Cryptocurrencies have grown too big to ignore. On finews.first, Taimur Hyat explains why cryptocurrencies are not a sensible investment option and which problems and opportunities the crypto sector offers for institutional investors.
This article has been published on finews.first, a forum for authors specializing in economic and financial topics.
From a technological standpoint, cryptocurrencies’ combination of distributed ledger technology and cryptography represents a legitimate breakthrough. However, after a prolonged boom, crypto markets have recently experienced a sharp crash. From an investor's perspective, there is little evidence that cryptocurrencies offer any meaningful opportunities for institutional investors.
Since its launch in 2008, bitcoin has spawned thousands of other cryptocurrencies and digital tokens. No two of which are the same as all these currencies and tokens make design decisions along four dimensions: decentralization, security, scalability, and stability. Taken together these four dimensions allow one to neatly classify the crowded cryptocurrency space while each cryptocurrency still is a unique trade-off between the four elements.
«Bitcoin does not even meet the three basic functions of a currency»
While it may be that a few cryptocurrencies will endure on the fringes of the monetary system, the broad replacement of fiat currencies globally is unlikely to happen. Reasons for this include increasing regulatory scrutiny and the growing likelihood of central bank digital currencies, which provide the functional benefits of fiat-linked cryptocurrencies without liquidity or currency risk.
For example, bitcoin – the first and still the most prominent cryptocurrency – does not even meet the three basic functions of a currency. A currency must provide a stable store of value, at least over short periods of time. However, the dramatic price gyrations of many cryptocurrencies are the direct opposite of stability. And even after a dozen years, few commercial enterprises accept bitcoin – or other cryptocurrencies – as a means of payment.
This situation is not likely to change soon as bitcoin’s maximum transaction speed and cost-efficiency pale in comparison to conventional payment networks. The time it takes bitcoin to complete a single transaction, Visa, for example, can complete more than 740 transactions. Bitcoin also does not fulfill the basic function of a unit of account. While some businesses may accept bitcoin as a payment option, very few businesses fix the price of their product in it and outside of the deep digital realm, this figure is even significantly lower.
«This was in fact true during its early days»
Bitcoin promised independence from broad macro factors, and thus a lower correlation to other asset classes. This was in fact true during its early days. However, it has shown an increased correlation with other assets since 2020. Thus, bitcoin's suitability for diversification of an institutional portfolio is somewhat limited.
But how does it perform in terms of an inflation hedge? The scarcity of bitcoin’s supply and its detachment from governments and institutions suggests its value may be resistant to price inflation. Yet, in the lone episode of elevated U.S. inflation since bitcoin’s inception, it has not held its value well. Hence, this supposed advantage does not apply either.
«Bitcoin’s carbon footprint is substantially higher than other payment networks»
While bitcoin exhibited some remarkable risk-adjusted returns early in its history, its Sharpe ratio has been similar to equities and bonds since 2018. Given the frequency and severity of drawdowns and its diminished risk-adjusted returns, there is no compelling argument for direct investment in bitcoin.
How about bitcoin being a «safe-haven asset»? The deliberate detachment from financial institutions, central banks and monetary debasement leads some market participants to believe it may be «digital gold» and will retain its value during turbulent times. But during the COVID-related market drawdown in early 2020, the promise was not kept – bitcoin was heavily under pressure while gold held its value throughout.
In addition, for sustainability-minded investors, cryptocurrencies are problematic along multiple dimensions of ESG. Bitcoin’s carbon footprint is substantially higher than other payment networks. While cryptocurrencies are developing protocols to be more energy efficient, they also raise concerns from a governance perspective, e.g., the anonymity of transacting makes it a preferred instrument for illicit activity – such as skirting sanctions.
«The blockchain ecosystem provides long-term investors with several attractive opportunities to evaluate»
In summary, there is currently no compelling case and little evidence for direct ownership of cryptocurrencies for institutional investors. The only exception is hedge funds exploiting inefficiencies to generate alpha on the other side of retail- and momentum-driven flows.
In contrast to direct cryptocurrency ownership, however, the broader blockchain ecosystem provides long-term investors with several attractive opportunities to evaluate.
Blockchains are highly secure and robust systems for verifying and recording transactions. For example, private applications of distributed ledger technology and smart contracts are being used in financial services, logistics, and supply chain management.
«Long-term value creation will be based not on direct ownership of cryptocurrencies»
The landscape for innovation in infrastructure is wide open, too, with tremendous potential to reduce current challenges and barriers. Companies solving issues around interoperability, due diligence, and fraud prevention might have a first mover advantage as the world of digital assets and central bank digital currencies mature.
Tokenization of real assets opens a simpler, more cost-efficient way to manage and transact assets and investments. Once legal, governance and regulatory frameworks become settled, this application will substantially reduce frictional costs across financial services and has an impact to reshape the current markets of illiquid assets.
Long-term value creation will be based not on direct ownership of cryptocurrencies, but on the real-world applications of blockchain technologies themselves.
Taimur Hyat is chief operating officer (COO) of PGIM. He joined the firm from Credit Suisse Asset Management (CSAM), where he served as Global Head of Strategy & Product Development and as a member of the Operating Committee. Prior to joining CS, he was Head of Joint Ventures and Americas Strategy at Lehman Brothers. Earlier in his career, he was a partner at McKinsey in New York. He holds a Ph.D. in economics from Oxford University, where he was also a lecturer in economics at St John's College.
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