Monday, March 1st, 2021
“Crypto Craze Goes Mainstream”
Cryptocurrencies are one of the most polarizing topics in finance these days. It seems you are either an impassioned holder of one or more digital tokens, or on the skeptical side with the likes of Warren Buffett, who has equated digital currencies to “rat poison”. There is hardly any middle ground in such a fanatical subject, but we will look to make some balanced observations.
At this point, it is apparent that the crypto market is not going anywhere anytime soon. That is less of an endorsement for recent price action, and more of an observation given the propensity for further adoption and rising skepticism towards insatiable money printing actions by government authorities.
Still, as of now, digital currencies are more of a speculative asset then a viable alternative to transacting in U.S. dollars or other major currencies for the developed world. They do have potential to be an alternative in the future, especially as institutions continue to adopt, enhance security protocols, and reduce frictional costs. They also hold tremendous opportunity for the developing world, in which many individuals lack an accessible global payment system. Like the network effect of many platform-based businesses, the more users that adopt will inevitably increase the viability of the system.
The biggest reason they may not be a true alternative at this point, however, is due to their volatility. To be a viable currency, as opposed to just a potential store of value, cryptocurrencies such as Bitcoin must become much more stable.
Bitcoin was invented in 2008, but its momentum really took off in 2017 when the price went from under $1,000 at the start of the year to a peak of nearly $20,000 in December. The price would ultimately correct nearly 90% over the subsequent 12 months. Bitcoin then went on a similar run towards the end of 2020 and into 2021, hitting a high of over $58,000 on February 21st. Since then, the price has corrected another 25%.
This surge has created a vast amount of digital wealth for the early adopters, as well as the ultimate FOMO (fear of missing out) feeling for those who missed out on the rally.
The volatility, however, is a headwind towards its intended role as a digital currency. Bitcoin’s implied volatility is multiple times that of the stock market and dwarfs the minimal volatility of the U.S. dollar. When volatility is so high, transaction activity will ultimately be impacted by the opportunity cost or risk of holding or spending the asset. An extreme example is the guy who spent 10,000 Bitcoins in 2010 to purchase two pizzas. Those pizzas are the equivalent of nearly $500MM today based on the current price of bitcoin. That does not speak to its potential role as a store of value, but solely as a viable means of exchange. Without that stability, it is most similar to the original fanatical dollar alternative, gold.
Nevertheless, the institutional adoption of bitcoin is without a doubt taking hold. PayPal, Mastercard and Visa are now accepting Bitcoin across their merchant network. Some companies, including Tesla and Square, have replaced a small part of their balance sheet cash with the digital currency. Institutional investors are also awaking, or chasing, to the potential benefits of Bitcoin in terms of asset allocation, although the true adoption vs. publicity has been very slow thus far.
A primary reason for skepticism is that the brief history of Bitcoin and other cryptocurrencies has been checkered by periodic security breaches. This is ironic given that the decentralized system is meant to be a more secure means of exchange. The most infamous was the 2014 hacking of Mt. Gox, then the largest exchange for bitcoin, which resulted in investor losses of over $230MM. In January 2018, the Japanese exchange Coincheck disclosed a hack that resulted in losses of nearly $500MM1. The integrity of exchanges has improved in recent years, but this will be a perceived risk for years to come, whether substantive or not.
These types of potential custody issues are one of the reasons why regulatory agencies like the SEC have dragged their feet for approving advisor-friendly products such as exchange-traded-funds that could hold bitcoin or other cryptocurrencies. That and the potential risk Bitcoin and cryptocurrencies pose to the reserve currency status of the U.S. dollar.
One other challenge to Bitcoin is the concentration of its holders. About 2% of anonymous accounts control 95% of the digital asset2. That may have a lot to do with how volatile the limited outstanding supply is for the remaining 5%. The other issue that needs to be addressed is the amount of energy waste that goes into transacting and mining bitcoin. By one estimate, the amount of electricity required to mine bitcoin is more than the energy used by entire countries such as Ireland and Argentina3. Even if much of this energy use were “green-friendly”, it is entirely inefficient to support transactions to the scale merchants and banks do today.
The biggest question is what it is all worth. We would note that giving an endorsement to the technological benefits of blockchain or digital currencies does not guarantee what Bitcoin, Ethereum or any other cryptocurrency tokens will be worth in 5-10 years. The global crypto market is valued at nearly $1.5 trillion as of today, with Bitcoin comprising nearly 60%, or $900 Billion of that total4. For comparison, the overall size of all the gold in the world is between 9-10 trillion, but that is comparing a hard precious metal, used as a universal store of value for thousands of years, to digital currencies that are just barely teenagers.
There are over 4,000 digital currencies outstanding today, surely many or most of them will eventually be worth nothing, but what should the others be worth? Isn’t the fact that anyone can create one an issue for their perceived finite capacity? Will Bitcoin be the entire market cap of crypto in the future or will the contractual framework of Ethereum present a viable alternative? Should a digital token of a dog (Dogecoin), created as a joke by its developer, be worth nearly $6.5 billion?
On the other hand, if Bitcoin was a bubble, wouldn’t it have been dead once it collapsed 90% in 2017/2018? And if monetary stimulus is going to be a headwind for years to come, surely cryptocurrencies are going to be popular for the foreseeable future.
There are so many outstanding questions and issues to address for the long-term viability of cryptocurrencies, which is what makes opinions on crypto so polarizing, almost cultish.
All this uncertainty makes it difficult for financial advisors, planning on behalf of their clients for the next 10 and 20 years, a period longer than the entire existence of the crypto market, to make assumptions on what will inevitably transpire. That may seem shortsighted today as cryptocurrencies sit near all-time highs, but that may also be the most prudent thing to do if viable and proven alternatives exist for managing capital towards a long-term financial plan.
Jack Holmes, CFA®
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. There is also no assurance that any investment strategy will assure success or protect against loss.