Crypto Commentary II

The first part of this series took a broad look at the arguments for and against crypto-assets. Building on that, this second part covers a variety of other considerations when it comes to investing in cryptocurrencies.

If you can’t beat them…

Despite being lauded as free from government interference, the sale of Bitcoin has not managed to escape the clutches of HMRC. Trading of cryptocurrencies is a chargeable event and therefore subject to capital gains tax. More information on paying tax on crypto-assets can be found on this Government page. It would be wrong, however, to suggest that the economic bodies of the UK have been engaging in idle thumb-twiddling when it comes to crypto-assets. The Bank of England (BoE) has published several reports on the topic over the past few years.

As cash continues to decline, the Bank of England is looking at alternative methods of providing the public with the ability to buy goods and services. One of these is the mooted introduction of ‘electronic money’ – a Central Bank Digital Currency. Image from source.

Using suitably British terminology, the BoE believes Bitcoin won’t “cut the mustard”22. They describe multiple factors preventing its widespread adoption in both the near future and longer term. As they point out, even if a crypto-asset does fulfil the economic definition of a currency, this doesn’t mandate its recognition as money for legal or regulatory purposes23.

Overall the BoE labels cryptocurrencies as unsafe, untrustworthy and unlikely to take over the currency market. Variations on the theme are equally dismissed, such as Bitcoin’s supposedly less volatile24 second generation cousin ‘stablecoins‘. The BoE concludes that cryptocurrencies do not pose significant risk to the stability of the UK monetary and financial systems25.

Having said all that, the BoE does concede that “a variety of potential risks to financial stability could emerge if a digital currency attained systemic status as a payment system26. Although this is felt to be extremely unlikely, the Bank of England is unsurprisingly keen to bring cryptocurrencies within its regulatory perimeter.

…join them

Although they are dismissive of crypto-assets, the Bank of England does recognise the potential of the technology underpinning them27. They are modifying the spine of the UK’s payment system to be compatible with distributed ledger technology, and collaborating with other countries to facilitate inter-bank, cross-border payments based on the same tech28. One of the threads of research spawned from the emergence of crypto-assets is whether the UK should develop its own Central Bank Digital Currency (CBDC)29. This is as of yet undecided.

The EU are singing from a similar hymn sheet – they too seem unconcerned about Bitcoin’s threat to financial stability, although are keen for enhanced regulation30. Sweden are prototyping the e-Krona; others will surely follow suit. Overall, to suggest that crypto-assets can remain uniquely and indefinitely outside the reaches of all government bodies seems naïve.

Ethical/environmental considerations

Socially responsible investing is on the rise. Does crypto fit in to a greener, greater investing strategy? Ethical arguments against Bitcoin arise from its historic use, and on-going potential for use, in criminal activity. One study demonstrated that the total percentage of ‘dirty Bitcoins’ (i.e. those from verifiably illicit sources) was less than 1%18 and another that the use of Bitcoin in illegal activity may be declining19. Conversely others have found that nearly half of Bitcoin transactions were associated with illegal activity20. During an interview, Nobel Prize winning economist Eugene Fama wryly quipped that the censorship-resistance of Bitcoin would only have value to drug dealers.

A counterpoint is that just because something can be used for unethical means does not make it in-and-of itself unethical. Fiat currencies and gold have been used in illegal activity; shunning them on this basis isn’t widespread. Furthermore, not all Bitcoin-related activity is nefarious – there are examples of cryptocurrency being used for philanthropic or humanitarian means.

Estimated energy consumption of Bitcoin mining in terawatt hours (2016-2019). The energy required to mine Bitcoin has been increasing and is seen by many as prohibitive to both its continued rise in value and ability to become a dominant currency. Adapted from source.

The nature of cryptocurrency does not make law enforcement impossible, merely reactive. There are also philosophical arguments to be had about the nature of illegality. The US Government leant on third-party payment providers to prevent donations to the Wikileaks Foundation21. Would using Bitcoin to bypass this block be illegal? Or merely an expression of individual freedom against a self-interested government?

