A decision to allocate to digital assets and cryptocurrencies will depend on an investor’s risk tolerance – put differently, any investor in these assets needs to be prepared for the value to go to zero.
Chief Market Strategist Asia Pacific
The recent price action in digital assets has caught the attention of investors and the business community alike. In response, some have suggested that owning Bitcoin is preferable to bonds, while others have called for a greater focus on the environmental impact of mining these assets. Regardless of one’s personal view, digital assets and cryptocurrencies are becoming an increasingly large part of the global financial system. As such, more and more investors are asking how they should think about them as both investments and a component of portfolio construction.
To start, cryptocurrencies are extremely volatile – Bitcoin hit an all-time of more than USD 63,000 per coin on April 15, 2021, before falling by nearly 45% to a level of around USD 35,000 just over a month later. However, this is just one example of how quickly things can change in the crypto market; as shown in the chart below, Bitcoin’s volatility is significantly higher than equities. Furthermore, correlations between cryptocurrencies like Bitcoin and traditional assets like stocks and bonds are unstable, making it difficult to predict whether they will “zig” or “zag” during periods of stock or bond market stress. This lack of consistency also makes cryptocurrencies difficult to integrate into a portfolio.
Despite the volatility of these assets, there is tremendous value in the underlying technology. Blockchain looks set to becoming an increasingly common way of processing transactions, and many developed market central banks are now actively discussing the idea of central bank digital currencies (CBDC). While the main difference between CBDC’s and assets like Bitcoin would be the centralized nature of the network (i.e. a digital dollar would still be backed by the Federal Reserve), there are other potential nuances as well. The Federal Reserve is in the process of conducting additional research on the topic, and a formal paper that dives deeply into the topic is expected over the summer. Meanwhile, the People’s Bank of China has already begun a series of trials in cities such as Shenzhen, Chengdu and Suzhou.
At the same time, it is difficult to see how Bitcoin is a unit of account, medium of exchange, or store of value, further undermining the argument that it is a currency in the traditional sense. For example, Visa processes more than 3,000 transactions per second, while the Bitcoin network processes just more than three; taking this a step further, as the size of a block increases, transactions fees rise and processing times increases. Until this changes, the ability to widely transact using cryptocurrencies will remain limited—nobody wants to wait for a block to be mined just so they can get their morning cup of coffee.
EXHIBIT 1: VOLATILITY IN CRYPTOCURRENCIES VERSUS EQUITIES
30-day realized volatility, annualized
In addition to the processing times, cryptocurrencies’ uncertain intrinsic value also undermines its effectiveness as a currency to buy and sell products. If currency holders expect the value of the currency to rise, they would be reluctant to spend it. The reverse is also true, if a currency is expected to lose value over time, no one would be willing to accept it unless they are compensated properly for it.
With growing retail participation, regulators are also starting to pay more attention on protecting investors from such volatility. China has banned financial institutions and payment companies to provide cryptocurrency related services. Hong Kong and South Korea are also looking into retail investing and tighter regulation around exchanges. U.S. financial authorities are also looking to take a more active role in regulating this market.
The ecosystem and regulatory backdrop for cryptocurrencies continue to evolve. These developments ideally would help these currencies to mature and become a more viable ingredient for portfolio construction. For now, a decision to allocate to digital assets and cryptocurrencies will depend on an investor’s risk tolerance – put differently, any investor in these assets needs to be prepared for the value to go to zero. An investment in cryptocurrency might be appropriate for some, but for those who view it as a panacea in a world of uncertainty and historically low interest rates, a bit of caution may be warranted.