Cryptocurrency was introduced with the initiation of Bitcoin mining in 2009 and has completely taken over the world in just one decade. Blockchain technology and Web3 have evolved together in this time, bringing several innovations and making digital currency gain mainstream acceptance and trust. Many countries have now recognized cryptocurrency as a legitimate currency, and many companies have started using it for their day-to-day and long-term operations.
A company needs to fund its daily operations, such as trading. These funds are the difference between the company’s current assets and liabilities and are called working capital. The assets could include the cash on hand, the balance in the company’s several bank accounts, any receivables, and its inventory. In contrast, the liabilities include unpaid bills and short-term debts and loans.
A business should aim for a healthy working balance by maximizing its assets and minimizing its liabilities. One way to do it is through hedging or maturity matching. This strategy involves using long-term financing sources to finance your working capital. As crypto’s popularity increases, firms have started using it as a hedging source.
Before we delve into the benefits and disadvantages of using cryptocurrency as a working capital hedge, it is essential to understand how cryptocurrency works and how working capital is managed:
Cryptocurrency is a virtual currency that relies on cryptography, coded information, to transact money securely. Its transactions are recorded on a public ledger, known as the blockchain, and anyone can verify transactions. Consequently, crypto is a decentralized currency that does not require any central agency, like a bank, to verify and process its transactions. The sender transacts money to the receiver’s node, recorded on the blockchain as proof. The receiver can be anywhere worldwide, making crypto a convenient option for cross-border transactions.
You have many crypto options to choose from, like Bitcoin (BTC), Litecoin (LTC) and Solana (SOL). You can trade these currencies and convert them to fiat money like the USD. However you must know how much converting them to fiat money is worth. For example, to convert Solana (SOL) to USD, you must find out the SOL to USD rate.
There are several benefits of using cryptocurrency instead of fiat money. The most popular reason for using crypto is its enhanced control over your cash. No one can control your transaction, not even the government, so they are immune to traditional monetary policy. Transactions are encrypted, making them secure and transparent, with records publicly available on the blockchain.
Cryptocurrencies have gained immense popularity since the launch of Bitcoin in 2009, with a significant increase in market capitalization. Crypto enthusiasts make money through crypto trading, a practice similar to stock trading. You buy, hold, or sell crypto according to the market situation. Yet others use crypto to store long-term investments. As crypto is immune to fiat money inflation, it can be used to appreciate your funds. This property makes crypto a possible working capital hedge.
“Working capital management is a critical financial strategy for businesses to support day-to-day operations.”
Understanding Working Capital Management
Working capital is the money a business has for its day-to-day operations, reflecting the short-term liquidity and ability to meet its daily goals. It is an essential metric of a firm’s financial health.
A company must have enough working capital to pay its suppliers and employees and expand the business. Without adequate working capital, a company cannot seize opportunities, buy other firms, or invest in new products. A healthy working capital is necessary to have a positive cash flow and handle unexpected expenses. Inadequate working capital can lead to financial distress and operational disruptions.
Operating capital may fluctuate seasonally, so businesses must plan accordingly to ensure financial stability for their firm. Consequently, it is essential to have a hedging strategy to provide working capital stability in the more challenging days.
Working capital management is a critical financial strategy for businesses to efficiently and effectively use their current assets and liabilities to support day-to-day operations. The first step in working capital management is to calculate and effectively manage your assets and liabilities. You must maximize your investments while minimizing your liabilities to have a healthy working capital.
There are several strategies to help you increase your working capital. These include inventory control, which involves managing and controlling inventory levels to avoid overstocking and reduce holding costs. Order new materials only when you need them using inventory management software.
Effective cash flow management also increases your working capital. It includes ensuring the business has higher cash inflows like investments or sales than cash outflows like debt payments or operating expenses. In extreme cases, a working credit loan or a line of credit can also increase your working capital, but this should only be the last resort.
“Cryptocurrency resists inflation as the supply of tokens does not increase.”
Pros of Using Cryptocurrency As a Working Capital Hedge
Cryptocurrency has several properties that make it an effective working capital hedge. Here is all you need to know about crypto’s hedging properties:
1. Protection Against Inflation
Cryptocurrency is known to be one of the best hedges against inflation. During periods of financial distress, your state bank prints more money, which increases the monetary supply. As a result, inflation rises.
On the other hand, cryptocurrency resists inflation as the supply of tokens does not increase. For instance, Bitcoin (BTC) has its total coin supply capped at 21 million tokens; no more BTC will be created once this limit is crossed. Instead, the total number of crypto tokens usually decreases for several currencies to maintain scarcity. Bitcoin (BTC) regularly undergoes halving events in which half of the active tokens are burned away, protecting against the eroding purchasing power. Consequently, the working capital stored as cryptocurrency will resist inflation compared to the capital in fiat money. Keeping your money in crypto is an excellent option to preserve its value.
2. International Transactions
For a multinational business, being able to send and receive money worldwide is a key feature. International firms have partners worldwide, and traditional methods of sending and receiving money take too much time to be practical. A wire transfer, for example, takes weeks.
Cryptocurrencies enable borderless and near-instantaneous transactions 24/7, eliminating the need for intermediaries like banks. Now, you can send and receive money in less than a minute using cryptocurrency, enhancing operational efficiency. This increased accessibility and reduced settlement times make business operations smoother for companies involved in international trade.
