With this high volatility in mind, we believe that current Bitcoin investments should be largely viewed as speculative bets rather than growth assets. Cryptocurrencies are still a novel asset class, and a true understanding of their valuation and price movement is elusive compared with traditional asset classes within a well-diversified portfolio. It’s also important to remember that Bitcoin has only existed in a world of rising equity markets and low inflation. That said, it is still useful to think about the future trajectory of Bitcoin and assess the challenges that must be overcome for cryptocurrencies to emerge as a credible allocation for institutional investors.
Challenges Facing Bitcoin Investors
A variety of challenges need to be overcome in order for Bitcoin to be considered a defensible choice for institutional investors. These include valuation concerns, risks stemming from the complexities inherent to the asset, and the long-term sustainability of the Bitcoin market.
Valuation. The lack of a tangible backing, yield, or income makes assessing the value of Bitcoin a complicated process and partly explains its elevated volatility levels.
The challenges in determining the intrinsic value of an unbacked cryptocurrency such as Bitcoin are numerous and complex. Existing fiat currency valuations are determined partly via expected cashflows and valuation metrics that are ultimately tied to a country’s growth and inflation patterns. With Bitcoin, there are no expected future cash flows that can be discounted to the present. Valuation is therefore based solely on supply/demand factors and predicated on the hope that future investors will pay more for this intangible asset. As a result, the risk of Bitcoin losing almost all of its value is not negligible.
The wide dispersion of Bitcoin price targets among different market observers is one indicator of the difficulty in valuing cryptocurrencies. Some commentators believe that Bitcoin has the potential to displace gold as a primary alternative store of value in the form of “digital gold.” In this vein, based on an equalization with the US$2.7 trillion global private stock of gold, JP Morgan recently suggested a long-term target price for Bitcoin of US$146,000. In December, the CIO of Guggenheim Investments suggested a fair value of US$400,000. On the other hand, UBS recently expressed that they “are somewhat skeptical of any essential real-world use cases… [and]are cognizant of the real risk of losing one’s entire investment.”
Risks. The boundary between theory and practice is considerable in the case of cryptocurrencies – and even more so for institutional investors looking to gain exposure to them. Outside of valuation, the complexities of investing in Bitcoin are multifaceted and include a range of risks that few investors are equipped to manage. These risks include those posed by a lack of understanding of the technology underpinning the crypto; fragmented regulatory frameworks; technical vulnerabilities (e.g., bugs in the code, risk of cybertheft); competitive risks (e.g., low barriers to entry for new cryptoassets); uncertainty in the application of accounting rules to cryptocurrencies; and environmental concerns related to the energy required for mining new Bitcoins.
Sustainability. In a non-asset-backed cryptocurrency market that moves purely on supply and demand –and is deliberately divorced from all discernible investing fundamentals – a logical question remains as to whether a particular cryptocurrency will continue to exist over the time horizon of an institutional portfolio. The comment provided by UBS above certainly gave us pause.
The Way Forward: Regulation
We are firm believers that the technological innovation that underpins cryptocurrencies will transform the global payments market going forward. The notion of waiting days for a transaction to clear will soon become as archaic as mailing a personal check and waiting for the mail carrier to deliver it. The remaining question, however, is whether Bitcoin is that payments future. At the moment, it is not.
Though the prospect of regulation seeks to deny the rogue birthright of cryptocurrencies, regulated cryptocurrencies would become more stable mediums of exchange and stores of value, which would open them up for consideration as a currency-like asset class. With rules and regulations in place, mainstream acceptance and adoption would follow, and higher acceptance would attract more capital to the space, providing more liquidity and ultimately reducing volatility.
Recent regulatory guidance in both the United States and Europe offers examples of regulators’ initial attempts to provide clarity, which should accelerate the legitimization process of cryptocurrencies as a whole. Conversely, further regulation may have the offsetting effect of dampening the interest of investors who are wary of authority and who were attracted to cryptocurrencies by the anonymity they provided. Nonetheless, we believe regulation is a requirement for widespread institutional adoption.
Institutional interest in cryptocurrencies has grown over the years. Despite the potential diversification benefits of Bitcoin, the challenge of determining its value and identifying its fundamental risk and return drivers is a major hurdle to understanding its role and purpose within a broader portfolio.
Although Bitcoin is the current cryptocurrency leader, no one can be assured that this dominant position will last. For investors who are determined to take on a cryptocurrency allocation as a strategic long-term holding, a diversified basket of cryptocurrencies may be appropriate. Another option is gaining exposure via trend-following Commodity Trading Advisors or other types of hedge funds, many of which implement real-time risk monitoring with defined risk guidelines.
Ultimately, we believe each investment in a portfolio should have known drivers and relationships that allow investors to reasonably anticipate the environments in which it will excel or underperform. We currently characterize Bitcoin’s behavior as that of a speculative risk asset; we continue to follow its development and look to further define its place within a diversified portfolio.
Originally published by State Street, 3/9/21
2 This discussion relates only to non-asset-backed cryptocurrencies, of which Bitcoin is the most prominent example. We will use “Bitcoin” in this article as a proxy for all non-asset-backed cryptocurrencies. It is helpful to make a distinction between asset-backed and unbacked cryptocurrencies. Central bank digital currencies (CBDC) and stablecoins are backed by an asset or basket of assets such as fiat currency, commodity, or index. The asset-backed principle is designed to reduce the volatility of a cryptocurrency and elevate its use case as a medium of exchange, rather than as an investment opportunity.
3 Bitcoin is a digital currency that was created in January 2009. It follows the ideas set out in a whitepaper by the mysterious and pseudonymous Satoshi Nakamoto. The identity of the person or persons who created the technology is still a mystery.
4 See https://static.bitwiseinvestments.com/Research/Bitwise-The-Case-For-Crypto-In-An-Institutional-Portfolio.pdf
5 JP Morgan (January 2021).
7 UBS (January 2021).