Cryptocurrencies: Handle With Extreme Care
Like you, we've been following the development of cryptocurrencies with great interest, as investors are understandably excited by bright, shiny objects with excess return potential.
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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.
This post provides an overview of Callan’s thoughts on the subject, and our white paper explores the subject in greater detail.
Some quick definitions
- A cryptocurrency is a digital asset designed to work as a medium of exchange, and it uses cryptography to secure transactions. Such a currency is implemented with a system that controls the creation of additional units and verifies the transfer of assets.
- Cryptocurrencies use decentralized control. 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.
- Cryptocurrency exchanges let customers trade cryptocurrencies for other assets, such as fiat money or other digital currencies.
- 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.
Are cryptocurrencies safe?
Mt. Gox, a bitcoin exchange based in Tokyo, revealed several years ago 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). Unfortunately, this was not an isolated incident, and additional attacks on exchanges remain prevalent as sophisticated hackers continue to find security flaws.
Due to 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.
Are they liquid?
No, cryptocurrencies are not very liquid. For example, the price of bitcoin (the most liquid cryptocurrency) may fall hundreds of dollars before a user can fully sell out of a position if there is a massive sale. That illiquidity is a headwind to institutional investment.
Are they taxable?
The U.S. 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— it 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.
Are they volatile?
In a word: extremely. Bitcoin declined 39% in just one month.
Are they ready for prime time?
Cryptocurrency gained widespread traction in 2009, but it remains early days for this asset type and the emergent technology of blockchain. The outsized volatility, illiquidity, tax implications, and concerns over the security of the system infrastructure give Callan pause. Potential investors, especially those acting in a fiduciary capacity for an institutional fund or trust, should take extra precautions before making an investment.