Two Sides to Every Coin

When new financial technologies arise, we are often sceptical because many of these ‘ground-breaking’ innovations often fail to live up to their expectations and quickly fall from the top of Silicon Valley and deep into the Silicon abyss. However, cryptocurrency has presented a case for itself as one of the disruptive drivers of financial technology in the last decade. Bitcoin (BTC), arguably the most influential cryptocurrencies, was created in response to the global financial crisis by a group hidden under the mysterious pseudonym of Satoshi Nakamoto. The purpose of Bitcoin was to serve as means of digital payment and to decentralise power away from the ‘untrustworthy banking institutions’ which were at the time being bailed out by governments.

Now almost twelve years since the first BTC transaction took place, (a Papa John’s order to the sum of 10,000 BTCs in case you were wondering) has it served its purpose and established itself as a viable alternative for traditional notes and coins?

At the moment, cryptocurrencies are still very much in their infancy stage and declined as payment by the vast majority of firms. Most cryptocurrencies differentiate themselves from traditional currency by using Blockchain technology. This is essentially a shared public database which holds transactional records across many locations and participants. Every transaction recorded in the ledger is secure and does away with the need for central banks or higher authority. These transactions are verified via a process called mining which involves a network of powerful computers calculating vastly complex mathematical problems to verify the large volume of daily transactions taken place – The reward for users calculating these sums is a precious fraction of newly issued cryptocurrency.

Mining has become a popular alternative method for users to earn cryptocurrency. However, this comes at a cost to the environment as the mining process used to verify transactions and issue new currency is inherently inefficient. Mining crypto requires a phenomenal level of resources which has led to criticism around sustainability and impact on future generations. While there seems to be a wide array of research investigating the environmental impact of crypto, most of the literature express the difficulties in in calculating the true impact. These environmental issues are only exacerbated when the price of crypto coins goes up and competition among miners increase. Mining has also placed a great strain on the resources needed to create PC components and has increased the amount of waste created as old components are regularly replaced with new ones. Many businesses and households have seen IT equipment become less accessible and considerably more expensive.

In our previous investment article, my colleague James Bacon discussed the consequences of inflation, and the tools central banks have at their disposal to control inflation and dictate the direction of our economy. Central banks control the supply of money via quantitative easing, interest rates or in extreme circumstances, can change the reserve requirements which commercial banks must hold. These are three monetary policy tools that de-centralised cryptocurrencies do not have access to as they are unregulated. Therefore, the pricing of cryptocurrencies is more vulnerable to factors such as scarcity, speculation and other exogenous risk factors are a primary cause for the extraordinary levels of volatility exhibited.

Despite this, investors of cryptocurrencies have interpreted the risks above as an opportunity for lucrative returns. Interestingly, compared to its rivals, BTC is market capped at 21 million coins. Of those, around 19 million has been mined so far, making BTC a scarce resource and one of the reasons why investors choose to hold it as a store of value. Investors speculate that as BTC becomes increasingly finite, the value of BTC will increase and for some, this has wager has paid off massively. Given its market cap, some BTC die-hards have argued that it is an effective option for those wishing to hedge against inflation. The advantage of having a finite supply and decentralised structure means that BTC is deflationary in theory. Since the start of 2020, BTC has yielded close to 400% returns rising from c. £8,000 in January 2020 to c. £40,000 at the start of May 2021. However, we are not convinced of its inflation hedging properties as it is far too volatile compared to Gold and far too early in BTC’s life cycle to give any confidence in its ability to hedge.

In contrast, one region where cryptocurrencies have proven to be a successful replacement for hard currency is in Venezuela. A deep recession and rampant inflation have created economic instability and since the death of President Hugo Chávez, there has been a complete lack of faith in governance. This has led to a financial revolution similarly to how had Nakamoto envisioned. As the inflation in Venezuela was an astronomical 6,500% in 2020 - suddenly, BTC’s price movements sound rather reasonable compared to the Bolivar. For Venezuelans, and other political unstable regions across the world, BTC has provided a lifeline for inflation hedging and for digital transactions.

Ultimately, this highlights that traditional currencies, cryptocurrencies and other forms of new financial tech all have one common factor – their value depends on the level of faith vested by market participants. If the participants lose faith in the issuing institution, then the perceived value of the currency will suffer, such as in the case of the Venezuelan Central Bank. This is a form of political risk which cryptocurrencies are highly susceptible to – This week saw China swiftly ban cryptocurrency services which led to a crash in crypto markets. Combined with Elon Musk’s comments around Bitcoins means that confidence in cryptocurrencies is being placed under severe strain. If other countries follow China’s footsteps this will be a detrimental blow to the future of cryptocurrencies.

To answer the question posed at the beginning of the article, it’s unlikely that cryptocurrencies will replace hard currencies and more likely they will coexist as an alternative. The biggest risk of cryptocurrencies is that they are far too volatile for use daily, unregulated, and not backed by any government or physical commodity. For some politically unstable regions, adopting cryptocurrencies can be beneficial, however, making a case for the use in developed economies, such as the UK where the willingness to hold GBP is nigh on indestructible, is a difficult proposition to justify.

Cryptocurrencies have been lengthy topics of discussion in our Investment Committee meetings and believe they are far too risky for even the most adventure seeking investor and should only be considered if the investor can afford to lose the sum paid. There are over five thousand cryptocurrencies at the time of writing which only exacerbates the asset class’s dependency on speculation. As strong advocates of behavioural economics, it is important for us to cast astray our fear of missing out and not to blindly follow the herd.

Lee Nguyen Investment Analyst

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