After a meteoric rise in 2020, crypto-currencies continued to rally in 2021. The price of Bitcoin, the most valuable crypto-currency, rose by 50% last year, even after a 25% fall from its peak in November to year end.
Bitcoin Price USD
Source: Refinitiv Eikon. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
Values have been boosted by increased interest from institutional investors, as well as from holdings announced by major corporates such as Tesla. But controversy has never been far away. While adherents point to a string of factors in favour of bitcoin’s ongoing “rise to the moon”, sceptics have a similarly long list of detractions – including the negative environmental impact of the vast energy required to “mine” bitcoin and process transactions.
One fundamental appeal is the premise that crypto currency could become “digital gold” – a new long-term store of wealth. This argument gained strength during the pandemic, on the grounds that quantitative easing and other policies – the effective creation on a large scale of new dollars, pounds and euro – will eventually erode the value of these traditional, “fiat” currencies.
Below, we set out our view on the rise of cryptocurrencies and the potential opportunities and risks they present investors.
The primary question: how do you value bitcoin?
Key to investing in bitcoin – or any other crypto currency – is trying to work out what it is really worth.
With established asset classes, we can invest in the knowledge that there is some fundamental value. This is likely to be based on profits, cash flow or some real-world use. With bitcoin we don’t have that luxury.
Whatever intrinsic value bitcoin might have ultimately rests on its “utility value.” In other words, what role could bitcoin play in the world?
We see three possible uses for a digital asset. These are: a medium of exchange, as a tool in digital contracts and as a store of wealth.
We think there are obstacles to bitcoin becoming a medium of exchange, with the key ones being its high volatility and limitations on the speed of transactions. It is hard to envisage anyone choosing to adopt a currency whose value can move 10% or more in a day. And by design, it takes time and significant computing power to verify bitcoin transactions, putting it at a disadvantage to many existing payment networks. Newer digital coins – including Ethereum, Solana and Cardano – have been specifically designed to overcome many of the difficulties of using bitcoin in transactions.
There is probably more potential in digital contracts. These might include insurance contracts that are automatically triggered in certain circumstances. However, bitcoin is unlikely to play a key role here and other cryptocurrencies look better suited to this use case.
Could bitcoin be a store of wealth?
Bitcoin’s most likely potential use is as a store of wealth – or as it’s sometimes called “digital gold”. One defining attribute that makes it well suited to this role is the scarcity engineered into the code on which bitcoin runs. The number of bitcoin that can exist is limited to around 21 million and the rate at which they can be created is programmed to decline over time. That scarcity has value when we know that central banks are likely to respond to the next financial or economic crisis by creating billions of new dollars and euros.
This can serve as a starting point when it comes to determining a value for bitcoin. Many of the price targets currently being talked about – from more or less credible sources – are based on the assumption that bitcoin will take a certain amount of market share from gold and other traditional stores of wealth.
However, this use case – and the path to it – is far from certain. Gold has earned its reputation as a safe haven over thousands of years and bitcoin can’t compete with that kind of pedigree.
Bitcoin also faces competition as a “store of value.” While the finite number of bitcoin theoretically gives it some scarcity value, the barriers to entry for new cryptocurrencies are low and it is possible that a newer cryptocurrency will assume the role of digital gold in investor portfolios – especially if it is also more practical as a medium of exchange.
With continued questions about its usefulness, the value of bitcoin is likely to remain under scrutiny, giving rise to further volatility.
Unstable risk/return dynamics
Like any multi-asset investor, we need to think about assets in a portfolio context. Bitcoin has delivered incredible returns but it has also experienced incredible volatility. In terms of the ratio of risk to reward over the last few years, bitcoin actually stacks up well compared to other asset classes.
The trouble is that its short history, and unstable trading dynamics, makes it hard to form long-term assumptions about how it will perform in future.
Bitcoin has often been volatile – but not consistently so. In recent months, we have seen a higher correlation with technology stocks, which have been under pressure since central banks signalled they would start raising interest rates. This could suggest that bitcoin will continue to struggle as interest rates rise. However, this may not be case: at other times in recent years, bitcoin’s performance has appeared disconnected from what’s going on in equity and bond markets.
Either way, this unstable pattern of correlations makes it difficult to work out whether bitcoin can or should fit in a portfolio, undermining its use a store of value for many investors.
Regulatory uncertainty
At the moment, there remains huge uncertainty about the regulation of bitcoin. China has formally banned trading in bitcoin. Officials elsewhere have expressed concern about a digital asset that can be transferred anonymously and could be used to facilitate money laundering.
Regulators in other major markets could follow China’s lead and prevent banks from interacting with cryptocurrency platforms, making it even more difficult for bitcoin owners to actually do anything with it in the real world. This kind of dramatic intervention would be a significant blow to those holding bitcoin as a store of wealth.
However, it is also possible that regulators agree on some ground rules governing the use and transfer of bitcoin, which could actually be positive for the asset class.
Lack of recourse
There have been some horror stories in the news about people losing bitcoin which would today be worth tens or hundreds of millions of dollars. Bitcoin owners have been subject to hacking and online theft, and people have simply lost passcodes or devices giving access to their bitcoin. The recourse mechanisms are weaker than they would be for financial assets stored in other ways. Banks are subject to supervision by regulators, individual depositors benefit from guarantees and physical gold can be insured. At the moment, those safety nets don’t exist for bitcoin.
Our view – as of January 2022
Despite only being launched in 2009, bitcoin has already survived several boom and bust cycles, which could signal a degree of durability. We are open to the view that it may offer an alternative to traditional currencies and give some protection against monetary debasement and inflation. We also believe that the underlying blockchain technology could be useful in many real-world applications .
However, we currently see many downsides associated with investing in bitcoin.
From an investment perspective, its risk/return characteristics remain highly unstable. There have been periods where it has been highly correlated with equities – such as March 2020 and December 2021 – undermining its ability to diversify portfolios when really needed. We are also concerned about the high level of retail ownership and concentration in ownership, both of which could result in further volatility.
There are also unanswered questions about whether crypto currency will achieve mass adoption – and whether bitcoin will retain its privileged position amongst virtual currencies. While bitcoin itself may have a scarcity value, the barriers to entry for other cryptocurrencies are low and some newer entrants may be better designed. Technical limitations on the speed of transactions using bitcoin, as well as the lack of clarity from regulators, both suggest it is currently unsuitable as an alternative to fiat currency.
We will continue to monitor bitcoin and crypto-currencies in general. While we continue to see valuable applications for blockchain technologies, we do not currently see a case for holding bitcoin in client portfolios. Our view still remains that buying bitcoin is more speculation than investment.
What is bitcoin?
To understand bitcoin, you first need to understand blockchain technology – a form of decentralized and distributed record-keeping with respect to transactions.
In simpler terms, blockchain is like a ledger of interactions between different parties. Years ago, this would have been a physical book in which a clerk would record buys and sells – or other types of interactions – between two people.
Decentralized means that no single party is in charge of the ledger. In the case of a traditional bank, the ledger of transactions would be controlled by the bank. They would be able to see every transaction and they would even be able to adjust transactions in which they are involved. This is not the case with a blockchain.
Distributed means that because no single party is in control of the ledger, someone else – or a community – has to verify transactions on the ledger. What this means in practice is that a network of computers contributes their computing power to the network to verify the transactions that occur on that network. Why would any of those computers bother? They are incentivized to do so by the code that is built into this blockchain technology. It says that if you successfully verify a block of transactions on the network, then you’ll be rewarded with a digital asset. That digital asset in this case is bitcoin.
