Q&A: Where to from here with Cryptoassets?
Bitcoin, Ripple, Litecoin or Ethereum. For anyone not familiar with cryptoassets, this may sound like a list from a chemistry textbook. But these names are just a few of the more popular cryptocurrencies attracting significant investment since the concept was first launched over a decade ago.
While cryptocurrencies are described as a type of electronic cash, they are very different from the paper cash found in our wallets. They exist electronically and use what is known as a peer-to-peer system. For many cryptocurrencies there are no central banks, governments or corporates to manage the system or step in if something goes wrong. That has both benefits and pitfalls.
As the crypto industry reaches almost US$3 trillion (at 31 October 2021) and there are more than 6 000 different cryptocurrencies available, should these assets form part of a long-term diversified portfolio?
Rademeyer Vermaak, Head of Portfolio Management at STANLIB Index Investments, answers some pertinent questions about investing in cryptocurrencies. As a quantitative investment expert with 17 years of industry experience, Rademeyer has deep insight into the technicalities of cryptoassets and the risks of investing in “electronic cash”.
It seems cryptocurrencies are here to stay and any investor who does not already know much about them is probably overwhelmed with jargon and stories. As a quantitative investment expert, can you explain this asset?
Before exploring cryptocurrency as a collective, it is appropriate to understand Bitcoin as the first and most important cryptocurrency, and some of the technology and vocabulary that surrounds it.
Bitcoin is a digital currency or asset built on an underlying technology called the blockchain. The blockchain is a special type of database that uses blocks to store information.
It will help to understand the technological challenge that the blockchain solves, and only then look at how that solution is applied to digital money in the form of Bitcoin.
A fundamental principle in economics is that scarcity underpins value – which is why a diamond is worth more than a grain of sand.
Digital objects are easy to replicate, so they are not scarce. For example, if you take a photograph with your phone and email it to someone, there would now be two copies. The photograph will only be regarded as scarce if you ensure that one of these copies is deleted. This requires trust.
Blockchain solves this. It creates digital scarcity by using a system called a distributed ledger which documents the ownership of any digital asset, as well as a history of owners and transactions. Everyone and anyone has access to this decentralised ledger, and anyone may have a copy of it. Through this simple yet sophisticated database, a digital object becomes scarce and, through the scarcity principle, gains value as a digital asset (Bitcoin).
Most money in circulation today is digital (except for coins and notes), and it is certainly not scarce. New money can be created at the tap of a keyboard, a fact that has become evident both in 2008 and with the recent COVID-19 stimulus.
In contrast, there will only ever be 21 million Bitcoins (each of which is divisible into very small units). No more Bitcoins can ever be created (or mined, which is the technical term). Bitcoin, however, is more than a scarce digital asset. It was engineered to be used and sent digitally as easily as an email. The result is a global monetary network that can operate alongside the US dollar to eliminate the centralised control of money by government agencies and ensure speedy processing of transactions.
The code and mathematics of the Bitcoin network perform and automate the essential functions of a central bank, including:
- Governance of monetary policy
- Maintaining a stable monetary supply
- Reaching consensus on account balances, and
- Facilitating international transactions with immediate settlement.
This Bitcoin central bank is owned by no-one and everyone, the chairman is mathematics and code, and it does not allow for any inflation of the monetary supply.
An analogy for Bitcoin would be simultaneously both email and gold. It is both an asset for storing value and a protocol and network for making payments, and practically it enables anyone to be their own bank. The speed and transparency that the blockchain, and consequently Bitcoin, provides are unmatched by anything else in today’s financial system, and are among the main drivers of interest in, and adoption of, the cryptocurrency.
Can you explain how it is valued and why it matters to financial markets?
The reality of crypto is that we have never seen anything like it, so traditional valuation anchors and models do not translate well. One way to look at crypto, is through the lens of the subjective theory of value. This theory states that the aggregate buying and selling decisions of individuals serve as their primary source of pricing information.