Perhaps more worrying is the environmental impact of Bitcoin mining. Often the global electricity consumption and carbon footprint of Bitcoin is compared to that of nations such as Austria, Denmark or Ireland. It is thought to represent half a percent of the world’s electricity consumption and this may rise over time. Some have postulated that the environmental impact may be less than previously thought31, while others are developing techniques to reduce said impact32. Of note, no research has compared the environmental impact of cryptocurrencies against that of existing currency systems.

Celeb watch

It wouldn’t be a post on investing without the inclusion of a quotation from Warren Buffet. Although Buffet concedes it’s a “very effective way of transmitting money“, him and partner Charlie Munger have between them called Bitcoin a “mirage“, “asinine” and “poison. These have prompted various rebukes from those high up in the cryptocurrency world, although the ad hominem nature of their polemics is perhaps in itself revealing.

Tesla eccentric Elon Musk is sometimes proposed to be the real face behind Bitcoin’s anonymous creator Satoshi Nakamoto. The reported owner of a quarter of a Bitcoin, he’s apparently “neither here nor there” on cryptocurrency, though does describe it as filling a niche as an illegal-to-legal bridge.

Über-philanthropist Bill Gates has described going long on Bitcoin as “super risky“. He’s previously said that its role as an unregulated anonymous currency has inevitably led to deaths in a direct fashion. Overall, however, Gates seems to relish the proof-of-concept that Bitcoin has afforded in promoting financial access to those who are impoverished. His Foundation has provided grants for improving use of mobile money and other blockchain-associated technology in Africa33.

Gates’ feelings are echoed by others. Kevin Kelly (of Wired magazine) says that Bitcoin functions as a “lottery“, but that blockchain technology will be useful where central banks are “not very effective…too greedy and charge too much11. UK billionaire Jim Mellon labels Bitcoin a “bubble“, but blockchain a “revolution“. His company are interested in the concept of frictionless micropayments and have invested as such. The prevailing sentiment is that it’s blockchain, and its various applications, that will prove to be enduring rather than Bitcoin or other cryptocurrency.

The value of Bitcoin (blue line) and Ether (red line; the second largest cryptocurrency) over the past year. Changes in their price appear to correlate. Close correlation of cryptocurrency performance would limit within-class diversification, despite the large number of crypto-asset options. Both of these cryptocurrencies fell sharply during the Covid-crash, a sign that crypto-assets may perform poorly in market downturns. Adapted from Yahoo Finance.

Diverse?

If diversity is the only free lunch in finance, should cryptocurrency be part of the buffet? Cryptocurrencies are considered by some (but not all) to be a ‘major’ asset class and perhaps therefore worthy of inclusion in a diversified portfolio8. Crypto-assets are presumably a geographical diversifier on account of their statelessness. Whether cryptocurrencies are suitably lacking in correlation to other asset classes in order to be considered a diversifying part of a portfolio remains to be seen34,35.

In the future, crypto-assets might behave like other currencies (which is part of the argument for their inevitable adoption). If so, we know that securing consistent returns with Forex trading is fraught with difficulty. Cryptocurrencies might behave like gold or other commodities. If so, its future returns mayn’t match those of equities in the long run. Cryptocurrencies might behave like an entirely new asset altogether. If so, we haven’t the historical data to make evidence-based estimates of its future performance. Every which way, long-term investing seems a risky strategy.

Alternative investments

Many baulk at the high-risk nature of direct crypto-asset investing. ETF’s might be a better way to temper that risk, while still enjoying a slice of the crypto cherry pie. Widespread introduction of cryptocurrency ETF’s is, however, currently beset with regulatory/legislative issues, sparse choices and high costs36,37.

Crypto purists will argue that owning an ETF defeats the whole purpose of engaging in the nature of Bitcoin. For those who see it as merely another asset, it might be a perfect alternative. If it is the underlying technology that you see as being most valuable in the future, blockchain ETF’s could be the way forward.

