While the recent launch of Bitcoin futures on two leading derivatives exchanges may have given the world’s first ‘digital currency’ a stamp of legitimacy, doubts remain whether it, and other cryptocurrencies, will become a mainstream investible asset class.
In October 2008, a pseudonymous individual or group by the name of Satoshi Nakamoto published what was to become a seminal paper, introducing Bitcoin.1 Three months later, the cryptocurrency was formally launched. Few at that time could have envisaged the extent to which it would be grabbing newspaper headlines around the world less than a decade on.
It is far from clear Bitcoin, or any of the other cryptocurrencies, will ever appeal to institutional investors.
That it should be doing so is hardly surprising when one considers that between July 19, 2010 and December 11, 2017 the price of each Bitcoin climbed more than 29 million per cent, pushing up the value of each dollar invested to $292,494.2 Over the same period, a dollar invested in the S&P 500 index would have risen to just $2.90.3
The surge in Bitcoin’s price helped spawn a deluge of rival digital currencies; Ethereum, Ripple, Bitcoin cash and Cardano being among the most popular. According to the coinmarketcap.com website, as of January 30, 2018, there were as many as 1499 cryptocurrencies in circulation with a total market worth of $554 billion. Bitcoin accounted for just over a third of that total.
With Bitcoin rarely out of the headlines in recent months, there has been a surge in the number of funds offering investors an opportunity to profit from a further rise in its price. According to Autonomous NEXT, a London-based provider of research on the fintech sector, there are 175 ‘crypto’ funds with $3-4 billion of assets under management. While it appears the majority are looking to lure investors hoping to make a quick turn, even respected fund managers have been getting in on the act. For instance, famed value investor Bill Miller recently revealed his MVP1 hedge fund had half its assets invested in Bitcoin.4
However, while the main US markets regulator – the Commodity Futures Trading Commission – may have given the green light to two of the world’s largest derivatives exchanges, Cboe Global Markets and CME Group, to launch futures contracts, it is far from clear Bitcoin, or any of the other cryptocurrencies, will ever appeal to institutional investors.
Are cryptocurrencies money?
At present, there is little evidence of digital currencies being used across societies in a co-ordinated way.
To see why, one firstly needs to try to establish just what Bitcoin is. Given its name, it is little surprise many people think of it as a form of money. In his article announcing its impending arrival to the world, Nakamoto somewhat cryptically described Bitcoin as a “Peer-to-Peer Electronic Cash System”.
Interestingly, the open-source software released in January 2009 that contained the so-called Genesis Block – the first entry in Bitcoin’s transaction ledger and the means by which Nakamoto created the first 50 Bitcoins – included the following text from the UK’s Times newspaper: “03/Jan/2009 Chancellor on brink of second bailout for banks.”5
It seems likely Nakamoto appropriated this headline for good reason. By drawing attention to the flaws in fractional reserve banking that were exposed by the global financial crisis, he was attempting to boost the chances of Bitcoin being accepted as an alternative to traditional fiat currencies. But should Bitcoin be thought of as money and, if not now, what are the chances of it ever being considered so?
Money is vital to a modern economy, since it is used to underpin virtually all transactions. Throughout history it has come in many different guises. For example, the use of gold can be traced back to ancient Egypt. That form of exchange was replaced over time. For instance, in the middle of the 17th century London goldsmith-bankers began to issue receipts for gold lodged with them. Not long after, central banks issued their own promissory notes, which were redeemable in precious metals. Nowadays, money generally takes the form of banknotes, whose value depends not on gold but on the issuing central bank’s monetary policy.
Money’s three roles
From the perspective of economic theory, for something to be considered money it needs to perform three vital functions. Firstly, it needs to provide a store of wealth by enabling holders to transfer ‘purchasing power’ from today to some future date. To do so it needs to maintain a fairly constant value. Secondly, it needs to serve as a medium of exchange. Without money, goods would have to be exchanged through barter. And thirdly, it needs to serve as a unit of account. In other words, it provides the common standard by which the value of different goods and services can be measured.
The extent to which an asset can serve these functions can differ, both from person to person and over time. Theoretically, any object can be used as money so long as two people looking to make a transaction can agree on its worth. For millennia, gold’s value has derived largely from its efficacy as a medium of exchange and store of wealth. During World War II, even cigarettes performed this function in prisoner-of-war camps.
