What financial asset is down nearly 20% during the past month, but is still up more than 500% over the past year? The answer is bitcoin, the dominant ‘cryptocurrency’.
Cryptocurrencies are digital currencies, created and stored electronically in a ‘blockchain’, that use encryption techniques to control the creation of monetary units and to verify the transfer of funds. Alongside bitcoin, a host of new cryptocurrencies are springing up, with names such as ‘ether’ and ‘Ripple’. Many have experienced stratospheric price rises over the past year, although there has been a significant sell-off in recent weeks.
To some [cryptocurrencies] are seen as the future of money.
The astonishing rise in cryptocurrency prices has certainly benefitted early-adopters. The appeal of cryptocurrencies is their decentralised nature and immunity to the machinations of central bankers and politicians. To some they are seen as the future of money. And with the total market capitalisation of cryptocurrencies recently exceeding $170 billion, they are becoming increasingly difficult to ignore. Nevertheless, institutional investors have generally held back from entering this new market.
To sceptics, cryptocurrencies are an incredibly volatile asset class, without the fundamental anchor of a fair value. During mid-September, in the space of three days, the value of bitcoin plummeted 40%, and then recovered more than 25%. Year-to-date annualised volatility (which measures the variation in an asset’s value over the course of a year) stands at 87% for bitcoin and 151% for ether – intolerable levels for institutional investors.
Difficult to value
Establishing a fair value is also extremely difficult. At least gold has an intrinsic commodity value, while central banks seek to control the value of their respective currencies. One valuation method for cryptocurrencies is based on their potential future usage. However, there has not been any significant breakthrough in their acceptance as a currency. Perhaps cryptocurrencies could one day complement or replace gold as a ‘store of value’, or fiat currencies as a ‘medium of exchange’, and should be assigned a corresponding discounted value today. Nevertheless, this valuation method is very speculative.
A regulatory clampdown in China suggests a fundamental antipathy, and adds to the uncertainty.
Cryptocurrencies do have a few things going for them as an asset class that institutional investors could one day be interested in. Bitcoin has demonstrated a low correlation with other asset classes and volatility-adjusted returns have been very good. It is becoming increasingly easy to invest in digital assets. Investors finally have a regulated way to invest in cryptocurrency, after the Commodity Futures Trading commission granted LedgerX a license to operate as a derivatives clearing organisation for digital currencies.
Blockchain – the future is bright
Perhaps the bigger opportunity lies in the underlying technology that powers bitcoin, the ‘blockchain’. A blockchain is a type of distributed ledger or decentralised database that keeps a record of digital transactions. Rather than having a central authority (think a bank or government), a distributed ledger has a network of computers that must all approve an exchange before it can be verified and recorded. Blockchain technology can be used to record transactions in any asset, from financial securities to houses, and even has broader applications in everyday life, such as in voting or in healthcare.
Applied to voting, for example, constituents could cast votes via their smartphone or computer, resulting in immediately verifiable results. As all activity is recorded, an audit trail would verify that no votes were changed or removed, and no illegitimate votes were added.
It is in finance, however, where the most obvious opportunity arises. Distributed ledger technology could reduce the cost of cross-border payments, securities trading and regulatory compliance. In fact, several large banks have already started looking at blockchain applications, including the development of a “utility settlement coin” that aims to clear and settle financial transactions over blockchain, at a fraction of the time, cost and capital required in post-trade settlement and clearing.
Blockchain still has a long way to go before broad adoption. There are outstanding issues of understanding, regulation, governance and efficiency. The lack of understanding in particular is hampering investment and collaboration, and regulators are struggling to keep up with the technology. Nevertheless, the future of the technology seems bright.
Even if cryptocurrencies are here to stay, it is unclear which one among a crowded field will be the winner. Hundreds of start-ups appreciated rapidly during the dotcom bubble, on the premise that ‘the internet will change the world’. It did, but the majority of those companies are now worthless. A similar fate may await the vast majority of today’s cryptocurrencies.
Editorial image credit: skodonnell / iStock