Crypto Commentary I

Cryptocurrency is an exquisitely divisive topic. Its ‘marmite effect’ generates a vacuum of reasoned discourse, which is problematic for uninformed investors. Understanding the balance of risk/benefit is important in deciding whether cryptocurrencies might form part of your portfolio. Investing without due diligence, based on the opinions of those who fawn over its ‘world-changing potential’, might lead to significant losses. Conversely neglecting cryptocurrency, on the grounds that some ‘would rather play roulette’ than invest in it, could lead to loss of potential returns for those with the appropriate appetite for risk.

NB I’ll use the terms cryptocurrency, crypto-assets, and Bitcoin (the archetypal cryptocurrency, which commands the majority market cap1) interchangeably. This is for the sake of simplicity and variety, although I appreciate they are different. I won’t be detailing either the mechanics behind Bitcoin/blockchain or its history, as this has been summarised elsewhere2,3.

Crush on crypto

Bitcoin certainly doesn’t lack for ardent admirers. It was designed as a peer-to-peer version of electronic cash, aiming to cut out the middle man4. As such, its decentralised nature is supposed to render it immune to government interference. Crypto-assets are also supposed to protect you from (hyper)inflation and government corruption, growing in value all the while. The rhetoric is that in the future, ‘the people’ of tomorrow’s (brave) new world will seek freedom from untrustworthy governments. They’ll need a monetary system to support this – cryptocurrency.

ROI

If we acknowledge that the goal of investing is to increase the value of one’s initial outlay over time, then Bitcoin could certainly have done that. Since 2014, the price of a Bitcoin has risen from $123 to over $11,000! The returns on this juvenile investment option have run laps around pretty much every other asset class over that timeframe. You’d have had to stomach some fairly spectacular volatility along the way, however. For example Bitcoin’s value fell from $18,000 to $3,000 in a single year (December 2017-18). This potential for huge gain/loss is what’s attractive/off-putting for many investors. The pertinent question is, as always, what does the future hold for crypto-assets?

Bitcoin value in USD since inception. The price of Bitcoin has (overall) increased dramatically, but fluctuated wildly too. Adapted from Coindesk.

World domination

Those bullish about crypto’s trajectory aren’t shy about predicting an inexorable rise in its value. The basis of this is the idea that Bitcoin will supplant all existing fiat currencies as the dominant world currency3. Consequently the (maximum) 21 million Bitcoin will contain the value of all the wealth in the world, giving any one Bitcoin a valuation of millions or tens of millions of dollars5. If this is the case, you only need to own 0.003 of a coin to own more than your ‘fair share’ of Bitcoin6 and thus be disproportionately wealthy.

The step-down from these bold claims is that ‘even if Bitcoin only reached the market capitalisation of gold, its price would still dwarf current-day valuations forty-fold3. The argument is that one should therefore spend the ~£30 on that fraction of a Bitcoin, because it might be worth many times that in due course. Sometimes this argument is extended into posterity; ‘you should buy Bitcoin now to benefit your descendants as it will take one or two generations for Bitcoin to reach its zenith’.

The foundations for these ideas of omnipotence are numerous. Bitcoin’s suitability as a currency has been lauded. Its lack of history is a presumed future victim of the Lindy effect. Some believe Bitcoin’s incipient monetisation is making headway, as its value follows both Gartner hype cycles and the sigmoid curvature typical of technological adoption7. Overall, ‘crypto-bugs’ seem extremely confident in the ascendency of cryptocurrencies, both in terms of adoption and, consequently, value.

The adoption of various technologies over time. Bitcoin’s growth is thought to mirror these adoption curves, which is used to support the argument that it will inevitably become ubiquitous. Adapted from source.

Being mean

More impartial crypto-commentators are less optimistic, suggesting that Bitcoin’s value will revert to its (unknown) mean8 or trend to zero. As Bitcoin is not based on any underlying asset, estimates of its value are little more than baseless pseudo-valuations. Some research would suggest that the value of Bitcoin is linked to the cost of mining it and that the price may not end up at zero9, though there is no strong evidence for a robust method of valuation.

Perhaps the ‘best’ reason to invest in Bitcoin is because of innate human irrationality. We’re evolutionarily hard-wired to go with the flow. Greed, fear (of missing out), the ‘what if?’ factor – these drive the market for cryptocurrency. This is an example of greater fool theory. As long as people want to ride the Bitcoin wagon, it will likely hold some value. It’s easy to dismiss the effect of this ‘soft’ psychology in light of cold, hard numbers. It should be said, however, that secondary market sentiment is predominantly what drives gold prices, which have continued to climb on the back of Covid-induced fear.

Auric ambitions

Indeed some see cryptocurrency as gold sans histoire; a commodity that relies heavily on market sentiment for its value. This has led to suggestions for treating Bitcoin like gold, particularly when it comes to asset allocation8,10,11. There is, however, already a debate about whether to own gold or not. Gold bugs are perhaps more likely to be tempted by the allure of crypto-assets, especially those who anticipate an eventual degradation in the current societal structure. For those already reticent to invest in gold, unsecured and volatile cryptocurrency is unlikely to be more attractive.

