Cryptocurrency is at the center of today’s discussion and how these digital assets are changing the fabric of investing. To discuss these implications is Brian Jacobsen, Senior Investment Strategist with our Multi-Asset Solutions Team.

 

Brandon Brouillard: I’m Brandon Brouillard and you’re listening to On the Trading Desk®.

I’m really excited for today’s conversation around a topic that’s been dominating headlines recently within the investment industry, which is cryptocurrency and blockchain assets.

With this in mind, we’ll spend our time today talking about three themes within this arena.

The first, what are digital assets and why is everyone paying attention to them?

The second, how are these assets helping to facilitate the move toward digitization?

And the third, why is the investable world changing as a result?

And with me to discuss these implications is Brian Jacobsen, Senior Investment Strategist with our Multi-Asset Solutions Team. Welcome to On the Trading Desk, Brian.

Brian Jacobsen: Thanks for having me back.

Brandon: Thanks for joining. I really appreciate it. Let’s get started with building our understanding of digital assets. What is crypto and blockchain and why is it gaining so much popularity amongst investors currently?

Brian: Crypto typically refers to cryptocurrencies, and those are a type of digital assets that can be exchanged, right? A currency is something that can be exchanged for something else.

The crypto part refers to cryptography, so it’s a field of mathematics that deals with writing and solving codes where you can take information and obscure what it means.

We use cryptography all over the place, right? It can help secure and verify information that you have at the bank. It can also help secure your emails. And so cryptography, how it’s used as it relates to cryptocurrencies is about securing and verifying the ownership of these types of digital assets.

The blockchain is a type of ledger, like an accounting book of transactions. Or if you’ve heard of the register of deeds, so if you have a property, you know that you have to file a document with the register of deeds to effectively announce to the public who owns what.

And this ledger, this blockchain, it stores the ownership and transaction information. Now there are many different types of blockchains, but the one most people think of are where these records are stored, not in a centralized place, like a county’s register of deeds for property ownership records, but instead, it’s distributed across several computers that are linked. So it’s a way to have a decentralized record of ownership.

Now why is it gaining in popularity? Well, many cryptocurrencies have really shot up in price over the last few years. We’ve also seen the prices plummet for quite a few of those. And from conversations that I’ve had, a lot of people are interested in exploring these things because they either think that it’s the future of finance or they might be worried instead about the future direction of government-issued currencies with all of the fiscal stimulus and monetary stimulus that we’ve seen in response to the coronavirus crisis.

Now whether these perceptions are right or wrong isn’t for me to judge, but it does seem like that’s what has people really interested. Either they’re viewing it as far as kind of a technology and it’s the future of finance or they’re trying to view it as a way to maybe try to kind of play the idea that inflation could be picking up or maybe government-issued currencies could be going down in value.

Brandon: Well, that’s really interesting and exciting to think about the prospects for these asset types. And so I wonder if you can talk for a bit on how many different versions of digital assets there are and what makes one more appealing over another from an investor’s perspective?

Brian: Yeah, so digital assets, it’s a broad class of assets. And let’s think about what an asset is. An asset is anything that is expected to generate economic benefits in the future. And economic benefits, they don’t necessarily have to be dollars and cents. They could be anything that people attach value to.

A digital asset, then, is something that exists on a computer or a computer network. Pre-Bitcoin, I think most people thought of digital assets as things like documents, digital photos, videos, music, things like that.

Digitizing things was supposed to make life a lot easier to help replace the physical storage required for all that paper or for all those physical photos or the compact discs and things like that that we all had. So digitizing things, it also made things searchable and sometimes easier to share.

Now other assets can take a digital form, so it doesn’t just have to be files. You have cryptocurrencies where part of the value proposition seems to be about not needing to rely on a government issuer, so technology is supposed to, in a way, replace trust in the government to help make these types of currencies work.

Central banks are considering issuing digital currency and actually some already have. The Bahamas actually already has a digital currency. China is launching the digital yuan. And these could help provide nearly instantaneous payment services. They could also lower the cost of providing financial services, which could, in principle, provide banking services to the many, many people who don’t have access to reliable or trustworthy banking services in some of these countries.

One of the newest digital assets is the NFT, or the non-fungible token. Something that’s fungible is something that isn’t unique. It can be replaced with another identical item. If you think of your music files, because of their form, it would be really easy to just copy as many versions as you would like. So music companies obviously want to prevent that.

NFTs are kind of a way to authenticate the version that you have to say that it is the original, right? And so it’s being used for digital artwork and people are even creating digital worlds with digital real estate.

Brandon: That’s incredible. And taking a step back to the currency side, I’ve heard that most of these cryptocurrencies don’t actually have any underlying assets supporting them. And so with nothing tangible to point to, what is it that investors are really basing their decisions on when they make an investment or start to evaluate, say, a Bitcoin or a Dogecoin?

