Are cryptocurrencies the next Beanie Babies – a brief and bizarre craze that will soon pass - or is it the future of finance that savvy investors should claim a piece of today?

Prior to 2020, cryptocurrency technology and investing were still quite fringe. In 2021 however, mainstream investors took notice as Bitcoin and other tokens finally started to be used for legitimate and legal commerce. And of course, who could miss the headlines of all the people apparently getting rich off crypto? Given all this activity, we at Longwave felt this was the right time to provide our insight.

To many observers, today’s crypto-frenzy feels like the California gold rush. In that era, the promise of mining riches out of the ground lured hopeful prospectors into make the long, expensive and dangerous journey west… but the gold did not give itself up easily. A few made small fortunes but most were left penniless or worse. Still others made a living off the migration - running stores, saloons, laundries, and boarding houses, creating towns and cities that exist in California to this day.

In the 170 years since, there have been many more ‘gold’ rushes. In the last 30 years alone we’ve seen frenzies for dot-com stocks, bio-tech, and baseball cards, all with similar investment trajectories. A rush of irrational speculation, a crash and then the emergence of a few strong, high-quality investments.

Over the past several years, the hottest investment category by far has been cryptocurrencies. In 2021 alone there were crypto coins that gained 1,000, 13,000 and 43 million percent (and many that crashed or were simply scams).

Today, there are cryptocurrency conferences, clubs, newsletters, criminal gangs, billionaires, reporters, and every other kind of associated interest group looking strike it rich – like getting in on the ground floor of the internet. Few people understand what these coins are, but more and more, regular folks are nervous they could be left behind.

For more sober investors, opinions vary from every portfolio should have a little, to it’s all a big Ponzi scheme. At Longwave we believe it’s important to understand new technologies but fear of missing out is a powerful emotion that can only be combatted with patience, perspective and knowledge.

History of Digital Currencies

Bitcoin, launched in 2008, was the first cryptocurrency. The idea behind Bitcoin was to create a utopian cash alternative where finance is decentralized (DeFi). Crypto-currency idealists, then and now, envision replacing regular currency to (1) protect people from governmental financial oversight and (2) disintermediate the banking system.

Regarding the first, many people prefer to do their business in private and cryptocurrency promises this capability. The second goal aims to break the banks’ costly and inefficient transaction-processing monopoly. Every time a credit card is swiped, a bank takes a 3% cut. Every time a home is sold, there is a 5-6% commission. If there were a means to purchase things and settle contracts without these middlemen, the global economy could repurpose trillions of dollars of savings into more efficient, beneficial uses.

However, banks, brokers and governments perform an important and ubiquitous function related to trust and transactions. For instance, they help combat fraud which greases the wheels of commerce. It’s a tall task to try to replace or improve on the status quo. The advent of Bitcoin became the first step in creating a technology that could verify and enable transactions between companies and people worldwide but potentially at much lower cost.

Bitcoin’s innovation was to utilize a technology called blockchain to verify transactions. People called “miners” would use powerful computers to do the work of verifying these transactions and create ledgers that store transaction history forever. In return they would receive new Bitcoin.

Initially Bitcoin caught on at the fringes of economic activity. Because it was designed to be untraceable it became very popular with criminal enterprises. Additionally, the value of Bitcoin was minimal because there was no tangible profit in doing the work of verifying these transactions. Mastercard has a way of taking a cut when something is purchased but Bitcoin miners at that point did not.

But throughout the 2010’s interest grew as use-cases expanded. However, at the same time Bitcoin was experiencing major growing pains such as governmental bans, emerging competition and cyber-theft of ‘digital wallets’. This caused major volatility in its price.

Now, when something is volatile and tradeable, it becomes investable, regardless of its intrinsic value, and so interest in Bitcoin as a stand-alone investment began. As the price of Bitcoin fell and rose, technologists, speculators and the simply curious began to jump in. And because the market for Bitcoin was tiny and illiquid, new money coming in had an out-sized impact on price movements.

Yet, just like the first automobiles, it was quickly realized that Bitcoin may not actually be very good at what it was designed to do and that there was massive opportunity to improve upon it. Processing digital transactions (mining) through the Bitcoin blockchain is incredibly energy-intensive. Indeed, if you were to purchase a cup of coffee at Starbucks with Bitcoin, it would take ten times the amount of energy to verify that transaction than to make that cup of coffee.

Quite early on, groups of technologists began trying to create better, more efficient versions of Bitcoin (including Bitcoin administrators themselves). ‘Alt-coins’ such as Ethereum popped up claiming to verify transactions and contracts more efficiently and with much lower energy requirements. Then others came along claiming to be more efficient still. As the price of Bitcoin rose, the opportunity to create new alt-coins for a variety of uses was compelling to hopeful entrepreneurs. Today there are hundreds of alt-coins.