Performance of Bitcoin (BTC; red line), gold (blue line) and Vanguard’s FTSE All-World equity ETF (green line) over the past year. Bitcoin has been exquisitely volatile, losing 50% of its value during the ‘Covid-crash’. Gold has been less volatile and maintained/gained value since the market downturn in Spring 2020. Adapted from Yahoo Finance.

Bad Bitcoin

The number of issues surrounding crypto-assets are legion. Some are relevant predominantly at the personal investment level. Others are broader issues that will likely preclude the total ascension of Bitcoin as the world currency. Even if a crypto-asset were to become the overarching global currency, there’s no reason that the eventual ‘winner’ has to be one of those that exist today. As the space matures it may be an entirely different entity, evolved out of today’s prototypes, that takes pole position.

Some of the issues facing cryptocurrency
• Personal investing: volatile nature, difficulty in valuation, lack of a compensation scheme, tax uncertainties, technical demand to buy/hold, risk of fraud.
Technical factors: electricity consumption, scalability, protocol risk, exchange shutdown risk, imitators (‘forking’), competitors.
Psycho-social factors: short history, poorly understood, no social accountability, no self-regulation, environmental and ethical concerns.
Economic factors: no underlying asset, volatility, high fees, slow transactions, compromised fungibility of tainted coins, oligopoly of Bitcoin mining, fixed supply of Bitcoin, unlimited supply of cryptocurrencies.

Arguments mitigating some of the above issues have been made:
• Concerns about volatility are brushed off as a function of crypto’s nascency.
• Scalability issues are being tackled (e.g. the Lightning Network).
• Concerns about overt competition are rebuked on account of the network effect.
• Bitcoin’s value must be maintained because of fixed supply.
There are, however, still enough stumbling blocks to make the future of cryptocurrencies rather clouded. As such, many use the term ‘speculation’ to describe buying cryptocurrencies rather than ‘investing’; some use ‘gambling’ instead12.

Insurance, security and fraud

The FSCS scheme currently lets us sleep a little easier. There’s no widespread compensation scheme for crypto investors, although crypto platform Ziglu recently announced a £50,000/customer compensation scheme13. Good on paper, this has been likened to the ‘provision funds’ of peer-to-peer lending platforms, which are barely weathering the Covid storm. Some crypto-asset investors have been stung by insurance that turned out to be fraudulent14.

Not only are bona fide Bitcoin investments unbacked, but cryptocurrency has proved a fertile stomping ground for fraudsters15,16. Naïve investors are low hanging fruit; they’ve been primed by the crypto hype and have rushed to join the gravy train. Concerns about fraud are strong enough that there have been reports of banks blocking transfers to Bitcoin exchanges17. Cautions about the risk of putting money into crypto-assets seem to be largely unseen or un-heeded. Perhaps they are diluted or drowned out by the existing regulatory warning-cry: ‘past history doesn’t predict future performance, investments can go down as well as up, capital at risk’. A ‘boy who cried wolf’ effect, if you will.

Enough to be getting on with

I’ve split this summary of my research into cryptocurrency in half, as it would otherwise be too lengthy for one post. In Part 2, I’ll take a look at what the Bank of England and various renowned investors think of cryptocurrencies, as well as examining the ethical and environmental concerns surrounding them.

TTFN,

Mr. MedFI


References
1 – Top 100 Cryptocurrencies by Market Capitalization. Available here.
2 – The Definitive Crypto Guide for Beginners and Veterans Alike. Available here.
3 – V. Boyapati. The Bullish Case for Bitcoin. 2018. Available here.
4 – S. Nakamoto. Bitcoin: A Peer-to-Peer Electronic Cash System. 2009. Available here.
5 – Email exchange. Bitcoin v0.1 released. 2009. Available here.
6 – Bitcoin As Real Estate; A Thought Experiment. Available here.
7 – B. Armstrong. What will happen to cryptocurrency in the 2020s. 2020. Available here.
8 – Craig, A. (2019). How to Own The World: A Plain English Guide to Thinking Globally and Investing Wisely (3rd ed.). John Murray Learning. Available here.
9 – A.S. Hayes. Bitcoin price and its marginal cost of production: support for a fundamental value. Available here.
10 – J. Dorfman. Bitcoin Is An Asset, Not A Currency. 2017. Available here.
11 – K. Kelly. The Future of Blockchain . 2020. Available here.
12 – M. Lewis. Should you invest in Bitcoin? Four things you need to know. 2017. Available here.
13 – J. Martin. Ziglu Insures Cryptocurrency Holdings up to £50,000 Against Cybercrime. Coin Telegraph, 2020. Available here.
14 – Online cryptocurrency trading platform shut down by courts. Government Press Release, 2020. Available here.
15 – Cryptocurrency fraud leads to £2 million worth of losses this summer. 2018. Available here.
16 – J. Redman. Hackers Have Looted More Bitcoin Than Satoshi’s Entire Stash. 2019. Available here.
17 – I. Woodford. Santander denies blocking payments to Coinbase, but says some exchange payments are subject to checks. 2019. Available here.

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