Cryptocurrencies: The Good, the Bad and the Bubbly

We explore the case for and against bitcoin and how the technology behind it is the big winner.

On 20th December 2017 we published an Insights piece looking at the origins of Bitcoin and the wider cryptocurrency market. We wrote that Bitcoin “possesses many of the characteristics of a speculative bubble” but that “we will be following the development of this technology with interest”. Since then much has changed.

What has happened to Bitcoin?

After peaking on 17th December 2017, Bitcoin’s price fell 80% over the next 12 months before recovering to around $7k per Bitcoin (see below).

BITCOIN PRICE


Source: Bloomberg (24.01.2014 - 22.11.2019)

The Bull Case: Bitcoin is the most well known and liquid cryptocurrency; benefits that perhaps helped it weather the crypto “winter” better than its peers, during which its market share increased as cryptocurrency prices declined (see below). If its brand and liquidity continue to strengthen, it could become the go-to asset for those seeking investment exposure to the industry. Forecasting the future price under this scenario is difficult, but a comparison to gold could be made given that both Bitcoin and gold are unregulated and have little use except as a store of value. By this comparison Bitcoin has a long way to catch up with the gold market, which is roughly 65x larger by value and absorbs 10x more supply.

PERCENTAGE OF TOTAL MARKET CAPITALISATION


Source: coinmarketcap.com as at 21.11.19

The Bear Case: There are few barriers to entry for new cryptocurrencies and, due to improved technology, new coins permit faster and cheaper transactions. These are obvious benefits for customers and may promote wider use of newer coins versus Bitcoin, considered to have one of the slowest transaction speeds amongst peers. In addition, the transparent nature of Bitcoin whereby all transactions are public could limit its appeal to those who want to keep things private, preferring instead to use one of the newer “dark” crytpocurrencies. These risks to Bitcoin’s liquidity and price are unquantifiable.

What’s changed? Less Bitcoin, more Blockchain

Whilst our last Insight piece was wary of Bitcoin, we noted “Blockchain technology is here to stay”. Since then the distinction between cryptocurrencies (e.g. Bitcoin, Ether, Ripple etc), and the underlying technology, has continued to widen. Cryptocurrency’s reputation has been damaged by high price volatility and its use for fraudulent and criminal purposes. In contrast, the legitimate applications for and investment in Blockchain are increasing rapidly. Blockchain technology or “distributed ledger technology” makes information available to a number of users, any of who can add an entry to it, but none can delete one. This “immutability” is a valuable feature for many business processes. For example, over the course of a commercial flight, an item of luggage is handled by a number of different agents, often across different countries. When a bag is lost (a problem that costs the industry over $2bn a year [1]), it can be difficult to identify which part of the chain broke down as there is often not effective information sharing between the airports, airlines and their multiple contractors. A system whereby all handlers added to a shared ledger (by scanning the bags label when they handled it), would greatly help find lost luggage by seeing where the process broke down.

More broadly, the ability to monitor items with greater accuracy as they are passed across different handlers is of great value to the many companies who are part of long, complex supply chains in sectors like manufacturing (especially automotive), technology hardware, retail, pharmaceuticals and logistics. Blockchain technology is starting to be applied in all these areas.

Big Business Moving in

The world’s most valuable bank, JPMorgan, has created a “BlockChain Centre of Excellence” which is exploring blockchain use cases[2], one of which is now used by over 220 other banks. However, the bank’s attitude towards cryptocurrencies has not changed since their CEO, Jamie Dimon said he would “fire in a second” any employee caught trading them. Similar blockchain initiatives have been launched by Goldman Sachs, CitiGroup, Barclays and Deutsche Bank.

The world’s largest asset managers are also getting involved, including BlackRock who are “looking into blockchain technology”[3] and Fidelity now offering custodial services to clients wishing to store cryptocurrencies safely with them[4].

Outside finance, blockchain technology is being adopted by Amazon, Uber, IBM, GlaxosmithKline and many others. The most controversial new entrant though, is Facebook.

What is Libra?