3. Security and Transparency
Traditional systems of storing money are less secure for businesses, being susceptible to various forms of fraud, including counterfeiting, identity theft, and payment fraud. Cryptocurrencies can mitigate these risks through cryptographic verification and decentralized record-keeping. The currency is also cryptologically secured and encrypted throughout, making your capital safer.
As cryptocurrency uses blockchain technology, transactions are secured transparently in rows of linked blocks. This structure makes a transparent and immutable public ledger open to anyone for verification.
The innovative smart contract technology also increases the security and transparency of your transactions. They are self-executing contracts with the terms of the agreement directly written into code. This minimizes the counterparty risk in traditional transactions, where one party may fail to fulfill their obligations.
4. Reduced Fees
Traditional transactions usually have lots of fees. Bank fees, credit card fees, processing fees, and clearance fees add up and eat away your working capital. Cryptocurrency is decentralized, and crypto transactions do not go through these intermediary institutions, significantly reducing costs. Crypto fees are also fixed regardless of the size or nature of the transaction.
Similarly, international transactions are much cheaper with crypto. Cross-border transactions are associated with significantly more fees, including currency exchange, transfer, and bank fees. As crypto does not need to be converted to a different currency, is processed digitally, and is decentralized, these fees do not apply when working with crypto.
5. Assert Diversification
Asset diversification is a crucial principle of hedging and investment. You must never put all your eggs in the same basket. Diversification of assets means that your investments should be spread along different asset classes, such as stocks, cash, or crypto. This is a fundamental risk management strategy for businesses: if one asset class does not perform well, its risk is not spread out for the entire portfolio.
Consider diversifying your assets by converting some of them into cryptocurrency. Cryptocurrencies may exhibit a low correlation with other investments, potentially reducing overall portfolio risk.
“Crypto markets are very volatile and react to news events quickly. Businesses can make money fast and lose it all in seconds, too.”
Cons of Using Cryptocurrency As a Working Capital Hedge
While cryptocurrency is a suitable option as a working capital hedge, its unregulated nature and high volatility can be risky. Here are some cons of using crypto as a working capital hedge:
1. Price Fluctuations and Volatility
In 2021, Bitcoin (BTC) rose to as high as $68,000. Since then, the coin has devalued to less than half at around $27,000. This is the ultimate reality of cryptocurrencies: their price fluctuates considerably, and they are volatile.
Crypto markets are very volatile and react to news events quickly. Something as insignificant as a tweet by Elon Musk can make or break cryptos. As a result, businesses can make money fast and lose it all in seconds, too.
2. Regulatory Uncertainty
Cryptocurrency is not widely recognized as a legal currency, and working with high amounts of crypto may lead you to legal trouble. The regulatory environment for cryptocurrencies is still evolving as crypto is a decentralized currency with little oversight, and there is considerable uncertainty regarding how governments will regulate and tax these assets.
Businesses may face challenges ensuring compliance with evolving regulatory frameworks, potentially leading to legal issues and financial penalties. There are potential tax issues when working with crypto, as taxation on crypto assets is less clear. Without consulting with the lawyers, prolonged use of crypto may send the IRS after you.
3. Limited Acceptance By Vendors and Suppliers
Cryptocurrency was launched just a decade ago, so it is still making its space. Not everyone trusts and accepts crypto, so a crypto-exclusive working capital may close off potential vendors and suppliers for your company.
There are several reasons for some vendors and suppliers' lack of acceptance of crypto. Some believe that crypto business transactions are illegal, while others are concerned about their volatility. However, some vendors don’t accept crypto because converting it into traditional fiat money is complicated, and they cannot use digital currency for everyday usage.
4. Technical and Security Risks
Cryptocurrency’s digital nature is a double-edged sword. While the digital medium enhances security, it can also be a liability. Crypto trading entirely depends on technical infrastructure, like well-functioning computers and a steady internet connection. Any threat to the technical infrastructure, like a cyberterrorist attack or a system malfunction, can paralyze a business dependent on crypto.
Cryptocurrencies' decentralized and digital nature makes them susceptible to hacking and cyberattacks. Security breaches can result in the loss of funds and sensitive business information. Mismanagement of digital wallets or loss of access keys can lead to irreversible loss of funds.
Concerns about the environmental implications of crypto’s overreliance on technology exist. Crypto mining and trading consume significant energy, and the use of crypto has attracted the ire of environmental activists.
5. Accounting and Tax Implications
Cryptocurrency poses unique accounting challenges for a business. Since cryptocurrency is quite volatile, it is difficult to ascertain how much it is worth at a particular time, which provides accounting issues. Cryptocurrency accounting standards may vary by jurisdiction, and businesses must adhere to applicable guidelines.
The resulting gains or losses may have tax implications when converting cryptocurrencies into fiat currencies. You must carefully manage the timing of these conversions and the associated tax liabilities. Compliance with cryptocurrency-related tax obligations and accounting standards can involve additional costs regarding software, professional services, and administrative efforts.
A business must ensure its financial health by adequately managing its working capital. With less working capital, your firm will not have enough to operate or innovate. Most companies keep their working capital in traditional fiat money, but some have switched to crypto as a hedging measure as digital currency’s influence expands.
Crypto can protect you against inflation and facilitate you with international transactions. However, several cons are associated with crypto as working capital, like price volatility and regulatory uncertainty. Ensure that you do your research before integrating crypto into your business.