Cryptocurrency and investor portfolios: Is an allocation warranted?

Bitcoin leads the pack

Today, Bitcoin is the leading cryptocurrency by market value.⁴ Bitcoin can be sent anywhere in the world with considerable speed. However, Bitcoin is unlikely to be adopted for everyday transactions for several reasons. The first is that energy consumption to validate transactions is an issue with Bitcoin.⁵ Due to the proof of work method used to validate transactions, energy consumption is a concern for high volumes of transactions.

A second concern for United States citizens is that Bitcoin is treated as property. Each time Bitcoin is sold, the seller must report realized gains. Using Bitcoin for everyday transactions would create an exhausting tax return. This is why we, like others, see Bitcoin’s primary use case as large transactions like money wires and storage of value outside of a fiat currency. This is also why Bitcoin is sometimes referred to as digital gold.

What is Ethereum?

Ethereum is the second-largest cryptocurrency by market capitalization.⁶ Whereas Bitcoin’s blockchain platform is geared toward secure transactions, with limited other uses, Ethereum’s platform offers a range of decentralized exchange applications. The Ethereum platform allows assets, loans and contracts to be encapsulated into smart contracts that are executed on the platform using standardized protocols. As an example, digital art, loan covenants and even rules-based rebalancing investment strategies can be tokenized and managed on the platform.

What are Stablecoins?  How can they help with price volatility?

A noted issue with cryptocurrencies as a medium of exchange is their price fluctuations relative to fiat currencies. As a potential solution, Stablecoins have been introduced to address price volatility. Stablecoins peg their value to a target fiat currency or asset such as gold. These coins allow users to transact on cryptocurrency platforms while mitigating the risk of price fluctuations between the coin and their base currency.

What are Central Bank Digital Currencies (CBDCs)?

Central banks are also experimenting with digital currencies, known as Central Bank Digital Currencies (CBDCs). CBDCs have the potential to disintermediate the banking system, which central banks would prefer not to do. This is why central banks are proceeding with caution. Ultimately, the use of CBDCs may be limited to a specific set of users, such as banks.

What are some risks of investing in cryptocurrency?

While there are many potential and emerging use cases that may improve adoption of cryptocurrencies, investors would be wise to consider systemic and coin-specific risks. Some of the key risks we see include:

• Regulatory risks
  Cryptocurrencies face major legal and regulatory risks. While many countries with unstable currencies could meaningfully benefit from cryptocurrency, there are other governments that do not want competing currencies in circulation. Additionally, governments are concerned about cryptocurrencies facilitating money laundering. As of September 2021, China has banned the use of cryptocurrency.

   

• Fraud
  With lack of regulatory oversight in digit asset markets, fraudulent activity is more likely. This is evidenced by a recent U.S. Federal Trade Commission report, which notes an increase in scammers luring people into bogus investment opportunities. Losses of around USD 80 million related to scamming activity in digital asset markets were reported between October 2020 and May 2021.⁷

   

• Theft from hacking
  Bitcoin and other cryptocurrencies accounted for 80% of total attempted digital thefts during 2011-2020.⁸ Investors who keep their currency on digital currency exchanges that don’t provide cold storage wallets (storage that is not connected to the internet, such as a USB drive) are the most susceptible to hacks. However, more and more financial intuitions now provide cold storage custody services for clients.

   

• Transaction processing speed and electricity consumption
  Each Bitcoin transaction requires 500,000 times more energy than that needed to process a digital transaction on the Visa network.⁹ While technological innovations such as using proof of stake rather than proof of work may alleviate this issue, environmentally conscious investors may shun the idea of currencies that compete with essential energy requirements. Moreover, central banks are working to improve transaction speed in fiat currency.¹⁰

   

• Cryptocurrency-specific risks
  Research indicates that around one-third of newly launched crypto coins don’t survive beyond the first year, with additional data demonstrating that a newly launched cryptocurrency has only a 30% chance of surviving five years.¹¹ Most investors would consider a 70% chance of total loss over a period of five years as quite high.

   

• Enhancements to centralized systems
  Fast payment systems are being developed that will speed up centralized banking transaction speeds. While this wouldn’t invalidate the anti-fiat currency wealth storage use case, it would remove the transaction speed advantage of cryptocurrencies.

Investing in cryptocurrencies: Diversified options

We believe investors seeking cryptocurrency exposure have several diversified options, including:

1. Broad diversified long exposure

Holding a diversified basket of cryptocurrency provides exposure to an emerging payment system. We believe investors seeking broad cryptocurrency exposure should hold a diversified basket of currencies that mimics some sort of market capitalization weighting, as opposed to a single cryptocurrency. Investors can gain this exposure by buying cryptocurrencies directly. Importantly, however, we expect to see more and more cryptocurrency-wrapped products.

2. Specific cryptocurrency exposures that align with use cases the investor sees as most prolific or disruptive

Investors can either choose cryptocurrencies that align with use cases they see as most promising or hire active cryptocurrency managers with the expertise to size specific cryptocurrency exposures. Investors can also gain specific exposures through listed companies and private capital investments. Notably, venture capital and angel investors are experts in screening nascent technologies, where large potential returns and risks exist.

3. Exploitation of mispricing in cryptocurrencies

Though the market cap of cryptocurrencies has grown exponentially over the last decade, several researchers note that cryptocurrency markets remain inefficient. We believe these inefficiencies create opportunity for investors with the right skills.

In particular, hedge funds with access to leverage are well-suited to exploit market inefficiencies, such as the one referenced here¹², where profits could be made by going long Bitcoin and short futures contracts. Exposure to cryptocurrency hedge fund strategies should have the benefit of low correlation to long cryptocurrency positions.

What to consider when investing in cryptocurrency: Our guidelines

Cryptocurrencies are in such an early stage of adoption that it’s difficult to assess them as a prospective investment. At present, we don’t have capital market assumptions that can be used for portfolio construction. Given this, we believe it’s prudent to avoid typical quantitative portfolio construction techniques, as they are likely to provide a false sense of security. Instead, we believe investors will have to bootstrap their approach to sizing allocations to cryptocurrencies.

We believe that investors would be wise to consider the following guidelines when investing in cryptocurrency:

• Investors should put no more money in cryptocurrency than what they are willing to lose.
• We view a position in cryptocurrency as a speculative investment in greater adoption of decentralized finance applications and anti-fiat money wealth storage.
• Investors should diversify their exposure across various cryptocurrencies.
• Investors should extend their exposure to holding listed companies, private companies and hedge funds operating in the crypto space, in addition to coins.

The bottom line

Cryptocurrencies are a nascent investment opportunity, where there are still large risks to broader adoption. However, this doesn’t mean investors should completely avoid cryptocurrencies. Rather, we believe an investor should size the allocation to what they are willing to lose. Moreover, investors can ameliorate some risk by diversifying across different currencies, investing in companies that are developing technologies that extend use cases, and by seeking exposure to crypto hedge fund strategies.

Click here to read the full version of our research paper on cryptocurrency investing