Brian: There’s lots of different ways to try to value these things. And just to kind of survey just a few of them because I’m sure that there’s many more, there’s a cost of production approach, there’s a network effects approach, and then a use value approach. Those are the three that I’ve heard the most about, but like I said, I’m sure that there are others, as well.

And so just to kind of step through these, some people think that something like blockchain, it takes resources in order to record the transactions. Cryptographic puzzles need to be solved and it requires specialized equipment, lots of energy in order to solve these puzzles in order to record the transactions.

And so, in a way, some people might think okay, well, the value of the coin must somehow be related to the cost of recording these transactions. Now I’m not sure how many people actually still subscribe to that because it’s kind of based on what I think is a flawed economic theory that was quite popular actually back in the 1800s and 1900s called the labor theory of value. The idea is that the more it costs to produce something, the more valuable it must be. That’s not necessarily the case because if you think about, if you’re building a road, it doesn’t increase the value of it if you suddenly instead of using an earth-moving equipment to use spoons or shovels instead.

Some people place the value based upon the network effects. That seems to be, I think, a more popular way to view it. Imagine if you have a phone but nobody else does, that phone isn’t really all that valuable. It’s only valuable when there is someone to call. So when there are more people to call and the network grows, it becomes more valuable. So people could look at some cryptocurrencies and try to base their evaluation on how many people are using it and how many people are likely to use it in the future.

Another approach is about the use value, as far as what are these things actually used for. Is it an exclusive way to get a particular service or product? Well, then you could find that the currency is valuable, even if it’s just a means to an end. Or is the use—and I’ve heard this as far as with many cryptocurrencies—as far as a secure and less expensive way to transfer money or things of value from one location to another. That’s kind of based on what’s the value of that service that’s actually providing. So that’s another approach.

There’s some others, as well, as far as you get into people look at the price movement and they confuse price for value and they just extrapolate out into saying that oh, if the price has gone up, maybe it’s going to keep going up. And so they base their investment on that just type of price movement. And that’s probably more borderline speculation, so they might not care so much about what’s the actual value of the cryptocurrency. It’s just more about trying to chase the price.

Brandon: And that’s really interesting and there’s so many different ways of looking at it, but the one thing that keeps popping into my mind is there’s got to be some obstacles for these, right? And so what obstacles exist today that make long-term and broad adoption a challenge for cryptocurrency and really digital assets at large?

Brian: That’s always a good question to ask is: what’s the downside and what are the threats?

And I think that there are quite sizable ones, really, where you could obviously have competition from other cryptocurrencies. Who’s to say that you’re hitching your wagon to the right horse when you are saying that one is going to dominate the others or survive? It might be supplanted by something else.

Or just competition from central banks. Governments often have a monopoly within their country of issuing legal tender, and legal tender is a technical term that refers to those things that the government decrees that you can use for settling debts or paying taxes. And so some people say that well, if you think about government-issued money that it doesn’t have anything backing it and in a way, it kind of does. If you think about, it’s valuable to be able to pay your taxes and avoid going to jail for not paying them and so that has value. If the government tells me that you can pay your taxes with it, that helps kind of create, I think, almost like a focal point for people as far as saying that well, what should I accept in exchange for goods or services that I offer? Well, since I have to pay taxes in a particular currency or whatever it is that I may as well accept that for these other transactions. And so that kind of gives it some inherent value as a way to coordinate people’s decisions as to what to accept in transactions.

But I think there are some regulatory issues that some cryptocurrencies are going to encounter. Governments have a vested interest in protecting consumers. They have an interest in protecting investors, and what are the consumer or investor protections associated with using some of these cryptocurrencies and how might those rules change?

And there is some precedent here. During the free banking era in the United States—and so that was a period of time from about 1837 to 1866—there were lots of private currencies. So before we had what we know as the greenback, or the dollar, there were lots of private currencies that were being issued during that period of time. Now many of them were of rather dubious value issued by what were called wildcat banks, because they claimed it’s backed by gold, but they’re located in the middle of nowhere where you’d have to fight off a wildcat in order to actually go redeem it. So that’s kind of where that term comes from. And so you had lots of currencies being issued of very questionable value. They traded at discounts to each other.

And so the U.S. government passed the National Bank Act of 1863 to end that. They effectively just passed a rule, taxed it out of existence, and eliminated them. That is possibly a risk here, as well. And if you consider the risk of money laundering, mail fraud, counterfeiting, all sorts of nefarious activity that the government has an interest in protecting people from, regulation could help improve things for these cryptocurrencies, but some of them just might not survive.