Facebook has proposed the creation of Libra, a new currency which tracks the value of a basket of global currencies. In the same way the FTSE 100 is a mix of the UKs largest companies, Libra comprises some of the world’s largest currencies, with the United States Dollar making up 50%, Euro 18%, Japanese Yen 14%, Sterling 11%, Singapore Dollar 7%. As people purchase Libra their money is converted into the underlying currencies; the diversification achieved makes Libra less volatile than its constituents. This stability could appeal to those making international payments, ranging from foreign workers to multinational companies conducting business across different countries. Furthermore, given that globally one in five people use either Facebook, Instagram or WhatsApp every day they arguably have the world’s largest distribution network. The exact mechanics of how their system would work is similar to a cryptocurrency, but with the important difference that Libra’s price would be tied to its underlying currencies, not like Bitcoin, which fluctuates with supply and demand. There are other cryptocurrencies, like Libra, that fix their price to other assets, like currencies or gold, these are known as “stable-coins”.

Despite publishing an extensive library of documents on how Libra would mitigate various risks, Facebook probably underestimated the political response. Facebook’s founder and CEO Mark Zuckerberg was questioned by congress for over 6 hours and despite his best efforts to reassure them, the mood was summed up by Congressman McHenry who said “I’m not sure we’ve learned anything new here”. They expressed concerns over the extent to which it could be abused, both by Facebook and by criminals, but a likely concern they did not mention was the resulting power Facebook could wield over governments if Libra did get widespread adoption, (perhaps through adjusting the currency weightings).

Sensing damage through association, financial backers and partners such as MasterCard, Visa, eBay and others have pulled out. As it stands, it is unclear if the project will ever be launched. This is probably for the best as we believe that international currencies should be overseen by governments, not companies.

How to lose money with cryptocurrencies

There are many approaches, but the most popular is by purchasing one of the more fringe alternative cryptocurrencies (“alt-coins”) which often claim to have big advantages over each other but in reality often have little more than a celebrity endorsement and an evangelical promotor. After initial enthusiasm the excitement normally fades and the price declines. Over 80 alt-coins have lost more than 97% of their value from their all-time highs and we expect many of the 600 others to follow. The most high profile case was of OneCoin, where over $4bn was lost by investors. Other sources of losses have come from a “51% attack”, whereby a majority of the miners (the computers powering the cryptocurrency) are controlled by a malicious user who is then able to effectively steal the underlying coins. A final source of losses has come from exchanges being hacked and the perpetrators making off with the digital bullion. Sometimes the exchanges have enough assets to cover the losses, but often they do not. The largest ever was the hack of Coincheck in 2018 where the equivalent of $530m of client’s funds were stolen[5].

Can we invest in blockchain technology?

With difficulty. Whilst it is easy to purchase an ETF that claims to invest in this area, in reality almost all the companies they invest in, many of which we are familiar with, are only using blockchain technology in a small way. Like trying to invest in Artificial Intelligence, it is difficult to invest in some technological advances because they are not owned by anyone and as they are adopted gradually by so many companies, their benefits are gradual and diffuse.

Whilst not what we do at Waverton, individuals can invest in many of the crypto start-ups that are looking for funding. Whilst a few of these may go onto greatness, we believe that anyone who is not an expert should be cautious given the high prevalence of fraud and lack of legal protection.

Bitcoin as a Diversifier

As the chart below shows Bitcoin’s correlation with the S&P is not consistent, averaging slightly positive (i.e. not diversifying) since 2010. This compares to traditional sources of diversification such as 10yr US treasuries, which have had a consistently negative relationship with the S&P.

CORRELATION OF BITCOIN AND S&P500​
calculated on a rolling 60-day basis 23.07.10 - 12.11.19


Source: Bloomberg

What’s next?

We are maintaining our view that cryptocurrencies are best avoided but that blockchain technology will continue to grow. We remain focused both on seeing if there are opportunities to invest in listed companies which can benefit from these advances, but also in avoiding those companies who are overstating their ability to.

Day to day, most us will probably take for granted the extent to which blockchain technology is making our life easier, not noticing that our luggage is lost less often, cheques clear quicker, food is safer, medical records better maintained, products costing less etc. However, even if we do stop to give thanks, we cannot: the author of the original 2008 paper which gave rise to this exciting new technology, remains anonymous.

William Hanbury
Associate Director, Asian Equities
19th November 2019

Risk Warnings​

The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions.  The information provided does not constitute investment advice and it should not be relied on as such.  All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Past performance is no guarantee of future results and the value of such investments and their strategies may fall as well as rise.  Capital security is not guaranteed.