Cryptocurrencies Part 2 — An Asset Class?
A look at how cryptocurrencies measure up as asset classes on metrics such as returns, risks, diversification and of course, the regulatory environment as well…
In my previous article, I decoded bitcoins and altcoins and how transactions occur on the blockchain.
It’s been over a decade since cryptocurrencies made their debut with Satoshi Nakamoto’s Bitcoin white paper. However, bitcoins and altcoins haven’t quite managed to enter the mainstream payments space yet. While bitcoin trading and digital address creation have increased over the years, this is still a pretty nascent segment.
Items may possess inherent value or derived value, and this results in some fundamental differences between commodities, fiat currencies and bitcoins. Commodities like gold are scarce and possess intrinsic value while fiat currencies derive their value from acceptance by populations and the backing of the sovereign. Bitcoins and altcoins can be thought of as hybrids. Bitcoins are extremely scarce, even more so than gold, but they don’t possess inherent value. They also lack the centrality and government backing that deems fiat currencies as legal tender. Thus, bitcoins and altcoins must gain the trust of a large number of people who believe in their ability to act as stores of value, medium of exchange or as valuable asset classes.
Two primary use cases of bitcoins and altcoins are as investment-worthy asset classes or as mediums of exchange for use in transactions.
Bitcoins and Altcoins as Asset Classes
Bitcoins have been used as an investment option for quite some time now. According to Coin Metric’s latest State of the Network report, if the current growth rate is maintained, Bitcoin’s trading volume could even beat asset classes like stocks and bonds in 4–5 years, and that’s saying something.
Some of the factors that need to be analysed to ascertain the positioning of Bitcoins as an asset class:
Returns
Among the best performing asset classes over the years, Bitcoin saw an appreciation in value by a whopping 39% since the start of 2020. This stellar growth outshines that of US Treasuries and gold, pushing Bitcoins up the leaderboard as the best asset class of 2020. The daily income earned by Ethereum miners also soared by 60% in July.
With the May 12 bitcoin halving phenomenon (every 210,000 blocks, halving of the block rewards occurs, as described in my previous piece) tightening supply further and given the current market environment, one can expect a bull run, which would result in significant upticks in value.
According to Bloomberg, ‘something has to really go wrong for bitcoin not to appreciate in value.’ Active bitcoin addresses rose significantly and ‘unless advancing addresses abruptly reverse, history indicates bitcoin has a propensity to appreciate,’ according to the data provider.
The returns for a $1 investment in bitcoins, gold, US Treasury bonds and US stocks over a decade (December 2009 to December 18, 2019) present quite a picture…
Bitcoins: $1 → $90,000
Gold: $1 → $1.34
US Treasury bonds: $1 → $2.08
US stocks: $1 → $3.46
But, for any asset, along with returns, an analysis of risk is paramount.
Volatility
Along with extreme returns, bitcoins and altcoins have witnessed extreme volatilities as well. Between March 11 and March 13, 2020, bitcoin prices fell from ~$8,000 to ~$4,700, recovered to ~$6,400 by the end of March and surpassed $10,000 briefly on June 1st. Ether and other altcoins have also been pretty volatile over the years. While high volatility can be seen as an indication of high risk, it also offers immense opportunities to generate high returns.
However, one needs to take into consideration the fact that the cryptocurrency trading market is relatively nascent and sparsely populated. There aren’t a wide array of hedging instruments and mechanisms yet, and wide fluctuations are to be expected. A lot of the historical volatility has been in response to information regarding hacks, blockchain vulnerabilities, frauds, regulations surrounding bitcoins and altcoins, among others. Further, every time the bitcoin value reaches a new high, moves by investors to profit off it results in a large number of sell orders, and this can also bring prices down considering the smaller network and the resulting illiquidity. As more people join the cryptocurrency market and with more sophisticated instruments, there is a possibility that this could come under control.
With the equity markets witnessing high volatilities during this period of global disruption, investors are looking at cryptocurrencies for diversification. But, one cannot conclude much about cryptocurrencies’ status as an investment option based on this as the level of risk exposure is the investor’s call.
It is clear, however, that in the long run, crypto assets are more volatile and risky.
Diversification Benefits
One of the reasons why people use gold as a safe-haven asset is its weak correlation with the stock market and other asset classes. Cryptocurrencies aimed to possess this property too. Historically, there indeed hasn’t been much of a correlation between crypto coins and the traditional markets. Due to this, bitcoins and altcoins have been touted to offer attractive diversification opportunities and posed as a hedge against macro risks.
However, of late, the correlation between bitcoins and the S&P 500 has been rising, casting a shroud of doubt over bitcoin’s status as digital gold. While experts do mention that such a correlation may not last long, a possible reason for the increased association could be due to the new entry of traditional investors into the cryptocurrency space. Further, due to the pandemic, the stock markets also ended up becoming risky, contributing to the similarity in movements in the two consequently risky markets.
According to crypto analyst Tone Vays, during times of low stock market volatility, the correlation between cryptocurrencies and the markets are lower while, during times of steep market spikes or crashes, there would be higher correlation since both are private assets.
And, while short term correlations may be inconsistent, what matters is the long-term lack of correlation of bitcoins with traditional markets.
