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Pros and cons of cryptocurrency
The price of one bitcoin in US dollars quadrupled last year, gaining over 160% in Q4 alone. This meteoric rise sparked widespread media and investor interest in bitcoin specifically and in cryptocurrencies more generally. Moreover, many payment platforms such as BitPay, Square and PayPal have started accepting payments in bitcoin and other cryptocurrencies. It is also becoming easier to trade cryptocurrencies on established platforms. Here, we look at some of the potential advantages and disadvantages of cryptocurrencies.
1. Potential for high returns
In the five years to 31 December 2020, the S&P 500 index of large cap US equities has compounded at an annualised growth rate of 14.5% (in USD, net dividends reinvested); over the same time period the price of bitcoin in USD has compounded at an annualised growth rate of 131.5% (see graph below).
2. Potential diversification
Some have cited cryptocurrencies as an alternative hedging instrument to gold in a portfolio context. For example, the S&P 500 declined in 17 out of the 60 months to end December 2020, of which the price of bitcoin rallied in seven. In the five years to the end of 2020 a portfolio consisting of 10% invested in bitcoin and 90% in the S&P 500 would have generated compound annual returns of 26.8%.
3. Limited supply
There is a maximum of 21 million coins that can be created or “mined”. At the moment around 18.5 million bitcoins have been mined leaving less than three million still to come into existence. A related feature is that the rate of production of bitcoins slows over time via a process known as halving. In 2009 each block mined was worth 50 bitcoins, the value is now 6.25 bitcoins per block.
4. Protection from debased currencies and the threat of rising inflation
The Global Financial Crisis (GFC) of 2008/09 was a catalyst for central banks around the world to engage in unorthodox monetary policies, notably large-scale asset purchases. Since the GFC the Fed’s balance sheet has expanded by 8x, the ECB’s by a little under 4x and the BoJ’s by nearly 7x. Some people are concerned this will result in a massive debasing of national currencies and associated increase in inflation. They suggest cryptocurrencies offer alternatives that cannot be debased in the same way.
5. Growing acceptance and usage
A 2020 article on Coindesk.com claimed that Coinbase had seen $135 billion in cryptocurrency merchant transactions in 2019, a 600% increase over 2018. That same article cites a Chainalysis report that alleges payment processors saw approximately $4 billion worth of bitcoin activity in 2019. Separately, it is notable that there has been a significant increase in the number of bitcoin electronic wallets created over the past few years (see graph below) and there are an increasing number of institutional investors who are looking to invest in cryptocurrencies, the latest being Blackrock and Bridgewater.
1. High volatility and potential for large losses
The annualised volatility of the monthly percent change in the price of bitcoin in US dollars is about 90% as measured over the past five years. This compares to annualised volatility of the monthly percent changes in the S&P 500 and the gold price of 15.3% and 13.4% respectively. To give some idea of what this volatility might mean for an investor, consider the range of returns: the maximum monthly bitcoin return over the 60 months to end December 2020 was 76.1% and the minimum -37.6%. The timing of an investment in bitcoin or other cryptocurrencies will have a significant bearing on the returns achieved.
As noted earlier, of the 17 months the S&P 500 fell over the five years to end 2021, the price of bitcoin went up in seven. To put it another way, of the 17 months the S&P 500 declined, bitcoin also went down in 10 of them, which is slightly less flattering. Of the five worst months for the S&P 500 the price of bitcoin declined in four of them – one could argue that bitcoin has a poor record of providing diversification benefits when they are most needed. The correlation between bitcoin returns and S&P500 returns is positive and stronger than the correlation between gold and S&P500 returns.
3. Endless potential supply
Whilst it is true that the number of bitcoins produced will eventually be capped at 21 million and many other cryptocurrencies also have limited supply built into their protocols, there is currently nothing to stop an ever-growing number of new cryptocurrencies from being launched. Therefore, cryptocurrency supply is potentially limitless. It is also worth noting that several central banks are exploring the possibility of launching their own digital currencies, something that may take the shine off privately issued versions.
4. Poor store of value and limited acceptance
Whilst bitcoin and some other cryptocurrencies are now accepted across a growing number of payment platforms, the number of places where one can exchange cryptocurrencies for real goods or services remains very limited. For similar reasons the volatility inherent in cryptocurrencies makes them a poor store of value given the fact that when converted back into an individual’s base currency the value of crypto will swing about wildly even on an intraday basis.
5. Unregulated and unbacked
Cryptocurrencies are a construct of the private sector with no official oversight or regulation. This means that cryptocurrencies are wide open to being exploited by criminals as a means to scam unwary investors. A 2019 academic study found that 25% of bitcoin users are involved in illegal activity and that 46% of bitcoin transactions are associated with illegal activity.
This list is not exhaustive but it’s important to understand the potential for large losses. Supporters of cryptocurrencies would argue that this downside risk is offset by the potential for large returns and that the risks can be managed by appropriately sizing a cryptocurrency position within a portfolio of other investments. The overall decision on whether or not to add cryptocurrency exposure to a portfolio is based on each individual’s assessment of the balance of advantages and disadvantages, the main ones of which we have tried to highlight in this note.
Distinct from the discussion on cryptocurrencies, there are a number of potential advantages in utilising blockchain technology more broadly within the financial system. Perhaps paradoxically given the current lack of regulation of cryptos, blockchain could be a powerful regulatory tool. Blockchain could also be used as a means of cost reduction to make the financial system more efficient.