With interest rates all around the world at rock-bottom levels and the prices of shares and property sky-high, some people become attracted to the idea of buying something out of the ordinary.

Cryptocurrencies seem to fit the bill, but are they really worth it?

What is a cryptocurrency?

Digital currencies are no longer as exotic as they sound. They’re simply currencies stored and transferred electronically, with no physical form.

Cryptocurrencies are a particular type of digital currency, whose key feature is that they’re ‘decentralised’ – not backed by an authority like a central bank.

Instead, a network of computers keeps track of transactions and produces new currency. It uses blockchain technology to try to keep the currency safe from fraud and misuse.

Bitcoin was the first cryptocurrency to be created, in 2009, by the anonymous developer ‘Satoshi Nakamoto’, and it is still the biggest and best-known.

Not just about Bitcoin

But Bitcoin is far from the only cryptocurrency. There are well over 1,000 now: others include Ether, Litecoin and Cardano. Some of them, like Bitcoin, have no fixed price. But there are variations on this theme.

For example, there are some so-called ‘stablecoins’ whose value is fixed against a conventional currency or precious metal, such as gold, but which use similar technology to Bitcoin. The best-known is Tether.

Rollercoaster ride

Investors in Bitcoin have had a rollercoaster ride. In January 2017, one Bitcoin was worth less than US$1,000. By December that year, it was over US$19,000, before it plummeted to US$3,200 in December 2018.

At 10 November, its price was US$9,074. This shows both its attractions and its drawbacks – the scope for huge profits, and its apparently crazy price gyrations.

Other cryptocurrencies have followed similar trends to Bitcoin, and some have been even more volatile.

Will Bitcoin replace other currencies?

Fans of Bitcoin claim it will eventually replace money. This is in part because they believe its value cannot be eroded by inflation. The supply of Bitcoin is limited by an algorithm to 21 million, most of which has already been digitally ‘mined’ by computers solving mathematical problems.

But most economists doubt that a cryptocurrency will replace currencies such as the dollar, pound or euro.

The risk of inflation eroding the value of these currencies is surely smaller than the risk of another plunge in Bitcoin’s price. In any case, for most purposes conventional currencies do a better job.

The number of active investors in Bitcoin is tiny, and most are in it for speculative or investment purposes. Very few goods or services can be bought with Bitcoin, apart from illicit drugs and weapons.

Moreover, even Bitcoin, the most well-established cryptocurrency, is highly illiquid. People have found it hard to sell in exchange for cash when they needed to.

Transactions are slow, only three or four every second. Compare that to Visa’s over 3,500 transactions a second.

On top of that, Bitcoin has a horrendous carbon footprint, due to the phenomenal amount of computer power required. Even a couple of years ago, the total electricity Bitcoin mining used was the same as that used by a country like Switzerland.

Even if a digital currency did replace money, it might not be Bitcoin. New cryptos are being created all the time and some may have better technology or features.

If digital currencies have a long-term future, it’s more likely to be through central banks issuing a digital version of their own currencies. The Bank of England and the Swedish Riksbank are already looking into it. But that would be very different from a standalone digital currency and wouldn’t be an investment opportunity.

Is Bitcoin a bubble?

Bitcoin shows all the hallmarks of a speculative bubble. Its ‘true’ value can’t be determined because, unlike bonds or shares, it doesn’t generate income. And unlike gold, it’s not useful or beautiful.

Most people who invest in Bitcoin do so because they think its price will go up, not because they believe in its intrinsic value. That’s not a solid basis to invest your retirement money in.

My best guess is that Bitcoin will eventually disappear. Its value could collapse after a crackdown by regulators. Or it could be destroyed by a computer hacker, like the one who attacked the Mount Gox Bitcoin exchange in February 2014, causing prices to slump.

Interest in Bitcoin could fade when fashions move on to something new. But the price could easily rise a lot further before it falls.

What does the regulator say?

The Financial Markets Authority (FMA) says cryptocurrencies are high risk, highly volatile, and are not regulated in New Zealand. If you’ve bought cryptocurrencies you’re more likely to be a target of online fraud and scams, the FMA says. Before you invest, it says to understand common warning signs of a scam and the steps you can take to protect yourself. Read more at fma.govt.nz

Published 13 December 2019

This article does not contain any financial advice and has not taken into account any particular person’s circumstances. Before relying on it, we recommend you speak with a financial adviser. This story reflects the views of the contributor only. Content comes from sources that we consider are accurate, but we do not guarantee that the content is accurate.