Cryptocurrencies: Bubble, boom or blockchain revolution?
Dr. David Kelly
Maria Paola Toschi
- The current generation of cryptocurrencies, most notably Bitcoin, have substantial shortcomings as currencies.
- While cryptocurrencies have attracted a great deal of investor interest, they appear to be highly speculative assets and their role in portfolios has not yet been clearly demonstrated.
- Central banks are likely to launch their own digital currencies in the years ahead, but the result may not be the idealized, de-centralized financial systems originally imagined with the introduction of blockchain technology.
Bitcoin, the original cryptocurrency, and its legions of competitors, are making an enduring mark on the financial landscape. The blockchain technology empowering cryptocurrencies is revolutionary; it enables de-centralized, peer-to-peer transactions without a trusted third party, while addressing the risk of the same asset being spent twice. Bitcoin has created fortunes for some investors and attracted the attention of many others – despite its volatility. And its predetermined scarcity gives it the potential to challenge gold in its perceived role as a safe-haven asset.
In our view, despite the acclaim, cryptocurrencies like Bitcoin face significant limitations, both as currencies and as assets. It is not clear that they will ever be adopted as traditional currencies and their role in portfolios is still ill-defined. We think central banks will likely launch their own digital currencies in the years ahead. That may be one of cryptocurrencies’ most enduring legacies, whether or not the boom ultimately goes bust.
Limitations of cryptocurrencies as currencies
Cryptocurrencies are highly volatile, making them poorly suited to the primary functions of traditional currencies – as a store of value, a unit of account and a medium of exchange. Transaction speeds are well below those of credit card and other payment platforms. Cryptocurrency systems can also be energy intensive – thanks to the fundamental design of their verification processes. What’s more, as bearer assets, cryptocurrencies are inherently susceptible to theft and loss.
Role of cryptocurrencies in portfolios
We look at three potential roles for cryptocurrencies in portfolios. In each case, we find (through our analysis of Bitcoin) that cryptocurrencies’ potential contributions to portfolio performance have yet to be convincingly demonstrated. Cryptocurrencies appear to be:
- Unreliable as diversifiers and safe haven assets: Bitcoin’s correlation to stocks and bonds have been unstable and its volatility has been far more pronounced than that of gold.
- Limited as inflation hedges: Bitcoin has not shown a strong correlation with inflation expectations.
- Inadequate as a way to gain exposure to the tech sector: Bitcoin is more volatile than tech stocks and can’t provide equity ownership and control. It’s correlation to tech stocks could be spurious – simply reflecting investors’ interest in finding the “next big thing.”
Perhaps the best way to think about a cryptocurrency within a portfolio is as a call option on its underlying blockchain technology. Like options, these assets can be volatile, speculative and offer investors limited ability to shape their future development.
Our analysis asks what the expected return for various Bitcoin allocations to a 60/40 portfolio would have to be to maintain the portfolio’s volatility-adjusted return. The answer: extremely high – any allocation should be undertaken with caution.
Central bank digital currencies
Cryptocurrencies are putting pressure on central banks to issue digital currencies and many are actively pursuing that possibility (China has already launched its own). But – while some central bank digital currencies may incorporate elements of blockchain technology, the resulting landscape is likely to be something short of the idealized, authority-free, decentralized financial systems originally envisioned at the onset of the blockchain revolution.
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