Cryptocurrencies | Mercer New Zealand

Bitcoin or Bust | Mercer New Zealand

Investments

BITCOIN OR BUST: Should Cryptocurrencies Be In Your Investment Portfolio?

Eye-watering cryptocurrency price appreciation was the speculator’s delight of 2017.  The proliferation of new coin launches and widespread excitement around digital currencies hinted at the existence of a speculative bubble which, based on price weakness so far in 2018, perhaps had some basis.

In this article David Scobie, Head of Consulting at Mercer Investments, outlines the drivers behind the enthusiasm and considers some of the challenges facing cryptocurrencies as an investable asset.

Chips off the block

While the goal of this article is not to canvas the mechanical aspects in depth, we can summarise by saying a cryptocurrency is a decentralised digital form of exchange where cryptographical techniques are used to control the creation of new units of currency and to verify the transfer of funds.  With the major examples to date, new coins are created via a “mining” process whereby “miners” are rewarded with coins for solving cryptographical puzzles. Most cryptocurrencies are designed to gradually decrease production of the currency, with some placing an ultimate cap on the total amount that will ever be in circulation, thus mimicking the finite supply of precious metals.

The underlying transaction record for a cryptocurrency is the “blockchain”. The cryptographical puzzle solved by the miners is part of the process of validating transactions.  In a conventional digital transaction, you, the counterparty and your banking provider are aware of a transaction.  However, in the blockchain, there would typically be thousands of “aware parties” keeping a record of such transactions, and this negates tampering via an attack on an individual copy.

It’s important to distinguish between blockchain technology and cryptocurrency. Blockchain is an infrastructure that has been heavily invested in by major players in the world of digital transactions, and applications are also being developed for non-financial sectors.  Blockchain is therefore an exciting development that could have a significant impact on the finance sector and wider economy over the coming decade.

The hope and the hype

The huge interest in cryptocurrencies has been driven by a number of features that distinguish them from government-backed fiat currencies:

·         Cryptocurrencies aren’t controlled by central banks. If a central authority cannot print large sums of the currency, it could potentially have more legitimacy as a store of value (some view cryptocurrencies as a form of digital gold). A motivator behind the introduction of the first cryptocurrency, Bitcoin (which has a limited supply of 21 million coins), was the large-scale quantitative easing programmes introduced after the Global Financial Crisis.

·         Cryptocurrencies offer a degree of anonymity. In May 2017 a piece of ransomware called WannaCry was released globally. For the unfortunate individuals and institutions whose computers were infected, this often meant that they had to pay a ransom to remove the harmful program from their computers, and this was achieved by paying a sum in Bitcoin. Bitcoin’s cloak of secrecy in this case proved to be helpful to the extortionists behind the virus.  Individuals are also able to make anonymous purchases for illegal items using cryptocurrencies. For example, it’s been estimated that just over a quarter of the UK’s drug-users have purchased banned substances on the Dark Net, generally using cryptocurrencies.

·         Social media excitement and FOMO. The interest around cryptocurrencies has been amplified by the effect of discussion and shared news reports on social media. As with any asset exhibiting astronomical price rises, individuals are drawn in as they act on a “fear of missing out” on further increases. This is despite Bitcoin sporadically experiencing dramatic falls in value – sometimes 10-20% or more over a matter of days (one recent example being the 35% decline in late December 2017).

Bitcoin price history

 

Source: www.99bitcoins.com

Digital dilemmas

Cryptocurrencies face a number of significant challenges in attempting to establish themselves as serious alternatives to fiat currency or gold, thereby countering their suitability as an investment or store of value at this point in time:

·         Hacking and theft. In 2016, hackers managed to exploit a weakness in the coding of an online crowdfunding platform (The DAO), which used the cryptocurrency Ether, and stole approximately US$50 million in cryptocurrency. More recently, in January 2018, the cryptocurrency exchange Coincheck was hacked and US$530 million of NEM cryptocoins were stolen. Individuals have also been robbed of cryptocurrency at gunpoint. Thefts occur frequently and are likely to reoccur. Even so, the blockchain itself is rarely, if ever, compromised. What this means is that hackers have so far carried out exceptionally large robberies but have not fundamentally altered the viability of a cryptocurrency – for example, by forgery.