The CFA Institute Research Foundation brief on cryptoassets, contains several alternative valuation methods for cryptocurrencies, such as:
- Total Addressable Market (Bitcoin replacing gold as store of value)
- The Equation of Exchange (size of the market served)
- Value of the Network (model based on Metcalfe’s law)
- Cost of Production model (similar model to commodity pricing)
- Stock to Flow model (based on scarcity of assets) and
- Protocol Revenue to Price model (similar to P/E ratio)
Perhaps the most intuitive approach to valuation is through the praxeological lens of Austrian economics. This view touts Bitcoin (by virtue of its underlying technology and design) as the hardest and most secure financial database and network ever created, potentially replacing and automating the functionality of central banks and securities markets.
It consists of 100 000 independent and secure nodes that allow anyone to transact 24/7 without relying on the trust or goodwill of any third party. As global geo-political powers ebb and flow, Bitcoin remains totally non-political, and its essential value lies in enabling anyone to truly own something that cannot be taken away or inflated away.
The number or types of cryptoassets seems to be growing. Which are the main ones and how are they different?
The current landscape is very similar to the “Dotcom” internet stock boom of the early 2000s. Initially the market comprised a lot of highly speculative stocks, for example Microsoft, Amazon and Pets.com. Many ultimately fell away, and a few went on to become household names.
Just as ecommerce and Amazon disrupted retail over a period of more than 20 years, there is the potential for Bitcoin and Decentralised Finance (so called “DeFi”) to disrupt the existing financial system. It will take time. However, significant inroads are already being made in replacing portions of the existing banking and security sector, and beyond.
Many new cryptocurrencies are listed and delisted daily. Bitcoin was the first and remains the largest and most important cryptoasset. It was created by an anonymous individual (or group), with the pseudonym Satoshi Nakamoto.Other prominent cryptos include:
- Ethereum – programmable smart contracts for Decentralised Finance (it is also the second largest crypto by market cap behind Bitcoin);
- Ripple – a method of facilitating global payments between financial institutions and various regions, in a fast, transparent and efficient manner;
- Meme coins – these are a growing class of tokens which include the likes of Dogecoin and Shiba Inu (among many others). These “joke” crypto have a typically uncapped supply, are low quality (the GameStop of crypto) and highly speculative; and
- Stable coins – these are cryptocurrencies trading on the blockchain as proxies for fiat currencies, such as USD Tether and USD coin. These open a new world of borrowing and lending similar to fixed income markets.
I would recommend learning about Bitcoin as an initial step and only then looking at the potential value of other cryptocurrencies. Bitcoin remains the most important cryptocurrency as it combines a truly limited supply with true decentralisation (no central corporation or organisation controls it, in contrast to many other cryptocurrencies). A good starting point is the book The Bitcoin Standard.
“With the wide variety of cryptocurrencies available, it is crucial that one understands the specific use-case, reads the white papers, and does sufficient in-depth research before investing. Never invest in what you do not understand, for that is pure speculation, remain acutely aware of the risks, and position the size of your investments accordingly.”
Some investors have doubled their money, others stay away based on the perception that investing in cryptoassets is comparable to gambling. What are the true risks of investing? Are some cryptoassets riskier than others?
Overall, the cryptomarket is significantly more volatile than traditional financial markets and needs to be treated as such, drawdowns of 80% and more have occurred historically. Inside the cryptomarket, just like the stock market where we find stocks of differing quality, we will find different quality cryptoassets with different risk profiles. Think of Amazon or Ford vs GameStop.
As with any investment, there are risks, and especially because crypto is a frontier landscape with uncharted territory, we just do not know what the future holds. A number of risks are related to this uncertainty:
- Regulatory issues and government interference are probably some of the biggest risks to investing in Bitcoin
- The downside risk is, of course, that the valuation eventually goes to zero, and
- The upside risk is that it becomes a global reserve currency as traditional currencies lose value.
Keep in mind, investing in anything is speculation if you do not know why you are investing or what you are investing in. Again, this comes down to doing the necessary research, having a well-formed view, and, of course, not investing more than you can afford to lose.
As you stated above, regulation or rather its absence is a key risk. Is the regulatory environment shifting in the near term and how will this impact investors?
