Many investors are having the ‘FOMO’ (Fear of Missing Out) feeling that’s experienced when watching the value of cryptocurrencies surge ever higher.
Earlier this year, the market value of Bitcoin, the dominant cryptocurrency, surged past the US$1 trillion mark for the first time[1]. This meant Bitcoin’s market value was higher than most of the world’s listed companies.
So what’s our assessment? Is it time to invest?
While cryptocurrencies seem to hold much promise, there are a few issues to consider. Unlike traditional currencies and mediums of exchange, they can’t be widely used to purchase material goods or services. Nor do they produce any income in the way that shares can generate dividends, or property generates rent. They don’t have an inherent value as they’re not used in industrial production, like gold. You can’t even touch it. This makes it very difficult to value.
When you make a digital transaction there’s a deposit holding bank acting as the security for the transaction but as cryptocurrencies aren’t backed by regulated financial institutions there’s limited security in place when transactions are made.
All of these issues mean that cryptocurrencies currently experience very wild swings in price. It’s fair to say that if more institutional investors were to add ‘crypto’ to portfolios, then the volatility may stabilise but until it’s more stable that’s unlikely to happen – so it’s a bit of a ‘chicken and egg’ situation.
Another major risk for cryptocurrencies is the security. While secured by a password, in this age of hacking and data breaches, more would need to be done to ensure crypto assets are able to be safely secured and stored before it would be considered for portfolios.
Cryptic cryptocurrency explained
Cryptocurrency is a digital currency that operates on a decentralised peer-to-peer networked program on your computer, meaning that transactions can be conducted between a buyer and seller without the need for any third-party oversight such as a regulator.
Cryptocurrencies are very different to digital transactions that are managed by financial institutions like banks that can ‘back’ transactions as they take deposits, although some forms may be backed by currencies like the US dollar.
The underlying technology that makes all cryptocurrencies possible is the blockchain – a digital, shared record book which keeps track of all transactions.
When a transaction is made, it is added to the end of the blockchain and confirmed using a series of complex calculations by the computers of other users who are on that currency’s network. So, a digital coin is like a bit of code, that could be copied and reused and sent to multiple people. The blockchain stops this from happening because all computers on the network reach a consensus that that coin has changed to a new owner when a transaction is made.
More importantly, there’s a real focus on regulation. This is understandable considering how cryptocurrencies symbolise such a radical new approach in the financial system, the huge volatile swings that have seen some investors experience significant financial losses (and gains), and the use of cryptocurrency as a medium of exchange by criminals due to anonymity.
China’s authorities cracked down in 2017 with strict regulations that sent the value of Bitcoin spiralling downwards. Western regulators have also expressed concerns since, best summarised by European Central Bank President Christine Lagarde who stated, “This is a highly speculative asset, which has conducted some funny business and some interesting and totally reprehensible money-laundering activity.”[2] That said, in contrast, El Salvador made Bitcoin legal tender on 9 June 2021, the first country to do[3] so and, interestingly, some central banks are exploring the introduction of public central bank digital currencies (CBDCs) that would allow transactions to be undertaken directly with the central bank.
The amount of energy required to process transactions is staggering. While Bitcoin ‘mining’ will no doubt become more efficient over time, it’s an extremely energy intensive way to transact so it has significant consequences from a climate change perspective. The Bank for International Settlements (BIS), the organisation that represents most of the world’s central banks, stated in a recent report, “Bitcoin in particular has few redeeming public interest attributes when also considering its wasteful energy footprint”[4]. Some analysts have stated that annual electricity consumption for Bitcoin is comparable to what Ireland or Denmark uses in a year, but it's very difficult to verify this as there are currently no recognised authoritative sources on energy usage for digital currencies.
All the risks and concerns we’ve outlined mean we’re also wary of investing in any companies that develop cryptocurrencies. It’s still unclear if these business models can generate a sustainable dividend stream for investors.
There’s likely a future for the technology and innovation that underpins the cryptocurrency regime but it’s hard to say what will happen next. Over time it may become an asset that adds an extra layer of diversification that enhances portfolios as cryptocurrencies, like Bitcoin, have a very low correlation with the returns of all other major asset classes (shares, bonds, cash and property).
While it’s very exciting, we have a healthy level of scepticism. There’s no FOMO feeling for us at present, but we continue to keep a close watch as cryptocurrency advances.
[1] Bitcoin’s market value hits $1 trillion for first time ever as the cryptocurrency continues to rise. Noah Mansker, New York Port. 22 February 2021. Bitcoin skyrockets to $1 trillion in value, accessed 26 February 2021.
[2] ECB's Lagarde calls for regulating Bitcoin's "funny business", accessed 29 June 2021
[3] AP News. "El Salvador Makes Bitcoin Legal Tender." accessed 10 June 2021.
[4] BIS Annual Economic Report, 29 June 2021
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