Can Crypto Go to Zero? You Betcha!

Can Crypto Go to Zero?

You Betcha!

Of all the asset classes traded today, none has the need for a collective set of beliefs as much as cryptocurrencies.  These virtual assets fluctuate widely in value, which is set supposedly by supply and demand.  The problem is that, with no central place to trade, transactions are taken on faith. There is no validation of the volume of trades, much less the trades themselves.

Crypto is a marriage of technology with the utopian ideals of libertarianism. With cryptocurrency, there is no way for a government to trace a transaction, making it ideal for those who want to evade government oversight and taxation.  It also attracts the criminal element, who find the lack of tracing appealing for different reasons.  Cryptocurrency such as Bitcoin is a standard tender for ransomware attacks, as payments cannot be traced in the manner of bank transfers or wires. 

While there is no central location for cryptocurrency, there has to be a way to transfer title from one party to another.  There also needs to be someone who controls the issuance of the currency so that the market is not flooded with so much currency it loses its value.

This assumed restraint on currency creation is the heart of crypto appreciation.  Bitcoins that sold for $800 a few years ago now go for $50-60,000.  Naturally, this rapid appreciation has attracted others who believe that crypto coins can only go up.

It also attracts those who may have otherwise invested in gold.  Some people believe gold is a store of value, especially during inflationary times.  Since the amount of new gold produced is small relative to the amount of gold outstanding, gold is assumed to be an excellent barometer for inflation.  The idea behind tying the growth of gold back to currency creation is to prevent materially more currency from being created and a rise in prices along with it. The key difference is that gold production is tangible and traceable.  Cryptocurrency is neither.

The US Government is very interested in who invests in cryptocurrency.  It is assumed by the IRS that such purchases, if unreported, are to avoid taxes by trying to make financial assets untraceable in an effort to spirit them out of the country undetected.  Buying Bitcoins are thus, in theory, a way to ensure IRS audits for the rest of your life. The IRS has categorized crypto investments as subject to capital gains taxes, which is to say they want to know if you have them, and what you gain on trading them if you do.

All of this is to say that regulation of crypto investments is coming. While some investors may consider such compliance with reporting requirements voluntary, the IRS will take a very dim view on unreported assets.  With this requirement, the crypto world will be fenced in much as was the American West in the late 19th century.

There have been reports of criminal elements hacking into crypto vaults to try to seize the coins for themselves.  In spite of this, the attitude of some investors towards crypto is to party on.  Such invasions of crypto exchanges are often not reported, as such would be bad for business.  As for the fleeced crypto owners, how can you report the theft of an asset you never acknowledged owning?

Significantly, no one seems to ask how a currency became an item of speculation.  Usually, a currency represents a stable value.  The purchase of Bitcoin by the young and naïve for speculation represents perhaps one of the later chapters in their existence.  

So how does this end?  Badly.  Like Dutch tulip bulbs, the value of Bitcoin and other cryptocurrencies exists at the pleasure of supply and demand.  Should value decline, more coins would be required to make the same dollar transaction.  Should faith in their soundness be successfully challenged, then the game will be up.  With no government or other body standing behind the coins, their value could fall to zero. 

The idea of a currency, independent of a government and readily tradable, is as old as gold.  However, to the extent its use acts as a competitor to legal fiat, do not be surprised when no central bank will come to the aid of the crypto investors. With nothing more than perhaps a variant of the Wizard of Oz standing behind it, the ability of cryptocurrency to survive having its legitimacy questioned is problematic.  Like the tulip bulbs in Holland, the aftermath will be both painful and sobering.  The scale of the losses could measure in the billions of dollars, assuming people are willing to admit to them. 

The Economy

Coming out of Covid, the economy is doing well. Supply chain disruptions are still making manufacturing and retail less than optimal.  We are perhaps one to two quarters away from a more normal supply. 

Next year will likely see, for most businesses, the first expansion of revenues since the pandemic.  2022 will finally outperform 2019.  The infrastructure spending should help ensure that business and employment are good.

Interest Rates

Interest rates are widely expected to increase in 2022 – the question is how much.  The end of the government bond-buying program will be a de facto interest rate increase, as there will be fewer dollars in circulation.  The taper program, supposedly started last month, has already seen interest rates on home mortgages go over three percent. 

Some people are calling for aggressive interest rate hikes to stem inflation.  Inflation will, in some ways, take care of itself.  While we will likely see positive interest rates in 2022, a decline in inflation will make that more easily attainable than otherwise the case.

Inflation

Inflation, so much on people’s minds now, will partly recede in 2022.  Oil prices should decline next spring, as rising domestic supply along with OPEC’s gradual increases counters prevailing prices.  Shipping should hopefully be sorted out by then, with the off months after December giving ports time to rationalize how they do things.

The semiconductor chip shortage should also resolve itself, at least for the less sophisticated chips.  Coming out of this will be better coordination between product designers and chip suppliers.  This industry, which has principally been driven by price, may see more in the way of long-term contracts for a fixed amount of chips, at least by its larger buyers.

The Stock Market

Rising interest rates will bring down the curtain on an era of investing.  It need not bring down the overall stock market.

Normally, low-interest rates favor high-growth companies.  If both interest rates and inflation are low, growing companies are often seen as being the only firms that generate excess returns.  With low-interest rates, the cost of attracting capital to grow is minimal.

As interest rates increase, growth firms are saddled with higher costs and stiffer terms for incremental capital to fund their expansions, while more established firms get a higher return on their cash flows.  Also, even private equity and hedge funds have to pay more for investment funds, making their ventures less profitable.

More established companies with the ability to grow cash flow will begin to share the floor with the less seasoned upstarts.  Also, should there be a crash in something like Bitcoin, there will be a lesson that not all market disruptions are positive. 

The staff at Barnett & Company wish you and yours a safe and happy Thanksgiving! We are so grateful for you.

Warren M. Barnett, CFA

November 23, 2021

Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or elizabeth@barnettandcompany.com

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