Australian Taxation Office.
So what does this all mean in the context of cryptocurrencies as an investment?
Based on my arguably biased view and potential lack of understanding of the intricacies of this emerging technology, I think cryptocurrencies deserve to be recognised as an investment asset class simply because many of them have increased (and decreased) in value over time.
However, given that they do not produce an income stream and the value imputed to them at this stage seems to rely on the specific investor’s perception regarding their future, it is my view that cryptocurrencies carries a much higher risk relative to conventional investments. As a risky investment, it may produce spectacular returns or you may lose it all.
Therefore, whether cryptocurrencies should have a place in your investment portfolio will depend on your specific circumstances, which is why it is highly advisable to consult a properly licensed financial planner who works with you to balance your risk versus return requirements as part of your overall financial plan.