Although cryptocurrencies have been around for a while, in recent months they are something I, and probably yourselves as advisers, have noticed being mentioned more often in client assets or in conversation. But what exactly are ‘cryptocurrencies’ and what exactly is the FCA position on them?
On as a basic level, cryptocurrency is a form a digital currency that operates on a medium called the blockchain. Many different cryptocurrencies are available, but all are formed on slight variations of the blockchain (take Bitcoin, for example).
The blockchain essentially is a publicly available database holding records on each cryptocurrency transaction. This forms a Digital ledger.
This is very similar to a bank’s ledger, however in the case of a traditional bank, transaction records and account details are only accessible by a single entity and are not in any form publicly available. With a bank only having access to these transaction records, this forms what we know as a ‘centralised’ approach. When a transaction is required, one bank exchanges queries with another bank to confirm required funds are present in the requested account number and agrees a withdrawal. A small transaction fee is charged to the bank which is responding to the query.
In a ‘decentralised’ approach (as is the case with crypto assets), all the records of each transaction are publicly available and no single entity has ownership over the records. Instead, the records of all transactions ever made are duplicated to every person/device participating in the entire blockchain network.
In a cryptocurrency world, you still get an ‘account number’ but it’s in the form of a hash (160 alphanumerical characters) and is called a wallet. While the funds in this wallet are also publicly available, they cannot be linked back to an actual person. When a request for a transaction from one wallet to another is made, the cryptocurrency wallet is queried by multiple persons/devices involved in the blockchain network to confirm the funds are available, only after multiple verifications have been made are the funds transferred.
So, how exactly is cryptocurrency made, if not through a government or a physical asset? This is where mining comes into the picture. The process of mining cryptocurrency involves a piece of software installed on a computer. This software uses the processing power from the computer to perform verifications of each of those transactions, by cross referencing of all the records in each node in the blockchain, to ensure a transaction took place. By performing verifications of these transactions, a small reward is given in the form of the cryptocurrency on which the transactions are being checked and this is paid directly into a wallet.
Since these records are not owned by a single entity this gives benefits around security. Everyone has a copy, so if someone attempted to hack or insert falsified transaction records into the blockchain these records can be quickly identified by cross referencing records from all the persons/devices in the blockchain. With current technologies, this makes it incredibly difficult, if not impossible for someone to successfully create a hack or counterfeit, as every record on every node involved in the blockchain would have to be adjusted, as once these records have been verified, they are stamped and cannot be changed.
So that’s how cryptocurrencies are made and work. But what then, are the issues surrounding them?
There are a number of controversies and future issues which plague cryptocurrency. Firstly, in the case of Bitcoin for example, is its scarcity. Only a finite amount of Bitcoin can be mined, and Bitcoin will be fully exhausted at 21 million coins. At present, there are around 18.6 million coins in circulation. It is expected that the current remaining coins will be fully mined by 2040.
Another point, which is an important consideration, is the impact on the environment. A study by the University of Cambridge found that the amount of energy required by the Bitcoin network each year is c.115.57 TWh. To put that into context, the entirety of the Netherlands only uses c110.68 Twh per year, and the amount of electricity consumed by the Bitcoin network in one year could power all the kettles used to boil water in the UK for 26 years.1 In a world where we are trying to reduce our carbon footprint, this asset in particular isn’t the most environmentally friendly, or sustainable at present.
Following the concerns surrounding the environmental impact, Tesla have in recent weeks suspended the purchase of cars with bitcoin due to climate concerns, which resulted in a 10% drop in the cryptocurrency.
In addition, there are concerns surrounding the decentralised cryptocurrency’s potential to destabilise or undermine the authority or control of central banks. Governments themselves have concerns that this form of currency could be used to more easily aid illegal activity, such as money laundering or to aid illegal purchases with more difficulty in tracking the origin of the funds. There is also the impact on monetary policies. Governments increase and restrict the amount of currency in circulation, to stimulate the economy or to avoid out of control inflation, and so control over currency is an important point going forward.
