Forget stocks and bonds. Today's hottest investment is digital currency.
Bitcoin, the eight-year-old granddaddy of the virtual-cash revolution, rocketed more than 20 per cent this week, to around $2,645 (U.S.), as rival groups finally reached agreement after a highly technical debate about how to scale up the payment system.
The cryptocurrency has quadrupled in value over the past year. Amazingly, though, bitcoin remains a distant also-ran compared with newer, sexier rivals such as ethereum, litecoin, dash and ripple. At least on paper, the prices of several of those digital coins have shot up twentyfold over the past 12 months.
Their soaring value has inspired a flock of me-too projects. Starry-eyed investors now pore over the details of ICOs – initial coin offerings, which occur when a startup company sets out to raise funds to develop yet another form of online money.
Coinmarketcap.com, a site that tracks this burgeoning world, lists more than 800 cryptocurrencies.
As exuberance grows, promoters are rushing to market with new products designed to make it easy for even the most technologically inept investor to place a bet on the continued growth of digital currencies.
This week, First Block Capital Inc. of Vancouver announced the launch of Canadian Bitcoin Trust, while Ross Smith Asset Management ULC of Calgary said it was starting the Ross Smith Cryptocurrency Investment Fund LP. Both funds say they will offer accredited investors a convenient, non-technical way to hold bitcoins.
Should you jump aboard the digital-currency bandwagon? As tempting as it is to speculate on the growing wave of cryptoenthusiasm, you may want to engage in a bit of unencrypted skepticism before swapping your loonies for virtual tokens.
At the very least, you should make sure you understand the potential weaknesses, as well as the possible strengths, of digital money.
Supporters praise bitcoin and similar payment systems for their ability to transfer funds quickly and cheaply. The key is "blockchain" technology, an ingenious protocol that allows a common, secure ledger of transactions to be maintained flawlessly by multitudes of users operating without any central authority.
Unfortunately for bitcoin investors, all this innovation still looks, in many ways, like a solution in search of a problem. As things stand, transferring money isn't a major ordeal for most people – banks, credit card companies and PayPal do a fine job for relatively small fees, without any of the technical hassles that go along with swapping digital coins.
Money transfers aside, the biggest market for digital currencies lies among libertarians and law breakers. Cryptocurrency sites such as Coindesk.com argue that you should use bitcoin because "central governments can't take it away" and "it's as private as you want it to be." The wink-wink-nudge-nudge implication is that those who conduct business in bitcoin will never have to worry about snooping auditors or grasping tax authorities.
This may be true. However, what bitcoin enthusiasts see as a big selling point could turn out to be the major flaw in the cryptocurrency movement. According to one major line of economic thought, money has value not because it allows you to avoid taxes, but because it allows you to pay taxes.
If that sounds odd, think about the history of money. At one point, people believed a currency was worth something only because it was backed by precious metals. But the final, rather tenuous link between money and gold was severed decades ago.
So why do we continue to regard the bills in our wallets as valuable? In part, it's because a currency is useful in at least three ways – it allows us to price all kinds of goods and services in standardized units, it lets us exchange those units, and it offers us a secure way to store the value of those units.
You'll notice, however, that those three advantages just amount to a strong case for having a currency of some kind; they don't tell us which currency we should all agree to use. Given that, why does everyone in Canada use the Canadian dollar as opposed to, say, the greenback? One big reason is that Ottawa demands we pay our taxes in loonies. That legal requirement makes the Canadian dollar valuable to anyone living or working in Canada and pushes us to adopt the currency as our standard.
The idea that a currency derives its value from the need to use it to pay taxes was first put forward a century ago by Georg Friedrich Knapp, a German economist. His doctrine, known as chartalism, remains the most coherent explanation of what transforms a pretty piece of paper into something that people are willing to accept in exchange for goods or services.
Chartalism implies that attempts to launch stateless currencies with no central taxing authority are nearly certainly going to run into problems. Bitcoin and its digital rivals may have advantages as mediums of exchange over traditional currencies, but without a guaranteed source of demand – such as the need to pay taxes – there's nothing to anchor the value of a cryptocurrency.
For now, it's not clear why anyone would trust a virtual coin as a stable store of value. Bitcoin's erratic course – it soared above $1,100 in late 2013, only to fall below $200 in 2015 before rebounding spectacularly this year – demonstrates the problem.
To be sure, cryptocurrencies are on a tear and may go even higher, especially if geopolitical turmoil gives Chinese citizens or others a powerful reason to evade restrictions on moving wealth abroad. But before you invest, make sure you understand both sides of this fascinating new world.