Inflation Resistance
Inflationary economics, rising unemployment and an overall negative macroeconomic sentiment. Seems to sum up what’s happening now, right? Well, such a situation, termed stagflation, rattled the US in the 1970s. In such circumstances, historically, gold has been looked up to as a safe-haven asset. But, come the 21st century, can bitcoins play the same role?
Theoretically, bitcoins do fit the mould of an inflationary hedge, with a limited supply encouraging a deflationary attitude. As the number of bitcoins is fixed at 21 million, with a rise in demand, the value is only set to go up. Also, the purchasing power of bitcoins has seen a prodigious increase since its inception in 2009. With the rising trend of digital transactions and calls for banking the unbanked, bitcoins do seem to be in a favourable position.
There are arguments both in favour and vehemently against the deflationary economics of bitcoins. Regardless, the underlying fact is that as a store of value and as an asset class, the deflationary nature does add desirable features to bitcoins.
Accessibility and Ease of Trading
A factor that’s quite important when it comes to investing in any asset or alternative investment opportunity is the ease of investing. Investing in stocks is quite easy, with the likes Robinhood and Zerodha democratising investing and delivering it to millennials in an accessible format. There are numerous apps facilitating investments in bitcoins and altcoins as well.
While Zebpay and Unocoin cater exclusively to cryptocurrency investments and trading, platforms like Robinhood also offer crypto trading services.
One thing that needs to be noted is awareness around crypto investing. The number of debutante stock traders on the various investing platforms has soared since the pandemic, with falling FD interest rates and increased time available. A lot of these new investors are millennials.
While it’s good to see increased interest around investing and the rising accessibility offered to different people, multiple participants are buoyed by beginner’s luck. They might not be aware of the nitty-gritties and consequences of their actions. The cryptocurrency environment is highly complex, uncertain, volatile and not as regulated as traditional markets, restricting redressal options. It is quite a risky business. Thus, platforms must take efforts to educate participants on the various products and their implications.
Regulatory Status
Different countries around the world have various regulations surrounding bitcoins and altcoins.
In the US, cryptocurrency exchanges are classified as financial institutions by the US Treasury, answerable to KYC and AML laws. The IRS labels cryptocurrencies as digital assets liable to taxes. Australia, Canada, Germany are some other spots where cryptocurrencies are legal.
In countries like Bolivia, Ecuador and Vietnam, the use of cryptocurrencies is illegal.
In India, the RBI, via an April 2018 circular, had banned entities under its regulatory purview from providing services to businesses or individuals dealing in cryptocurrencies. The Supreme Court quashed the circular in March 2020. However, with banks still displaying hostility towards crypto traders, news doing rounds of the government seeking to pass a law to ban such trading and without robust regulations in place, the scenario is still pretty volatile for cryptocurrencies. A drawback of the lack of recognition or regulatory framework is the fact that grievance redressal becomes murky, and this erodes investor sentiment.
Bitxoxo, Zebpay, Coinbase, WazirX are some crypto exchanges that operate in India. A few merchants do accept bitcoin payments, but it’s rare.
A Detour — DeFi
One of the most significant developments in the crypto world is DeFi. DeFi stands for Decentralized Financial services. It is an ecosystem of decentralised, new-age banking products on a blockchain, with offerings ranging from collateralised loans, assets, derivatives, etc. Ethereum is the most preferred blockchain network for DeFi as it is highly programmable.
DeFi allows easy interconnection of these products and transfer of assets into and out of them quickly. There are also options to gain interest on money just sitting in one’s wallet. DeFi looks to be a pretty bustling space within the cryptocurrency-blockchain ecosystem and currently has over $4.5bn locked up in such projects, emerging as a potential game-changer for the industry.
Expert Opinion
Overall, bitcoin investments seem to be receiving mixed signals. The lure of lucrative returns, weak correlation, inflation resistance and ease of trading thanks to digital platforms is dampened by the lack of redressal mechanisms and extreme volatilities. Experts have conflicting opinions too.
Nobel laureate Robert Shiller said that bitcoin is a failed experiment and ‘another example of faddish human behaviour.’ Warren Buffet has also been highly vocal about his disdain for bitcoins. Goldman Sachs recently put out five reasons for not investing in cryptocurrencies.
On the contrary, Yale economist Aleh Tsyvinski published a paper in 2018, in which he recommended bitcoins occupy at least 6% of every portfolio for optimal construction and that, regardless of one’s opinion on bitcoins, it should occupy at least 1% of the portfolio for diversification benefits.
Jamie Dimon, CEO of JP Morgan had, in 2017, made the following scathing comment regarding bitcoins: ‘It’s worse than tulip bulbs. It won’t end well. Someone is going to get killed.’ He also contended, ‘It’s just not a real thing; eventually it will be closed.’ However, he later conveyed his regret in making such a comment and now, in a report titled ‘Cryptocurrency takes its first stress test: Digital gold, pyrite, or something in between?’, the bank’s strategists have commented on bitcoin’s resilience in comparison to other asset and that cryptocurrencies do possess ‘longevity as an asset class.’
According to Matthew Dibb, co-founder of Stack, a provider of cryptocurrency trackers and index funds, ‘Bitcoin, by all accounts, is still a risk asset. Despite those who may tout its fundamental similarities to gold, it has not yet proven to be a sufficient hedge or a flight to safety in times of risk-off sentiment.’
Despite this back and forth, it does seem clear that the cryptocurrency environment is developing at a pace that’s impossible to ignore.
