Cryptocurrencies are an exciting new form of technology with the power to shake the foundations of the financial world. Dr. Keith Black explains the risks and possibilities.
Cryptocurrencies have exploded in popularity—and controversy—in recent years, and they show no signs of ceasing their disruption of traditional market mechanisms. Dr. Keith Black, managing director and program director of the FDP Institute—an organization dedicated to training finance professionals in data science—delved into the intricacies of crypto in a recent presentation at IE Business School.
According to Dr. Black, cryptocurrency presents various advantages over traditional bank and brokerage ledgers. Since it is a public, decentralized transaction record of assets, it is less vulnerable to the security risks that might harm the financial integrity of a single bank or financial institution. Cryptocurrency can be broken down into two fundamental components: blocks and chains. These components form a blockchain of financial data on transactions that can be distributed around the world. Blockchain transactions are safe and immutable.
Examples of crypto such as Bitcoin have offered a key innovation by solving the double-spending problem, he states. Digital assets recorded in blockchain cannot be spent more than once. Transactions are updated every 10 minutes and a complex Proof-of-Work problem is then performed to understand the encrypted transactions data—hence the term “crypto.”
Another key advantage is the full transparency that blockchain allows. Data on transactions and values cannot be hidden, so no deception about assets is possible. Furthermore, blockchains can be used to store any type of information records, including health, academic and property, and so on.
Cryptocurrencies and decentralized digital assets are particularly appealing to those who live in countries without a strong national banking system or currency.
In these cases, he adds, they offer a more secure and likely less volatile means of maintaining one’s assets than the local currency. Furthermore, cryptocurrencies are international and unlinked to any particular local financial system. Bitcoin has even been recognized as a form of legal tender in countries such as El Salvador to reduce remittances.
On the other hand, there are significant risks to crypto, the main one being custody. How do you keep your coins safe in a completely digitized environment? While it is possible to keep crypto money on a centralized exchange platform that functions in essentially the same way as a bank—with passwords, logins and the possibility of passing your assets on to family members—such platforms are vulnerable to cybersecurity attacks.
Alternatively, Dr. Black notes that it’s possible to place crypto assets onto a physical USB that you keep safe with you. However, if something happens that destroys the USB or makes the data inaccessible, the assets are no longer accessible.
A further major drawback of crypto is the technology risk. Crypto codes lay out all of the rules, limitations and functionalities of the given currency. It’s the user’s responsibility to read and understand these and decide how they want to proceed. Additionally, in line with the principle of full transparency, many crypto codes are open-source, so their codes are fully publicly available. With limited intellectual property protection, it is very easy for users to copy the code of one crypto, make alterations and totally disrupt the value of the original code.
Given the novelty of cryptocurrencies and digital assets, not all countries have established appropriate legislation for managing them. This can place you in a legal gray area regarding taxes and you may find yourself limited by regulations that restrict your ability to trade, export or even own crypto.
An additional and perhaps unexpected consequence of cryptocurrency is its detrimental effects to the environment. The thousands of computers worldwide that solve Proof-of-Work puzzles and maintain digital assets ledgers for users consume a jaw-dropping amount of electricity—more than the consumption of entire countries like the Netherlands, Argentina or the UAE. This has serious consequences in terms of emissions and remains controversial, though Proof-of-Stake-based cryptos may offer a solution.
For Dr. Black, an important consideration when investing in cryptocurrency is its volatility. Even established cryptocurrencies like Bitcoin and Ethereum exhibit tremendous market volatility that may make you hesitate to invest, but they are also valued at $840 billion and $370 billion, respectively—60% of the entire cryptocurrency market.
However, there are other cryptos—and there are over 18,000 cryptocurrencies available on the market—that are likely to ultimately lose their value completely.
When evaluating a cryptocurrency for investment, the main indicator to look out for is whether it has a business model.
Bitcoin serves as a great example because it has a limited number of coins that are released at intervals, meaning that the coins’ value remains unaffected by inflation. But not all cryptocurrencies have a model that eliminates inflation through careful issuance procedures and even a crypto with a strong business model like Bitcoin are an investment risk. Dr. Black emphasizes that one should never place 100% of their capital into any investment, recommending instead a 1% to 2.5% allocation of one’s funds into a single crypto investment to avoid increased risk while still enabling improved returns.
Despite their risks, crypto and digital assets are making major waves in financial markets across the world. Though they pose a unique set of challenges, their transparency, flexibility and digital nature are a logical response to the needs of an increasingly globalized marketplace.
This presentation is just one of the many activities carried out by the partnership between IE Business School and the CAIA Association, which aims to promote the education of alternative investments professionals. In fact, IE Business School is the first business school in the world to offer CAIA members—and candidates who pass Level I—scholarships to study a finance program. Additionally, top students in the Master in Finance receive a full scholarship to sit for the CAIA exams. This partnership is yet another example of IE University’s real-world connections and its emphasis on preparing students as completely as possible for the professional realm.