But taking each of money’s three functions in turn, it appears digital currencies act as a poor store of value – even if they have made numerous millionaires and many people are buying them for precisely this reason – due to the significant levels of volatility seen. For example, Bitcoin hit an all-time high of around $19,343 on December 16 after its price more than tripled in just five weeks. By February 5, it had plunged 64 per cent, to $6,914.6
Whether digital currencies will provide a better store of value in the future remains to be seen. Since they lack any intrinsic demand for use in consumption or production, and no central bank stands behind them, demand will ultimately depend on people’s belief in their long-term ability to perform money’s second function.
Unfortunately, it appears cryptocurrencies at present are no better as a medium of exchange than a store of wealth. Researchers at Cambridge University’s Judge Business School in April 2017 estimated there were no more than 5.8 million active users of cryptocurrencies around the world, and perhaps as few as half that number.7 The picture is bleaker still when considering their acceptance by retailers. As of July 2017, just three of the world’s 500 biggest online merchants reportedly accepted Bitcoin, two less than a year earlier. According to Morgan Stanley, acceptance has been hindered by surging prices.8
One of the original arguments in favour of cryptocurrencies was the promise that over time retailers would be drawn to them by their low transaction costs. At present, it costs around $4.2 to transact one Bitcoin, or 0.06 per cent based on a Bitcoin price of $6,914. From a merchant’s perspective, that compares favourably with either debit or credit card transactions.
However, there is no guarantee transaction fees will stay so low. As figure 2 shows, they rose sharply in tandem with Bitcoin’s price, before collapsing. That is for good reason since they are directly proportional to the desire to transact in Bitcoins at any given time. Because of the way the system is designed, the greater the number of people trying to transact simultaneously, the more expensive transactions become since ever more computing power is required to ‘process’ them. A Bank of England research paper published in 2014 concluded that over time digital currencies would struggle to compete with centralised systems on the basis of costs.9
As for money’s third role, for an asset to be considered a unit of account it must be able, at least in principle, to be used as a medium of exchange across a variety of transactions between numerous people. At present, there is little evidence of digital currencies being used across societies in such a co-ordinated way. While that is hardly surprising since their prices have been too volatile and acceptance of them too low, there seems little prospect of this changing.
The Bank of England’s researchers concluded that although digital currencies may have the potential to perform at least some of the functions of money over time, they faced “significant challenges” to their widespread use and it was “very unlikely” a digital currency, as currently designed, would be used as the predominant form of money in any economy.
A new asset class?
If cryptocurrencies cannot be considered money, could they be thought of as a new asset class?
So if cryptocurrencies cannot be considered money, could they be thought of as a new asset class, or ‘digital gold’ as some proclaim them to be? As with money, there is no clear definition of what constitutes an asset. The lines are blurred.
There are some who adopt a strict interpretation, arguing that an asset is something that provides a claim on future cash flows. These cash flows can be valued, and assets with high cash flows and less risk should be valued more than assets with lower cash flows and more risk. For instance, dismissing the attractions of Bitcoin, legendary investor Warren Buffett recently told the Washington Post: “There are basically two kinds of assets. One you look to the stream of income it will produce; the other you hope like hell that someone will pay you more for it.”10
While there are some merits in this view, arguably such an interpretation is unnecessarily restrictive. For a start, it would appear to prevent commodities such as gold from being considered assets since they pay no interest. Currencies would also be ruled out. Yet there is no logical reason why a US Treasury bill with one day to maturity and paying a minimal rate of interest – which is widely accepted to be an asset – should be considered any different to a one dollar bill.
A more useful framework appears to be to think of assets in terms of those that generate some form of income stream, allowing them to be valued, and those that don’t, which can merely be priced. After all, this second category of assets still appeals to many investors. Changes in comparative rates of interest are only one of the factors driving exchange rates, yet that does not prevent many investors taking large positions in currencies.
The difficulty in attaching a value
Although there is a case for fitting cryptocurrencies into this second group of assets, they face a number of obstacles to becoming a widely used form of investment. In the short term, what both currencies and commodities such as gold possess, which cryptocurrencies do not, is a lengthy track record. Without that price history, it is impossible for investors to form a meaningful judgement on where the price of such an asset is heading. To try to do so is especially dangerous when the market is so volatile.