The best way to think about these alt coins (at least the non-meme ones) is that each one is a unique technology created to solve a problem related to improving digital transaction execution and verification. Each coin is a tech firm. Many of these technologies are themselves de-centralized: designed and managed by a group of coders and hobbyists. These computer scientists essentially give their work away for free because if their technology for running the distributed finance economy wins, the creators will become rich by holding a large amount of the coins that represent that technology. This is very similar to a company going public but with none of the regulatory oversight or consumer protections.

Even in 2022, with the internet still ‘young’, a currency that can become ‘native’ to the internet will have a very important and valuable function (verifying transactions, etc). That is a real service that banks, credit card companies and other intermediaries currently perform quite profitably. It’s quite possible that one of these alt-coins will end up representing the winning platform and reward today’s investors.

Yet, for one technology to win, many others need to fail… anyone remember AOL, Netscape and Ask Jeeves? Google, which is the dominant internet company today, didn’t even go public until 2004, twenty years after the internet was started.

In other words, we believe blockchain is an incredibly important technology that has the power to disrupt the entire global payments system. But we have no idea which company or companies will capture and monetize this opportunity. It’s possible Bitcoin will be the winner but history suggests first is not always best. Indeed, it’s possible the company that will be the Google of crypto has not even been invented yet (according to our investment analyst Brandon Wester, that inventor is probably still in college!).

Investing in the Crypto Space

Just like cryptocurrency is a young and unproven technology, investing in crypto is also young and unproven. It’s also worth asking, is cryptocurrency even an ‘investment’? Just because there is a limited supply of something does not mean a thing necessarily has utility. We invest in things that have value to us, like medicine, shelter, food and entertainment. The potential value of cryptocurrencies is still unfolding and which coin will capture that value, we think, is still unknown.

Thus, in our view, there are currently four types of cryptocurrency investment approaches: creators, speculators, accumulators, and facilitators.

Creators, we have mentioned, invest their time developing blockchain technologies in the hope that theirs gets adopted through coin usage. Some are amateurs and others are backed by billion dollar corporations like Facebook (now called Meta in recognition of the anticipated digital future).

Speculators are investors hoping to take advantage of market exuberance to make bets on price swings in either direction – up or down. These types of investors often buy from one another, with new money justifying higher and higher valuations. Because speculators prefer volatility, they tend to trade more in obscure “alt-coins” and crypto futures.

In the late 90’s dot-com stocks represented the volatile and emerging technology du jour. High-potential, profitless companies had day-traders in a frenzy. Like today, bankers and baristas alike were quitting their jobs to day-trade dot-com stocks full time. In the end, it’s likely less than 1% of investors became wealthy from this activity, having gathered their gains from the losses of the other 99%. Today, those folks are considered business legends: Mark Cuban, Marc Andreesen, Peter Theil. We don’t remember the 99% unless you were one of them.

For dot-com stock accumulators the story was hardly better at first. If you invested $10,000 in Nasdaq in March of 2000, by October 2002, you would have had roughly $2,400. It would have taken you until April 2015 to get back to $10,000. Only today would that investment have paid off with a value of just over $30,000. All in all, a return of just 5.82% per year as of end 2021.

The only way to have made money was to have avoided the tech sector entirely during the early 2000’s when valuations, like today, made no sense. However, if you were among the very few brave enough to get in after the 2000-2002 meltdown, investing in a passive basket of tech stocks, would you have been reliably rewarded you with over a 13% average annual return.

Finally, the last type of crypto investor is the one we call the Facilitator (for lack of a better word). Just like the suppliers who served old-west prospectors, this strategy looks for companies that provide the infrastructure that allows the crypto economy to function. These include chip makers, crypto exchanges, and blockchain innovators. In-fact, many of these companies are actually profitable and can be purchased today cheaply and efficiently through targeted index funds.

Of these four investment approaches, all currently display tremendous froth and entail significant risk of principal loss. We encourage you to continue speaking to your advisor at Longwave about this nascent landscape.

Final Thoughts

Finally, it’s important to remember that in the halcyon days of the 90’s the dream of the internet was to democratize everything and give the power of information back to the people. Perhaps inevitably, today the internet is run by a handful of incredibly powerful corporations, that harvest personal information, and governments that in many cases, use the internet to restrict freedom.

In fact, China recently launched its own cryptocurrency which eliminated fees and inefficiencies but provided the Chinese government complete visibility into users’ movements and financial activity.

Yet that doesn’t mean we shouldn’t continue to support innovation. During the mid-eighteenth century, China’s Qianlong unilaterally rejected trade and engagement with the west. Europe, which had to that point been on par with China militarily, sprinted far ahead of China over the next two centuries. Today China, and at least 50 other countries, ban cryptocurrencies either implicitly or explicitly. While we have strong conviction in global diversification, one thing we can be fairly confident about is that the future of digital currency will almost certainly emerge from our own backyard.

This article is intended strictly for educational purposes only and is not a recommendation for or against cryptocurrency.

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