Future of cryptocurrencies looks strong

Indeed, Bitcoin has soared by more than 200 per cent since October alone, while Ethereum, the second most popular cryptocurrency, climbed by 190 per cent over the same period.

The total value of cryptocurrencies briefly reached $1tn (£729bn) in the first week of 2021, with Bitcoin accounting for around 70 per cent of that, before losing 20 per cent within a week.

This volatile episode echoes the exponential rise observed during a short period in 2018 before most of the gains were wiped out.

Is Bitcoin really a currency?

Bitcoin and other cryptocurrencies, unlike sterling or the US dollar, are non-sovereign assets with some of the features of currencies.

As Bitcoin is not widely recognised as a means of payment, it does not serve as a medium of exchange

This means they have no state backing and are highly decentralised. The issuance of bitcoins is a transparent process, with a finite number that can be “mined”. This is often touted as being a positive as it means that cryptocurrencies can not be manipulated.

As a non-sovereign asset, it means that a cryptocurrency’s value, like gold, is purely based on collective thinking as there is no issuer’s economic power behind it. Depending on collective opinion, bitcoin’s value fluctuates, this volatility can reduce the appeal of bitcoin as a storage of value.

As Bitcoin is not widely recognised as a means of payment, it does not serve as a medium of exchange. Cryptocurrency value is at the mercy of sovereign countries’ decisions to recognise it or not as a legal means of payment.

Even though the name “cryptocurrency” suggests that those assets are a currency, it is difficult to envisage a strong development of those assets as currencies in the near future.

Time to add to a portfolio?

There has been a lot of talk about Bitcoin, and cryptocurrencies in general, being a 'digital gold'.

Similar to gold, there is a finite amount, it is not backed by any sovereign and no single-entity controls its production. But for Bitcoin to be considered in a portfolio and to become an investable asset, similar to gold, the asset would probably need to improve the risk/return profile of that portfolio. This seems a tall order.

While it is nigh on impossible to forecast an expected return for Bitcoin, its volatility makes the asset a difficult investment from a portfolio perspective. Indeed, while the asset’s correlation measures against equities, bonds and gold are relatively supportive, it seems to falter when diversification is most needed, such as during sharp sell-offs in financial markets.

In the five sell-offs since 2015, when equities fell by between 9 per cent and 34 per cent, Bitcoin performed worse than equities in three of them, compounding investors’ equity losses. US Treasuries, gold and US investment grade were better diversifiers than Bitcoin when it comes to equities.

Fears of a bitcoin bubble

The fact that cryptocurrencies also fluctuate alongside equities suggests that investment in Bitcoin is more akin to a bubble phenomenon rather than a rational, long-term investment decision.

The performance of the cryptocurrency has been mostly driven by retail investors joining a seemingly unsustainable rally rather than institutional money investing on a long-term basis.

Several studies around market structure have shown that emerging markets with high retail and low institutional investor participation are more unstable and more likely subject to financial bubbles than mature markets with institutional participation.

And while more leading financial houses seem to be taking an interest in cryptocurrencies, the level of institutional involvement still seems limited. Too much concentration of the asset is another issue: about 2 per cent of Bitcoin accounts control of 95 per cent of all bitcoins.

In summary, difficulty to forecast return, lack of diversification and high volatility makes it hard to consider Bitcoin as a standalone asset in a diversified portfolio for long-term investors.

An inflation hedge?

As fears of much higher inflation grow as governments turn on the spending taps and central banks flood the market with liquidity in response to the pandemic, might cryptocurrencies hedge against surging inflation? Possibly.

Regardless of its price, bitcoins' production is set on a precise schedule and cannot be changed to meet rising demand for the asset. This could be positive.

But other real assets, such as precious metals, inflation-linked bonds or real estate, already have a long record of hedging against inflation.

Other considerations

Bitcoin’s technology should theoretically make it extremely secure. As there is no intermediary, each transaction is reviewed by a large number of participants that can all certify the transaction. However, there have been frauds and thefts from exchanges.

Another point to consider is the risk of 'losing' bitcoins. According to cryptocurrency data company Chainanalysis, around 20 per cent of the existing 18.5m bitcoins are lost or stranded in wallets, with no means of being recovered.

What about its green credentials? Mining and exchanging bitcoins is highly energy intensive.

According to estimates published by Alex de Vries, data scientist at the Dutch Central Bank, the bitcoin mining network may have consumed as much electricity as Switzerland in 2018.

This translates to an average carbon footprint per transaction in the range of 230-360kg of CO2. In comparison, the average carbon footprint of a Visa transaction is 0.4g of CO2.

Then there is cryptocurrency’s large amount of electronic waste (e-waste). As mining requires more computational power, Mr de Vries’ study estimates that mining equipment becomes obsolete every 18 months.

The study suggests the Bitcoin industry generates an annual amount of e-waste similar to a country like Luxembourg.

Cryptocurrencies are here to stay

Innovation in digital assets continues rapidly and will likely drive increased retail and institutional investor participation. The underlying blockchain technology behind Bitcoin was meant to disrupt a few different industries.

While results have not lived up to the initial hype yet, more sectors are investigating the use of the technology.

And with social media heavyweight Facebook announcing a stablecoin, or a cryptocurrency pegged to a basket of different fiat currencies, central banks have accelerated the movement towards their own digital currencies. Those, in turn, might make life easier by making payment systems more resilient and facilitating cross-border payments.

Gerald Moser is chief market strategist at Barclays Private Bank