·         Survivorship. There are well over a thousand different cryptocurrencies in circulation and the field is widening with further “ICOs” or Initial Coin Offerings. 41 cryptocurrencies have market capitalisations of over US$1 billion, with Bitcoin leading the way at c.US$141 billion as at 16 March 2018.  Even most of the large players are likely to be surplus to requirements if and when a mature cryptocurrency payment framework emerges. It is therefore possible that many, if not all, cryptocurrencies with very high valuations today will be worth close to nothing at some point in the future.

·         Government intervention. Governments can intervene to outlaw or regulate certain aspects of cryptocurrencies and 2018 looks set to be a year in which such scrutiny comes to the fore. For example, policymakers could make owning, mining or running an exchange illegal and/or increase the compliance burden on exchanges. Some of these actions are harder to do than others - some exchanges have been shut down but it’s very difficult to eradicate ownership of cryptocurrency. Despite this, it would certainly be a large setback if a cryptocurrency were outlawed in a major territory (recently China and South Korea have launched crackdowns on digital currency activity).

·         Congestion. The network of the predominant cryptocurrency, Bitcoin, isn’t currently able to handle a large transaction volume.  Given the current state of the technology, payments would grind to a halt if there were widespread uptake of the system. This places pressure on transaction fees. Whilst early in the history of Bitcoin transactions were seen as essentially free, the average transaction fee at the end of 2017 was US$25.  Such fees, alongside slower processing speed, mean that Bitcoin cannot function as a high-throughput small payments solution in the same way that credit cards do.

·         Exchange fees. As well as the fees due to the miners for validating transactions, cryptocurrency exchanges will also take a spread on transactions. For example, on Coinbase, one of the major exchanges, spreads range between 0.25% and 1% for purchases of digital currencies. Other fees can be incurred on transferring hard currency to and from exchange accounts, either by your traditional bank provider or the exchange.

·         Sustainability. In terms of energy consumption, the Bitcoin network, for both mining and transacting, consumes about the same amount of energy as Morocco. Whilst some of the large cryptocurrency mining firms have often been using surplus hydroelectric power, this clearly makes it hard to regard cryptocurrencies that involve mining as “green” investments. From a social perspective the link to cybercrime, drugs and money laundering also shadows Bitcoin heavily.

What next? Two sides of the coin

“Bitcoin is the beginning of something great: a currency without a government, something necessary and imperative.” - Nassim Taleb (financial author)

“My best guess is that in the long run, the technology will thrive, but that the price of bitcoin will collapse.” - Kenneth Rogoff (economist)

The above quotes highlight that the future success of digital currencies is far from clear.  The blockchain technology that underlies their use undoubtedly holds promise in areas such as trade processing and settlement, with many other potential applications under active development. However, in our view cryptocurrencies have yet to prove that they offer much more than the benefit of anonymity and the potential for huge price fluctuations.

Although some argue that cryptocurrencies can be considered a form of digital gold, the key difference with physical gold is that it has played a role in financial systems and been seen as a store of value for thousands of years.  With no way of assessing the fair value or longevity of different cryptocurrencies, holders need to contemplate the very real possibility that many, if not all, cryptocoins may be close to worthless at some point in the future. Whilst it is possible that one or more cryptocurrencies might survive and even thrive as the underlying technology and unforeseen applications develop, it is also possible that many will disappear altogether.

Worth a place in portfolios?

In summary, we do not view cryptocurrencies in their current form as a compelling proposition for investment portfolios - either directly, via futures or via hedge funds set up to speculate on price movements. They offer no income to the passive holder of coins (i.e. non-miners) and assessing fair value is close to impossible. In addition, the wave of cryptocurrency launches and the spectacular price rises witnessed in 2017 exhibit many of the hallmarks of a speculative bubble, notwithstanding some deflation seen in recent months. We suggest that investors not partial to “rolling the dice” sit out the action and marvel as more of the story unfolds.

David Scobie is Head of Consulting at Mercer Investments, based in Auckland.  He advises institutional clients on their investment policies, portfolio structures and fund manager selection.

This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

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