In addition to these points, are the general concerns around the risk and volatility of these assets. The FCA have stated that, “Investing in crypto assets, or investments and lending linked to them, generally involves taking very high risks with investors’ money. If consumers invest in these types of product, they should be prepared to lose all their money.” 2
Anyone who loses money on cryptocurrency is unlikely to be covered under the FSC scheme which would usually cover losses up to £85,000 on fully regulated products. They also would not be eligible to settle complaints or apply for compensation via the financial ombudsman service against offending firms.
The FCA considers these products to be unsuitable for clients due to the potential harm they pose to investors. The FCA has also stated that, “ These products cannot be reliably valued by retail consumers because of the:
- inherent nature of the underlying assets, which means they have no reliable basis for valuation
- prevalence of market abuse and financial crime in the secondary market (e.g. cyber theft)
- extreme volatility in crypto asset price movements
- inadequate understanding of crypto assets by retail consumers
- lack of legitimate investment need for retail consumers to invest in these products.“ 3
And as such, they have banned the sale of crypto-derivatives to retail consumers. These are major concerns, and as you can see, the potential harm to end clients is clear.
This hasn’t put many investors off placing money into cryptocurrency of their own accord, however. There has been a large number of younger investors into cryptocurrencies, with one study by U.S. financial group Charles Schwab, finding that 51% of participants between 18-31 invested into or traded cryptocurrencies.3 This was in comparison to just 25% buying or holding direct equities. Although this is only one study, enough younger people are investing into cryptocurrency for the FCA to have commented on it, with the FCA publishing research findings into understanding why younger investors are willing to take more risk in this regard. The research found that for many investors, emotions and feelings such as enjoying the thrill of investing, and social factors like the status that comes from a sense of ownership in the companies or cryptoassets they invest in, were key reasons behind their decisions to invest. The research also found that, these investors have a ‘strong reliance on gut instinct and rules of thumb, with almost four in five (78%) agreeing “I trust my instincts to tell me when it’s time to buy and to sell” and 78% also agreeing “There are certain investment types, sectors or companies I consider a ‘safe bet.”4 Following this, the FCA have launched an online campaign and have issued a further warning, against investing into high risk crypto assets which promise high returns.
With celebrities such as Elon Musk endorsing cryptocurrencies such as Bitcoin and Dogecoin in the mainstream, it’s probably no surprise that the younger generation is taking this on board. Just like any trend, can we really be surprised when people begin copying one another, without much idea of what they are getting into in the first place? But, could the growth in cryptocurrency investment within the younger generation be due to other, more complex, reasons? The millennial generation is also a generation which has grown up watching the news, and families go through the global financial crash – could a distrust of institutional investment be part of this? A product which offers a way to ‘get rich quick’ with new technology without giving money to bankers in the first place may just be the perfect attraction for a generation feeling an air of distrust.
Ultimately, I’d judge the FCAs position to be a good starting point, but more education around the potential risks of cryptocurrency and investing needs to be introduced to help educate younger people, regardless of the underlying motivations for buying into cryptocurrency.
1 Cbeci.org. 2021. Cambridge Bitcoin Electricity Consumption Index (CBECI). [online] Available at: <https://cbeci.org/cbeci/comparisons>
2 FCA. 2021. FCA bans the sale of crypto-derivatives to retail consumers. [online] Available at: <https://www.fca.org.uk/news/press-releases/fca-bans-sale-crypto-derivatives-retail-consumers>
3 Ponthus, J., 2021. Young UK investors choose cryptocurrencies over stocks – survey. [online] Reuters. Available at: <https://www.reuters.com/technology/young-uk-investors-choose-cryptocurrencies-over-stocks-survey-2021-04-22/>
4 FCA. 2021. FCA warns that younger investors are taking on big financial risks. [online] Available at: <https://www.fca.org.uk/news/press-releases/fca-warns-younger-investors-are-taking-big-financial-risks>