Balentine’s View on Cryptocurrencies: An Update
Currency Series, Part 3 of 3
In the 2018 Capital Markets Forecast, published during peak Bitcoin hysteria, we felt compelled to write a piece on cryptocurrencies. Following our discussion on currencies as an investable asset class in Part 2 of this series, we wanted to revisit our 2018 piece, especially given the relative loss of interest in the cryptocurrency space since December of 2017 and the strong price appreciation most have experienced in 2019.
A Review of Our Previous Comments
In the 2018 Capital Markets Forecast, we attempted to classify cryptocurrencies as one of three traditional asset classes: commodities, currencies, or (private) equity. Our conclusions on the closeness of fit for each category were as follows:
We claimed that cryptocurrencies serve no utilitarian function, but they do exhibit some inflation-hedging properties. We explained that cryptos had behaved like safe-haven assets during some risk-off environments, but these phenomena were regionally contained and centered on wavering confidence in central bank efficacy (e.g., the performance of Bitcoin during the 2013 Cyprus bank “bail-in”). We proposed that cryptocurrencies, as with gold, could play the role of a safe-haven asset moving forward.
We stated that cryptos do, technically, qualify as “money” since most of them 1) function as mediums of exchange, 2) are units of accounts, and 3) function as stores of value (albeit poor ones given excessive price volatility). However, as discussed in Part 2 of this series, currencies, while an asset class, are not investable given that they have no intuitive, pervasive, nor accessible risk premium and play no predictable role within portfolios.
As a New Form of Venture Capital
We discussed the intrigue surrounding the initial coin offering (ICO), a new funding mechanism by which token holders are rewarded if their protocol is adopted en masse. We stated that this claim on future services rather than earnings is a potentially valid new form of venture capital.
Furthermore, we asserted that one must caveat any discussion of cryptocurrencies as an asset class by acknowledging the size of the nascent market. Ignoring stock versus flow technicalities—and multiplying the number of coins outstanding by the price per coin as a proxy for coin market capitalization—the size of the crypto market was a mere $700 billion at the beginning of December 2017. Two years later, that number has plummeted to about $200 billion, which is unsurprising given the disappointing price action over this period. For comparison, both the global equity and global fixed income markets each exceed $50 trillion in market cap.
Recent Developments in the Crypto Space
The Chicago Mercantile Exchange (CME) and the Cboe Futures Exchange launched cash-settled Bitcoin futures in early 2018. While the Cboe halted the introduction of new futures contracts in March 2019, capitulating at the tail end of an extended Bitcoin bear market, daily volume on CME listings is up ~130% year-over-year, and the firm plans to double risk limits for traders in the coming months. More competitors are planning to enter the derivatives space, with Atlanta-based Bakkt leading the way in the physically settled futures market.
We have also seen an entrance of large, reputable firms into the crypto sphere, including the likes of J.P. Morgan Chase, Visa, Toyota, and Santander Group, which recently settled a bond via the public Ethereum ledger. Facebook has announced its polarizing plans for Libra, an ostensibly decentralized blockchain and reserve-backed cryptocurrency. The public relations headache that is Libra has been a regulatory lightning rod, but it is emblematic of the broader trend in stablecoin development (i.e., cryptos pegged to traditional fiat currencies). These stablecoins have the potential to help skeptics better acclimate to blockchain-based systems. For example, Franklin Templeton, far removed from Silicon Valley, recently launched a stablecoin meant to facilitate ease of transaction within its money market funds. Regardless of whether corporate blockchain initiatives come to fruition, they bring media attention and lend credibility to the space, reducing the chances of crypto simply vanishing as a baseless, decentralist fantasy.
Cryptos vs. Traditional Asset Classes
Cryptos have not evolved in features or market behavior to more closely align with any of the three asset classes discussed earlier. Crypto’s ability to play the inflation-hedging commodity role (or simply the role of barometer for inflation expectations) has yet to be thoroughly tested, with the only real data to suggest that Bitcoin will fulfill this type of role in the future coming from events of extreme capital flight within nations such as Venezuela and Argentina. As a safe-haven asset or shock absorber, it has failed to live up to theoretical expectations. In fact, it has been the opposite of a safe-haven asset, acting as more of a risk-on, liquidity-driven trade. Take Bitcoin’s returns in the fourth quarter of 2018, for example:
The situation remains murky on the “crypto as currency” front. The number of merchants accepting Bitcoin transactions is slowly increasing, stimulating interest from large players as evidenced by the launch of Apple’s CryptoKit in June, but the odds of Bitcoin usurping traditional means of payment remain low; only 1.9% of all network activity was merchant-related through the first four months of 2019. Crypto’s prospects as a new form of venture capital also appear grim. In 2018, over $7 billion was raised in more than 1,200 ICOs, while only $360 million was raised in just shy of 100 ICOs through the first eight months of 2019. Much of this decline is due to the questionable motives of ICO promoters and an increased regulatory crackdown on ICOs that were patently engaging in fraudulent activity.
Our 2018 recommendation still holds—we are content to remain on the sidelines and diligently monitor developments in the cryptocurrency arena while its potential role within a diversified portfolio becomes apparent. Furthermore, the market is still relatively young, insignificant in size, and difficult to access. While there have been some improvements in cryptocurrency infrastructure, such as institutional-level custodial services, the fact remains that trading and holding Bitcoin or any other cryptocurrency can be an arduous process; investors still lack an easy way to own crypto through a simple vehicle such as an exchange-traded fund.
Additionally, there remain several idiosyncratic risks for which investors are not compensated. For example, the admittedly harmless September bug that caused spreads on Bitcoin, with a ~$10,000 price, to widen to $4,000 on the Kraken exchange, should not happen, nor would it happen on an established equity exchange. We expect the slow process of cryptocurrency institutionalization to result in fewer extreme price swings. Indeed, a reduction in the fatness of the tails of Bitcoin’s return distribution does seem to be occurring. But, even with some convergence to mean-stationary expected volatility, cryptocurrencies still do not fit neatly within any optimization framework. That is, we have no reliable method to estimate the expected return or expected risk. For those investors who do insist on holding cryptocurrencies, we continue to advocate the purchase of multiple coins, sized appropriately. While one or more cryptocurrencies may yet prove massively disruptive, there exists a nonzero probability that many will become worthless in the years ahead.
 Savills Studley, BIS, SIFMA, World Federation of Exchanges, UN Commodity Statistics Report
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