Despite lost trust, can cryptocurrency, especially Bitcoin, be the future of investment again?

Stocks have existed for more than a century. Bonds have been around for a few centuries. Commodities are centuries old and currencies have been exchanged since time immemorial. Now, there is a new asset class called “Cryptocurrencies” which is gaining immense popularity all over the world. Work on blockchain technology began in the early 1990s, but was later used and designed by a person (or a group of people) under the pseudonym “Satoshi Nakamoto”. In 2008, he/ they released a white paper, “Bitcoin: A peer-to-peer electronic cash system” and introduced to the world “Bitcoin”.

This open, decentralised digital software has been gaining favour ever since. Before we talk about the potential and impact of cryptocurrencies like Bitcoin, Ethereum, etc., it is worth mentioning that equity investing has been beaten by the returns of Bitcoin and other cryptocurrencies. Bitcoin has given a return of 10,869 per cent since 2015 against 102 per cent of Standard & Poor’s 500, 184 per cent of NASDAQ and 59 per cent of gold. Bitcoin has emerged as the clear leader. Therefore, having a small portion of cryptocurrencies in one’s portfolio could be a smart move and worth the research.

The die-hard equity pundits have been denouncing cryptocurrencies for many years as a giant scam, however, slowly, a few hedge fund managers and institutions have had a transformation in their mindset and have started allocating their capital to cryptocurrencies and have even invested their treasury money into crypto assets! This is a big change and indicates a gradual shift in the attitude of influential investors. A lot of the naysayers missed out on the meteoric rise and gains from crypto assets and are now left with a painful left-out feeling. World economics are run by “fiat money”, which is essentially government-issued currency that is not backed by any commodity. This allows governments the flexibility to print money and keep control over their economies.

Governments have resorted to “debasement”, which lowers the value of their currencies and increases the chances of inflation. Gold, traditionally, has been seen as a hedge against the debasement of currencies and inflation since it is a store of value and a preserver of purchasing power. Bitcoin has been called “Gold 2.0” and even “Digital Gold” since it has certain characteristics that compete with and complement the intrinsic nature of gold.

Interestingly, Nakamoto set the total limit of Bitcoin at 21 million, which means that there can only be 21 million Bitcoins in circulation at any point in time. There are several advantages of this limit that sets Bitcoin apart. Some of these are:

• Every single transaction can be proved and is recorded in Bitcoin. This cannot be done for gold or other currencies.

• Since the number of Bitcoin is limited, it is immune to any form of debasement and therefore a preserver of the purchasing power of the world and a store of value.

• Other positive fundamentals of Bitcoin include an increasing number of transactions in the world, a rise in people using Bitcoin as ‘wallets’ and the growth of individuals, corporates and financial institutions embracing it for their investments.

• Cryptocurrencies are enjoying the power of the “Network effect” – derived from Metcalfe’s Law, which states that a network’s value is proportional to the square of the number of its users. As more individuals participate and accept Bitcoin, the value of the cryptocurrency keeps growing. For example, if you are the only person using Google, then it will not be valuable. However, once millions of people use Google, it becomes useful and valuable.

• Cryptocurrencies, particularly Bitcoin, can be bought in a seamless manner, and as compared to securities, one does not have to worry about which company will eventually succeed and work.

• Bitcoin has an open decentralised digital protocol which is similar to the internet and its significance. Therefore, it has a strong and reliable computing network in this world, which allows for a high hash rate – meaning that the processing power of the network is high – which also creates greater security for the Bitcoin blockchain.

• Bitcoin is portable, transferable and divisible. As an asset, it is durable and difficult to hack or fake. The wallets are encrypted and secure.

• The verification of transactions is done by “miners” rather than a clearing house or exchange, as in the case of securities. Therefore, the process is quick and secure as well as inexpensive.

• Bitcoin can be exchanged for other goods and services, and also other cryptocurrencies and tokens.

These positive characteristics have led to crypto coming into vogue and accepting Bitcoin internationally. However, there is also a chorus of experts who are not yet comfortable owning cryptocurrencies. They cite many reasons. Some of them are enumerated below:

• Some experts argue that cryptocurrencies can be a conduit for crime and money laundering. They cite that hoarding the crypto asset could be used to destabilise the dollar. There is a fear that non-state actors could attack the network to subvert economic functioning.

• Bitcoin is not yet in the pantheon of currencies like the US dollar, Euro, or Pound. It is thus still a far cry from a replacement to any of these is still a far cry away.

• Bitcoin is not properly regulated yet and the regulatory uncertainties create an atmosphere of risk around the asset. Proper regulation allows for the protection of investor interests, which traditional financial institutions, banks and money managers comply with.

• Since no central bank is in charge of handling Bitcoin and cryptocurrencies, the traditional role of central banks to set quantitative easing or tightening as and when the economy requires cannot be implemented. Economic growth and inflation control are actively supported by central banks.

• Since the supply of Bitcoin is limited and fixed, it could lead to deflation if demand is not kickstarted with additional liquidity.

• There is huge volatility in the price of Bitcoin and cryptocurrencies, which creates instability. • The wild price swings attract a lot of speculators and not holders who spend.

• We have not yet seen employees getting paid in Bitcoin, which would prompt more sellers of goods and services to price their products in cryptocurrency. Most retailers are still reluctant to accept cryptocurrencies; therefore, they cannot function fully as a medium of exchange.

• A plethora of cryptocurrencies have now sprung up, distracting from the main players like Bitcoin and Ethereum.

• People believe that crypto wallets can be hacked.

• Bitcoin is facing an attack over energy use. To verify transactions, “miners” have to solve extremely complex math problems, which require superior computer systems that consume huge amounts of power, and use a lot of electricity. This means that many fossil fuels are being used to generate that power. There is a demand from investors to comply with better ‘green’ standards and use alternate power generation options.

Experts of the stock markets and fund managers have traditionally ignored cryptocurrencies. They have argued that crypto assets have no price-earnings ratio or return on equity or cash flows to value them, which is why they have preferred to stay away from them. The valuation thesis of conducting a bottom-up analysis, i.e. trying to value a company based on its fundamentals, was found to be improbable and questionable for crypto assets. Further, Bitcoin and other cryptocurrencies display massive volatility of up to 15–30 per cent per day, so they decided not to jump onto the bandwagon.

Also, market pundits could not decide if Bitcoin was a commodity or a currency or even a security. Among other reasons, one was that blockchain technology was understood by only a few. Legendary investors have compared Bitcoin with gold and this has set into motion a number of companies, individuals and fund managers, rushing to buy crypto assets.

Excerpted with permission from Investing Decoded: Simple Path to Building a Portfolio in Millions, Anirudh Rathore, Penguin India.