Cryptocurrencies dominated the mainstream financial news in 2017. Thus far in 2018, they’ve had a setback but are still among the more popular assets due to their high volatility and intriguing speculative nature. It’s only natural that news of people making a lot of money dabbling in something will attract a lot of people to whatever it might be.
- Cryptocurrencies may have value as alternative currencies in emerging markets due to weak financial infrastructure, capital control enforcements, and/or other issues
- Speculators in developed markets are less likely to view cryptocurrencies as assets having quality wealth storage properties, lending it as a mostly speculative asset class
- Regulatory risk, its lack of robust transactional functionality, and uncertain value as a store hold of wealth make bitcoin and other cryptocurrencies a risky bet
If you’re simply looking to trade cryptocurrencies using short-term strategies, whether it be through technical indicators, support/resistance levels, or whatever it might be, then the long-term outlook may have seemingly little relevance to you.
But it’s worth considering for those who hold cryptocurrencies with the pursuit of long-term capital appreciation, where bitcoin currently has about 35% of the market.
As someone who has “invested” in a relatively small amount of bitcoin, I nonetheless have concerns over its long-run vitality.
What Gives Currencies or Commodities Value
For a currency to maximize its value, it has to reliably have two properties:
- (1) serve as a medium of exchange and
- (2) act as a store hold of wealth
As a transactional medium there are superior alternatives – e.g., fiat currencies, fiat-based transaction mechanisms (e.g., credit cards), and even other cryptocurrencies.
As a store hold of wealth, if you live in a developed market, bitcoin and other cryptocurrencies probably don’t solve that much of a problem. In developed economies, the threat of asset confiscation, hyperinflation, or a breakdown in the fabric of the financial system is unlikely.
Therefore, its practicality is limited to most traders and inhibits the value that bitcoin et al might have in G7 economies. It may, of course, be a different story to someone in, for example, Venezuela or Zimbabwe who is likely to view one or more these as tangible risks. Or somebody in China looking to circumvent centrally enforced capital controls, as another example.
The decentralized nature of cryptocurrencies may augment demand in emerging markets but these largely aren’t problems for those residing in countries where some 44%-48% of all global economic activity takes place (US, Japan, Germany, UK, France, Italy, Canada).
The Cryptocurrencies Diversification Argument
While bitcoin’s correlation with other asset classes – i.e., stocks, bonds, commodities, fiat currencies, real estate – is low, it’s dubious whether it allows you to hedge risk. Over the past three years, bitcoin’s daily volatility has been 8x that of US stocks, 19x that of mid-duration US Treasury bonds, 13x that of the US dollar, and 7.5x that of gold.
Any diversification benefit, if bitcoin does indeed remain largely uncorrelated with these asset classes, can be achieved at levels well south of 1% of one’s net worth. Even then, bitcoin has no proven track record as a wealth storage mechanism over any material amount of time.
Bitcoin has had an advantage as the first-mover in the cryptocurrency space. It has ceded share of the market to others and this will be likely to continue, though won’t be a big issue if the cryptocurrency space continues to expand more broadly. But future returns are all but uncertain and cryptocurrencies can’t safely be labeled as anything more than highly volatile speculative assets.
With developed market equities, over the long-run, you know you’re getting about 6%-7% nominal annual forward returns at 14%-15% annual volatility; 5.5%-6.0% forward returns with high-yield US bonds at 11%-12% volatility; and 2.5% forward returns with mid-duration US Treasuries at 6%-7% volatility.
With bitcoin and other cryptocurrencies, we have unknowable returns at triple-digit annual volatility. Cryptocurrencies, the vast majority of which are not backed by anything of tangible value, don’t offer a means by which consumption can be shifted into the future in some reliable fashion or provide a share in some cash-producing asset.
With cryptocurrencies becoming popular, does this better help asset allocation or improve the efficiency of matching savings to viable investment and consumption outlets? It’s difficult to find the value in this respect.
The blockchain technology that cryptocurrencies are based on – a way by which transactions can be recorded without needing a financial institution as an intermediary – may help make transactions more efficient, faster, and more secure. Bitcoin is one such application of blockchain, but is irrelevant to its attraction as an asset that can cure inefficiency in either asset markets or the payments system.
Bitcoin’s Biggest Risks
Bitcoin’s risks reside in its inferior transactional functionality compared to not only pre-existing transactions mediums (e.g., credit and debit cards) but other cryptocurrencies as well. In this sense, bitcoin has been compared to gold as an asset; namely, one that has limited transactional value but maintains value otherwise as a type of wealth-storing commodity.
However, on the asset side it’s difficult to determine whether cryptocurrencies solve any tangible issue. In some jurisdictions, there is the perception that bitcoin and other cryptocurrencies aren’t merely speculative assets, but contribute negatively to the public sphere.
In South Korea, a country swept over by the crypto boom, is working to legally enforce banning of anonymous cryptocurrency transactions, and has even considered banning cryptocurrency exchanges outright, arguing that it saps time, productivity, and resources.
Even with bitcoin’s questionable value-add in improving the efficiency of the payments system or filling in a void in the asset markets, this is more of a long-term concern. The chief headwind in the short-term is regulatory risk. Given the blockchain off which bitcoin and other cryptocurrencies are based is decentralized, central governing bodies have dubious legal authority to intervene in the technology itself. But they can shutdown exchanges subject to domestic laws, thereby potentially destroy a sizable chunk of its market overnight.
For those who day-trade bitcoin or cryptocurrencies, it’s likely that you use charts and technical indicators on smaller time compressions and make decisions based on that. However, I believe that it’s always important to fundamentally understand what you’re trading and be familiar with the “big picture” as it can ensure better informed decision-making.
Based on the recent data, smaller retail investors have been heavily net long bitcoin – wanting to profit off its volatility – while larger institutional investors have been heavily net short. Skepticism among institutional market players largely comes out of concern for both regulatory factors and bitcoin’s ability to survive despite its transactional shortcomings, both with respect to fiat currencies, fiat proxies (i.e., debit and credit cards), and other cryptocurrencies with faster transaction speeds and more robust security.
While the blockchain technology represents an application of bitcoin, blockchain itself is irrelevant to bitcoin’s value. Theoretically an infinite number of cryptocurrencies can be built on the blockchain framework.
All things considered, it’s difficult to ascertain what social, economic, financial, and/or asset market-related problem bitcoin helps solve. Capital control circumvention and asset protection (through bitcoin’s decentralized nature) are important value-additive attributes, but are of minimal interest to investors in developed markets.
So what is bitcoin’s value? Who knows… that’s why it has triple-digit annualized volatility. When something has 20x the annual volatility of stocks – a highly volatile asset class in its own right – it simply means the pricing models and trading tactics are all over the map.
Could it be that there’s just too much liquidity in the system after $15+ trillion worth of central bank “money printing” since the financial crisis? Over half a trillion dollars – a small relative sum – ended up getting put into this new niche market with plenty of free marketing from the financial press.
Whatever one’s standpoint on bitcoin or other cryptocurrencies, regardless of trading strategy or intended holding period, tread carefully.