As the price of Bitcoin surged to yet another all time high, crypto-mania has truly taken hold as seasoned hedge fund investors have signaled their openness to allocating to the digital currency while JP Morgan has presented long-term forecasts as high as $146,000. Despite the renewed enthusiasm that accompanied Bitcoin’s 2020 rally, it’s acceptance as a mainstream asset relies on much more than speculation and narrative. To be considered a mainstream asset (on par with the likes of equities, bonds and FX), cryptocurrency need to pass the scrutiny of institutional investors, these include the likes of pension funds, endowment funds, sovereign wealth funds and asset consultants as they are the true gatekeepers of capital.
These fiduciaries manage or advise on trillions of dollars worth of multi-asset class portfolios globally where strategic changes on investment stance can have marked effects on the market landscape. Recent examples of this have included passive investing, private equity and ESG investing. Before institutional investors can take cryptocurrencies seriously as an investible asset class, there are considerable challenges that need to be addressed.
Bitcoin in its relatively short lifespan has been extremely volatile. On an rolling annualized basis the its volatility has been multiples of other assets such as gold and stocks. Investors often use return volatility as a measure of total risk meaning that even a small allocation to Bitcoin can have much larger effects on overall portfolio risk, making it difficult to initiate at a meaningful allocation.
2. Underlying fundamentals drivers of valuation
Investors often use valuation frameworks to help gauge whether assets are over or undervalued before making investment decisions. The drivers that underpin the fundamental value of Bitcoin are unclear, thus making it extremely difficult to determine its “fair value”. Although some attempts have been made, such as the use of Metcalfe’s Law, they differ from the accepted discounted cash flow and risk premia methodologies that are prevalent in institutional investing. The lack of yield on Bitcoin only serves to exacerbate the problem. The bottom line is that the inability to readily value Bitcoin makes the investment case much harder.
3. Effectiveness as a hedge
Market commentators have recently pointed to Bitcoin as a substitute for gold as a store of value due to its separation from fiat currency. This attribute means it could be potentially used to diversify US dollar weakness, inflation and risk events. While it might make sense at first glance two key points detract from this narrative. First, once again, the drivers of Bitcoin’s fundamental value are dubious, making it difficult to ascertain the prospective relationships it might have with the key economic and financial variables which are required for an effective hedge. Second, empirically, Bitcoin has not demonstrated persistently meaningful correlation to any of the assets mention
If anything, the correlation to stocks spiked after the drawdown event in Q1 2020 suggesting that it might be a poor hedge of growth assets going forward. Furthermore if we look at a drawdown comparison of assets in 2020, Bitcoin suffered a drawdown more than two times greater than the S&P 500 during the March sell off.
4. Fueled by speculation and bubble-like behavior
In “Narrative Economics”, Nobel Prize winning economist Robert Shiller notes that when confronted by Bitcoin enthusiasts he often asks them to explain some of the technical concepts at the core of the technology such as Merkel tree or Elliptic Curve Digital Signature algorithm, after which he is typically confronted with blank stares. He goes on to postulate that the reason people buy Bitcoin is to participate in something new and exciting as they buy into the narrative. This passage perfectly sums up the current state of speculation induced buying of Bitcoin as the price continues to soar even after doubling in the space of one month. The behavior displayed is reminiscent of other manias, like the Tulip and South Sea bubbles.
The anonymity and non-reversibility of transactions under Bitcoin means that it is ideal for the facilitation of illicit exchanges. This is but one of the reasons that governments and central banks are looking to regulate cryptocurrency. However, it is precisely this feature that makes enforcement of any such regulation extremely difficult. Despite this, many institutional investors will remain wary of falling foul of the regulators.
So What Does This Mean?
The merits to the technology underlying Bitcoin and cryptocurrency are clear, companies like R3CEV, a consortium of well-known traditional financial institutions such as State Street, UBS and Goldman Sachs already occupy the forefront of research and advocation for the integration of blockchain into the financial system. However the role of Bitcoin as a financial asset remains unclear, as its volatility, lack of robust valuation framework and future regulation all pose serious challenges to its acceptance.
Disclaimer: This post is purely an expression of personal views and opinions. It does not represent advice in any way.