Future of cryptocurrencies looks strong

Future of cryptocurrencies looks strong

Cryptocurrencies, and Bitcoin in particular, were among the best-performing assets last year and are back in the headlines again.

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.

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.