For Asian institutional investors, Bitcoin’s volatility, limited liquidity and voracious appetite for electricity will all be significant barriers – and including the cryptocurrency in traditional portfolios should only be undertaken by the seriously able
A question we are increasingly asked by investors, from large institutions to smaller wealth advisers, is what exactly is Bitcoin, should we invest and does it offer diversification benefits to an existing portfolio?
A meteoric price rise has catapulted Bitcoin into the spotlight and at one point Bitcoin’s market capitalisation breached $1 trillion – a valuation only matched by mega cap companies such as Amazon, Apple, Microsoft and Aramco.
Created in 2008, Bitcoin initially gained popularity as the official currency of the Silk Road, an online black market, where its position as a revolutionary, and anonymous, means of payment had great value.
It has since moved through various stages of evolution, with advocates proposing uses from an alternative to government backed fiat currencies to, more recently, an inflation hedge or store of value, similar to gold.
Although several notable companies have announced they will accept Bitcoin as a method of payment, most goods and services transacted using Bitcoin are based in traditional currencies at the prevailing Bitcoin exchange rate.
We believe there are a number of challenges that will prevent the widespread use of Bitcoin by consumers and businesses:
1. Volatility is high: The volatility of Bitcoin will be a problem for any intermediary looking to manage a business as the daily price can vary significantly.
2. Transaction speeds are slow: The average transaction time is around 10 minutes, with a processing limit of just seven transactions per second. This compares very poorly versus other payment systems such as Visa, which can process 65,000 transactions per second or newer cryptocurrencies.
As the number of transactions that can be cleared per second cannot be increased, the more transactions that are submitted through the network, the higher the transaction costs and processing time.
3. Transaction costs are high: The transaction fee is determined by supply and demand but has been as high as $55. For very large payments this is negligible, but it prevents Bitcoin being used for day-to-day activities such as buying a coffee.
For institutional investors these are just the start of the problems.
Several Bitcoin exchanges have been the victim or perpetrators of fraud, and although some banks are working to provide more secure custodial services, the risks of directly holding Bitcoin are not insignificant.
A growing focus on environmental, social and governance (ESG) from both investors and regulators also raises questions about investment in Bitcoin.
According to the University of Cambridge Bitcoin Electricity Consumption Index, the annual use of energy to maintain the Bitcoin network is currently similar to the annual energy consumption of Norway. In a world focused on decarbonisation that represents a significant amount of ‘wasted’ electricity. Then, given its decentralised nature, anonymity of ownership, and lack of regulation, Bitcoins can be easily used for illegal activities.
As governments focus on Bitcoin, the introduction of regulation is not without risk. This was recently highlighted in India, where the government has proposed an outright ban on cryptocurrencies which would criminalise everything from possession, issuance and mining to trading and transferring crypto assets.
For Asian institutional investors, Bitcoin’s high volatility, limited liquidity, ESG concerns and difficulties in estimating fair value are all significant barriers – and make it questionable whether Bitcoin should be included in traditional portfolios such as ones including currencies and gold.
Our sense is that any exposure to Bitcoin and blockchain technology should only be undertaken by investors with a deep understanding of the technology and the fast evolving landscape that surrounds it.
Although Bitcoin was revolutionary, and able to gain a dominant position via its first mover advantage, it now faces fierce competition from a range of new cryptocurrencies, or altcoins. These share similar characteristics to Bitcoin, but many also have technological advantages, which may allow them to erode Bitcoin’s dominant position over time.
In the longer-term though, several interesting aspects of this new technology could result in significant changes that all investors need to carefully monitor. Central banks are learning from cryptocurrencies and considering how features of the underlying blockchain technology could be integrated with fiat currency.
For example, a central bank-issued digital currency could make tax evasion and money laundering far more difficult. This is likely to lead to a new equilibrium in global payments where traditional fiat currencies will at some stage coexist with both private cryptocurrencies and government backed digital currencies.
This could have disruptive implications for both the banking sector and the way in which monetary policy is enacted.
- Francesca Fornasari is Head of Currency at Insight Investment, BNY Mellon