However, even assuming Bitcoin or any other cryptocurrency manages to acquire a long track record, there is no guarantee they will become any more attractive to institutional and other traditional investors. Crucially, although the supply of most existing cryptocurrencies may be predetermined – for instance Nakamoto designed the software behind Bitcoin in such a way as to cap its eventual supply at around 21 million ‘coins’11 – it is unclear this will afford them some kind of scarcity value. After all, there is nothing to prevent an infinite number of rival coins, with identical characteristics, from being minted.
Why gold has value
Gold is widely seen by investors as a hedge against long-term inflation.
That marks a key difference with gold. While the precious metal also has some intrinsic value due to its use in various industrial processes, its worth is derived mainly from its scarcity.
According to the World Gold Council, with three quarters of the world’s deposits having already been mined, there are just 57,000 tonnes of gold left in the ground.12 Furthermore, despite annual world gold production having more than doubled between 1960 and 2016, from 1399 to 3100 metric tonnes, production per capita has fallen 9.5 per cent to 0.134 ounces.13
Gold’s scarcity means it is not only prized as a form of jewellery but, more importantly, as a quasi form of money thanks to its ability to act as both a medium of exchange and a store of value. This is a role that has stood the test of time thanks to central banks’ inability to erode money’s value. As figure 3 shows, gold is widely seen by investors as a hedge against long-term inflation for good reason. It is surely no coincidence the gold price rose more than sevenfold, from less than $260 per ounce in April 2001 to $1850 per ounce a decade later, at a time when central banks around the world were printing money at a record pace.
Other barriers to investment
Another significant barrier to institutions investing in cryptocurrencies stems from the plethora of exchanges that have sprung up in recent years. According to one website there are currently at least 130 in existence.14 That presents a number of problems. For a start, many of the exchanges are unregulated, opening them up to the risk of fraud. Witness the experience of Youbit, the South Korean crypto-currency exchange that went bankrupt in December after losing 17 per cent of its assets to cyber thieves – the second such attack in eight months.15
Episodes such as this increase the risk of regulatory intervention, presenting an extra deterrent to investors. For example, the Bitcoin price fell as much as 14 per cent on January 11 after Seoul said it was planning to ban cryptocurrency trading in response to the Youbit scandal.16 That would make South Korea the second country to ban cryptocurrency trading after China shuttered exchanges last September.17 As part of China’s ongoing clampdown, the country’s central bank in January outlined a plan to drive ‘miners’ out of business by limiting their access to electricity. Chinese officials are said to be concerned that Bitcoin miners, by taking advantage of low power prices in some areas, are affecting normal electricity use.18
China is home to many of the world’s largest Bitcoin miners, who use massive computing power to verify transactions in the cryptocurrency, thereby earning an award in new coins. The Digiconomist.net website estimates Bitcoin miners consume the equivalent of 37.5 teraWatt hours of electricity a year globally, enough to power 3.4 million US homes, or a country the size of Bulgaria.
Lack of liquidity
With so many exchanges quoting rates independently of one another, and arbitrage between them far from straightforward, price discovery is difficult. In addition, the fact trading is so fragmented limits the amount of liquidity offered by any one trading venue. According to the blockchain.info website, the average value of daily trading volume on the major Bitcoin exchanges totalled $1.8 billion in December. But the coinmarketcap.com website estimates the biggest, Chinese exchange Batfinex, handles no more than a quarter of that total. By contrast, the London Bullion Market Association clears around $1 billion of spot gold transactions per day.19
More troubling still from an investor’s perspective, liquidity in the Bitcoin futures market is even thinner, with the daily underlying value of contracts traded on Cboe and CME to date having averaged barely more than $50 million.20 Contrast that with trading in gold futures in New York, where the equivalent of 27 million ounces, worth around $35 billion, change hands each day.21 While the lack of liquidity in Bitcoin futures is not totally unexpected given that the contracts are still in their infancy, it is far from evident why liquidity will dramatically improve. Unless it does, it is hard to envisage much of a pick-up in demand from traditional investors.
All of this is not to deny there are good reasons why investors have fallen for the mystical allure of digital currencies. In a world where central banks have been printing money like confetti and government deficits have skyrocketed, cryptocurrencies’ superficial appeal to investors is easy to understand. The problem is that they are unlikely to ever meet investors’ need for a reliable store of wealth.
Digital currencies’ fractioning problem
The ability to divide digital currencies into infinitesimally small fragments helps explain the dramatic rise in their price. Whereas the market for gold is priced per ounce and having to pay ever more for one ounce of gold hurts psychologically, thereby limiting price rises, there are good reasons to believe investors in digital currencies are far less price sensitive. Since exchanges will sell them whatever fraction they want to buy, investors tend to see themselves buying $1,000 worth of Bitcoin whatever the fraction, not one Bitcoin at an ever appreciating price. Eventually however, they seem bound to see the light.