Towards the other end of the risk spectrum, the burgeoning bitcoin derivatives market might tempt investors with an appetite for leveraged products. The floodgates holding back crypto-related investment products will surely open in the not-too-distant future.

FIRE and Crypto

Some say cryptocurrencies are ‘not in keeping with the FIRE mentality’. I think this overly generalises what is ultimately a highly individual approach to personal finance, investing and life planning. As I discovered myself when calculating the average FIRE blogger portfolio, there is no uniform investment strategy involved. (Of note, cryptocurrencies made up <1.5% of the average portfolio.) If Bitcoin continues to display the same volatility in the long run, it would certainly make a poor holding as a major part of a post-retirement portfolio.

Final comments

The quasi-religious fervour surrounding cryptocurrency often makes it difficult to thresh out bona fide points of consideration from pure speculation. There is a poignant conflict of interest in articles written by those who own Bitcoin – its value is dependent on crypto-evangelism stirring up hype and enticing investors.

It’s tempting to ‘get in on the ground floor’ of cryptocurrencies – but the lift mayn’t still be on the ground floor or even going up! As ever with evolving technology, there are vocal supporters on both sides. Certainly the realm of blockchain technology has garnered significant interest and may be a more prudent investment than cryptocurrency itself.

Crypto-assets may come to represent an entirely new class of investment. This doesn’t, however, necessitate an entirely new shape to one’s investment strategy. The future is promising yet unclear; a watchful eye on crypto-assets and their underlying technology is certainly reasonable for the time being.

TTFN,

Mr. MedFI


References
18 – T. Robinson et al. Bitcoin Laundering: An Analysis of Illicit Flows into Digital Currency Services. Centre on Sanctions & Illicit Finance, 2018. Available here.
19 – M. Boddy. $515 Million in Bitcoin Spent on Illicit Activity This Year. Coin Telegraph, 2019. Available here.
20 – S. Foley et al. Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed through Cryptocurrencies? The Review of Financial Studies, 2019, 32(5); 1798-1853. Available here.
21 – S.V. Lucey. More on the Ethics of Bitcoin. 2016. Available here.
22 – H. van Steenis. Future of Finance: Review on the outlook for the UK financial system: what it means for the Bank of England. 2019. Available here.
23 – R. Ali et al. The economics of digital currencies. Bank of England Quarterly Bulletin. 2014, Q3, p276. Available here.
24 – B. Dyson. Can ‘stablecoins’ be stable? 2019. Available here.
25 – Financial Policy Committee statement from its meeting. March 2018. Available here.
26 – Cryptoassets Taskforce: final report. 2018. Available here.
27 – R. Ali et al. Innovations in payment technologies and the emergence of digital currencies. Bank of England Quarterly Bulletin. 2014, Q3, p262. Available here.
28 – M. Carney. New Economy, New Finance, New Bank. 2018. Available here.
29 – Central Bank Digital Currency: opportunities, challenges and design. A discussion paper. 2020. Available here.
30 – EBA reports on crypto-assets. 2019. Available here.
31 – Estimating the environmental impact of Bitcoin mining. Science Daily. 2019. Available here.
32 – Researchers invent low-cost alternative to Bitcoin. Science Daily. 2019. Available here.
33 – Bill & Melinda Gates Foundation Grants: Bitsoko Ghana Limited | Jomo Kenyatta University of Agriculture & Technology | Denominator Group
34 – C. Deka. Bitcoin’s low correlation with other asset classes aids as a portfolio hedge. 2019. Available here.
35 – A. Xie. Bitcoin’s Correlations With Global Financial Assets Soar Amid Coronavirus Crisis. 2020. Available here.
36 – M. Tatibouet. The Trajectory Of Crypto ETFs So Far. 2020. Available here.
37 – T. Deng et al. Crypto ETFs: A Game Of Benefits and Risks. 2020. Available here.

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