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Why Legitimizing Cryptocurrencies Is Dangerous

Why Legitimizing Cryptocurrencies Is Dangerous

Finance and investing expert Robert Johnson explains why legitimizing cryptocurrencies as an asset class is a fool’s errand.

In a blog post last month, I addressed the speculative nature of committing funds to bitcoin and other nascent cryptocurrencies. While the recent trend in the price of bitcoin has been downward, interest in the overall cryptocurrency market has continued to grow.

Stories abound of cryptocurrency millionaires pocketing obscene sums of money, purchasing Lamborghinis with bitcoin and retiring to island mansions. A recent Bloomberg story detailed the case of several millennials who struck it rich trading cryptocurrencies and walked away from positions with top Wall Street firms such as Deutsche Bank, Goldman Sachs and BlackRock. One individual rationalized leaving his firm because “the one-day volatility of my portfolio is higher than my salary.”

Legitimizing Cryptocurrencies as a New Asset Class

Remarkably, there is a debate within the financial community as to whether cryptocurrencies represent a new asset class.

Most financial advisors would characterize the major asset classes as stocks, bonds, cash and real assets. The importance of asset classes is demonstrated by empirical studies demonstrating that asset allocation (the broad categories of assets) is more important than security selection (the specific securities within an asset class) in determining ultimate portfolio performance.

To find a parallel to the sudden prominence of cryptocurrencies, one only need to go back a few years to the rise of hedge funds. Although some people refer to hedge funds as an asset class, they’re more accurately defined by their strategies (long-only, equity long-short, event-driven funds, global macro funds, etc.).

The Importance of Asset Class Labels

Asset class labels can make a profound difference, as they can influence asset allocation decisions by investors. Many foundations, endowments, and public pension funds shifted a significant portion of investments away from traditional stocks and bonds and into carefully selected hedge funds, private equity, real estate, and other alternative investments. Following the so-called “Yale Model” (named after the university endowment that popularized the concept), institutional investors plowed assets into hedge funds and other alternative investments, only to be disappointed because the strategy underperformed in spite of high fees and proved to be illiquid.

Labeling cryptocurrencies as an asset class (or as a currency, for that matter) is laughable, but that the debate even exists shows that cryptocurrencies are capturing mindshare of the investing public. Of course, for all of the excitement around the topic, few can cogently explain how cryptocurrencies interact with blockchain technology, how they are “mined,” which tokens will ultimately prevail in any sort of business application, or other important details. What do the facts matter as long as the game is afoot and fortunes are being made?

Cryptocurrency advocates gain markedly if the debate even takes place. The primary catalyst of legitimizing cryptocurrencies is the financial news media. Logging on the Yahoo! Finance homepage, one finds the price of bitcoin prominently positioned between the Dollar/Yen exchange rate and the level of the FTSE 100. It is one of only 17 assets/indices listed. And, by the way, a banner ad appears extolling the reader to “Mark your calendars for the All Markets Summit: Crypto.”

The Role of Financial Media

One of the major sections on Bloomberg.com (alongside Politics, Markets, Technology, Fixed Income, Economics, etc.) is Crypto. Five “currencies” are listed at the top of the screen in the FX section of CNBC.com: Euro, Yen, Pound, Canadian Dollar and Bitcoin.

I am sure the financial news media would respond by saying that they are simply reporting what their readers or viewers demand. While true, providing legitimacy to an unproven commodity sets a dangerous precedent and blurs the line between true news and entertainment. I am reminded of Jon Stewart eviscerating Jim Cramer on The Daily Show in 2009.

Perhaps the height of absurdity in the crypto market is the recent report of a Cayman Islands start-up company that raised more than $4 billion through a yearlong sale of digital tokens. But the buyers of the company Block.one don’t know how the money will be used.

What We Can Learn from History

While it may seem unprecedented that investors would be willing to commit funds essentially “sight unseen,” there is ample historical precedent. Over 300 hundred years ago in Great Britain, the South Sea Company was granted monopoly trading rights with Spanish colonies in South America and the West Indies. On the surface, what could possibly go wrong: a whole new world to conquer and certain fortunes to be made! In reality, the company was the ultimate speculative endeavor, as it had no real assets or even any tangible prospects. Yet many investors committed funds, watched their shares rise, and ultimately crash.

What we can learn from history is that greed shows no bounds. The South Sea Company wasn’t the only speculative firm to raise capital without a solid business plan during that time period. Among the many companies to go public in 1720 is—famously—one that advertised itself as “a company for carrying out an undertaking of great advantage, but nobody to know what it is.”

Raw intelligence doesn’t insulate one from succumbing to FOMO – The Fear of Missing Out. None other than Sir Isaac Newton lost his fortune investing in the South Sea Company. He was quoted as saying “I can calculate the movement of stars, but not the madness of men.”

Believe what the great man learned and shares with us for our benefit. When it comes to cryptocurrencies, don’t be like Ike.

Robert R. Johnson, PhD, CFA, CAIA, CLF is Principal, Fed Policy Investment Research Group, LLC in Charlottesville, VA. He is co-author of the books Strategic Value Investing, Invest With the Fed, Investment Banking for Dummies and The Tools and Techniques of Financial Planning.

Robert R. Johnson, PhD, CFA, CAIA, is a Professor of Finance in the Heider College of Business at Creighton University in Omaha, Nebraska. He is co-author of the books Strategic Value Investing, Invest With the Fed, Investment Banking for Dummies, and The Tools and Techniques of Investment Planning.