Brandon: And that’s always a consideration to keep in mind, the potential for being washed out. Thank you for that background. And so taking a step back, earlier you mentioned that there were some other digital assets in terms of real estate and NFTs, and I just want to make sure before we move on from that, I wondered if you could expand a little bit more on these in the potential value that exists with these types of assets.

Brian: I oftentimes like to think of these by analogy to things that maybe I can relate to or other people can relate to.

Like I have some prints of famous works of art and they’re lovely. They were very inexpensive, right? Because they’re just copies. The originals, those are highly valuable, and they’re in limited supply. Museums can charge admission to people to view the originals. I don’t think I could charge admission to someone to see the prints that I have hanging on my wall. So the original has value.

And in the digital world, NFTs are, in a way, an attempt to assign more value to the original. So NFTs are a way to take something that could probably be copied an indefinite number of times, and probably already has been, and to identify which is the original.

Then what gives them value? Well, their value is their uniqueness. With many, it’s probably best to think of them as being similar to collectibles. You know, like why are certain items more collectible and valuable than others?

And so the NFTs, the tokens, they can also be used to represent not just a claim to the original but maybe a claim to something of value in the non-digital world, almost like a digital certificate or a ticket. There are some instances where musicians maybe they use NFTs where you have the original album, but then if you have the NFT, it gives you maybe preferential access to going to concerts or to merchandise, things like that.

So it’s about representing the ownership claim, trying to make the original more valuable. But then also, people are using them in order to serve as a way to almost—I don’t want to call it create a virtual fan club kind of thing—but it is to give you sort of this token or this certificate in order to get access to other things that might be of value.

Brandon: Well, that’s great context for another thought that I had. And my next question is certainly going to be more of a reach, but the inner kid in me had to ask about blockchain. I’ve heard that legitimate businesses, auction houses, broadcasting networks, and others really see an application for selling these unique rights to demanded content. So how is this changing the way that individuals and businesses look at and treat the investable universe going forward?

Brian: The investable universe is always expanding and it seems like it is only limited by people’s imaginations. However, it’s also limited by what others will view as valuable.

Data itself can be valuable as you know from your interactions on social media and how ads pop up that are often directed directly at you. There’s lots of experimentation going on and it is really exciting to watch, but not every experiment works out.

I think it makes sense to think about what’s the need or the want that’s being satisfied. And not everything that’s made is really worth making. So businesses are experimenting. Some are probably going to be colossal failures and some are going to be immense successes. The tough thing is try to figure out ahead of time which one is which.

Brandon: That’s a great point, and we have about a minute or so left. And I wondered if you could share a parting thought for our listeners.

Brian: I hope that this has piqued people’s interest in the topic, and it is just the tip of the iceberg. There’s a lot more detail that you can get into on any one of these topics.

But one thing that I’d urge people to do, and this doesn’t just apply to this topic, but I think to just about everything, is to diversify your sources of information and perspectives on these topics.

It is so easy to come down on the positive or the negative side and then just burrow down that rabbit hole for the rest of your information. And then there’s just a lot of what’s called confirmation bias that goes on where it’s like oh, I’m not going to pay attention to any dissenting views and it kind of reaffirms what could be a wrong view.

My thinking on the topic has evolved over time and part of that is, I think, because I was open to being wrong. I was also open to being right, but I wanted to explore those multiple perspectives and never really just try to get all my information from just like one website or just one particular perspective on the topic.

Brandon: Brian, I’ll be the first to be the first to say that this has definitely piqued my interest, and I’m confident that it’s going to pique the interest of a number of our listeners. And so I appreciate the opportunity to speak with you today. This has been such an enjoyable and really fun conversation to have with you. And so thank you again for joining and sharing these insights.

Brian: Thanks so much. I really do appreciate it. It’s been a lot of fun.

Brandon: Well, that wraps up this episode of the On the Trading Desk podcast. If you’d like to read more market insights and investment perspectives from our investment teams, you can find them at our AdvantageVoice® blog.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on iTunes, Stitcher, Google Podcasts, or Overcast. Thanks for listening. I’m Brandon Brouillard and we’ll catch you next time.

 

Disclosure

Any discussion of digital assets is not intended to provide investment advice or a recommendation of any kind. Cryptocurrencies have substantially less investor protection than in traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. Virtual or cryptocurrency is not a physical currency, nor is it legal tender. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment, and a potential total loss of their investment. An investor could lose all or a substantial portion of his/her investment. Cryptocurrency has limited operating history or performance. Fee and expenses associated with cryptocurrency investment may be substantial. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not backed or supported by a government or central bank. Their value is completely derived from market forces of supply and demand, and they are more volatile than traditional flat currencies.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

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