A Globally, regulators are taking very different approaches. It has not been a one-size-fits-all approach, as different markets, economies, and regions grapple with their own challenges. For example, China has restricted citizens from trading, owning, or exporting cryptocurrencies, while in El Salvador, Bitcoin has been made legal tender. Evidently, the space is fluid. But because Bitcoin is truly globally decentralised, it cannot be shut down by a single government. In fact, shutting it down would be like shutting down the internet.
Over the short- to medium-term, regulators are worried about tax collection, AML/KYC, currency controls and crossborder flows. These are areas of intense focus, as regulators continue to deal with the realities in this space, while attempting to develop appropriate regulation.
Over the longer-term, concerns relating to ESG will come to the fore and will be another challenge to address.
Should a long-term investor be thinking of crypto as an investment opportunity?
A With Bitcoin, we could only really be seeing one of two scenarios playing out: either the rapid adoption of a disruptive new technology, or it becomes the biggest speculative bubble in the history of mankind.
To provide more context to this debate, I did some number-crunching on several important historical bubbles.
- Tulip Bubble – November 1636 to February 1637 (four months), when prices soared by 2 000%
- South Sea Bubble – January 1720 to June 1720 (five months), when prices soared by 700%
- DotCom Bubble – January 1990 to October 2002 (almost 13 years), when prices went up by 900%
- The Bitcoin white paper was published in October 2008, and it has been trading since July 2010 (just more than 11 years) and is up by a staggering 104 million per cent or 242% per year (at 31 October 2021). It is the best performing asset of the decade, and perhaps of all time.
Considering this, we must ask ourselves whether this is the longest and largest bubble ever or is it something we need to be paying attention to.
From an investment perspective in a portfolio construct, an insightful and relevant piece of work was done on the case for including crypto in institutional portfolios.
The research found that, starting from a traditional institutional 60/40 portfolio and allocating Bitcoin at 1% or 2.5%, it has historically increased portfolio returns without a substantial increase in risk. This is largely due to the historically low correlation of Bitcoin with traditional assets.
I think as fund managers we tend to think in terms of mean reversion, which means we sometimes miss the big trends. There is an expectation that cryptocurrencies will mean revert, but seen in a long-term historical context, disruptive technologies such as the wheel, the printing press and the personal computer have never mean reverted. In moments like these, we need to appreciate that we are in uncharted waters. As investors and custodians of client assets, we need to be open-minded and allow our prevailing notions to be challenged. Perhaps then we may recognise those opportunities that drive us forward as an industry (and as a civilisation).
What is the ESG (Environmental, Social, Governance) impact of Bitcoin?
Bitcoin mining (the process by which Bitcoins are “created” and enter circulation) consumes a large amount of energy through intense computational hardware usage. However, this must be seen in the context of the existing legal, governance and financial systems. Too often, this argument is raised in isolation and not considered holistically. Doing the maths, the world consumes about 160 000 TWh of energy annually, whereas Bitcoin consumes 120 TWh. That means Bitcoin only comprises 0.075% of global annual energy consumption.
Bitcoin miners are actively moving to renewable energy sources. Bitcoin mining provides an opportunity to use stranded energy sources and act as a storage method for energy. For example, a hydro-electric plant that is too far from a city to feasibly transport the electricity can now be used to convert that hydro-kinetic energy to digital energy, and store it in Bitcoin, similar to a battery.
ESG has a social component as well. In countries with populations that are largely unbanked, crypto enables financial inclusion, bringing people into the global financial system. With that, it provides the hope of economic freedom to billions of people. This may not be such an important issue in developed economies, but Bitcoin provides an important lifeline in authoritarian countries with hyper-inflationary currencies, and their dire socio-political consequences.
In terms of Governance in ESG, it is difficult to argue against the transparency and robustness of the blockchain. With mathematics and code as the fundamental drivers, and human interference removed from the equation (specifically the case with Bitcoin), and with no central agency defining an agenda, Bitcoin may represent the very best of governance and freedom.
Do you have an investment in cryptocurrency?