The vast majority of commentators believe the current mania surrounding cryptocurrencies is unlikely to last. JPMorgan chief executive Jamie Dimon in September attracted attention when he said Bitcoin was “a fraud” and “worse than tulip bulbs”, a pointed reference to one of the most notorious bubbles in history.22 As for Buffett, he advised investors to stay away; describing the idea Bitcoin has some huge intrinsic value as “a joke”.23
Certainly, the idea Bitcoin can continue to command such a hefty premium to rival cryptocurrencies seems fanciful. While it may be the best known by virtue of its age, it offers no other obvious advantage. It is not as if it is a company that is able to employ marketing techniques to differentiate its product from competitors.
The perils of going short
History suggests asset bubbles tend to persist far longer than might have been expected.
However, while there is every chance the likes of Dimon and Buffett will eventually be proved right, there seems little merit and plenty of risk in ‘shorting’ Bitcoin futures, as some commentators have advocated. History suggests asset bubbles tend to persist far longer than might have been expected and trying to call the top of a market is fraught with danger. In the alleged words of famous economist John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”
Ordinarily, the futures and spot price would be expected to come broadly into line with one another almost instantly due to the presence of arbitrageurs. In the case of Bitcoin futures, however, arbitrage between the two markets is likely to be difficult. That is due to a number of reasons, including the lack of liquidity in both the spot and futures markets; the lack of price discovery and the time taken to conduct transactions in the spot market; the difficulty of borrowing Bitcoins; and the fact futures contracts are settled for cash.
In the absence of these crucial elements, there is no guarantee a fall in the futures price will push Bitcoin’s price down in a hurry. That potentially creates a sizeable disconnect between the spot and futures prices.
For example, it is far from clear that were US institutions to sell into the futures market it would necessarily deter retail buying of spot Bitcoin in China. In such a situation, shorting the futures contract is likely to become perilous. The lack of liquidity in both the spot and futures markets could potentially lead to a severe squeeze on holders of short positions in the run up to the expiry of the near-month futures contract, pushing up the cost of rolling over into a contract with a longer expiry to exorbitant levels.
From boom to bust?
There seems little doubt blockchain, the technology underpinning digital currencies, could prove invaluable for many businesses looking to safeguard their data, not least within the financial services industry. By preventing changes to data once it is written, unless all or a majority of participating computers agree to the change, it represents a revolutionary departure from the traditional ‘wall’ companies build to defend digital information.
However, the likelihood is that cryptocurrencies themselves will prove to be nothing more than a craze. Unprecedented money printing by central banks and soaring government deficits have provided a fertile backdrop by encouraging investors to seek out alternative forms of money authorities are unable to undermine. The fact they offer anonymity due to the technology underpinning them has only magnified their lustre. But there are better options out there. Certainly, there seems little prospect of digital currencies becoming a mainstream investment in a hurry.
1 Bitcoin: A Peer-To-Peer Electronic Cash System, Satoshi Nakamoto, October 2008
4 ‘Bill Miller’s hedge fund has half its money in Bitcoin’, December 2017
7 Global cryptocurrency benchmarking study, University of Cambridge Judge Business School, April 2017
8 ‘Bitcoin acceptance among retailers is low and getting lower’, Bloomberg, July 2017
9 The economics of digital currencies, Bank of England Quarterly Bulletin, Q3 2014
10 ‘Buffett on Bitcoin: “It will come to a bad ending”’, Washington Post, December 2017
12 World Gold Council
13 Aviva Investors’ estimates based on data from the US geological survey and The World Bank
15 ‘Bitcoin exchange Youbit shuts after second hack attack’, BBC, December 2017
16 ‘Bitcoin dives 14% as South Korea prepares cryptocurrency ban’, Financial Times, January 2018
17 ‘Beijing set to shut Bitcoin exchanges to ensure price stability’, Financial Times, September 2017
18 ‘China plans to deter Bitcoin miners by curbing electricity use’, South China Morning Post, January 2018
19 The London Bullion Market Association
21 CME Group
22 ‘JP Morgan CEO Jamie Dimon says Bitcoin is a ‘fraud’ that will eventually blow up’, CNBC, September 2017
23 Bitcoin Forum