Cryptocurrency Investing FAQ

Cryptocurrency investing is a subject that inspires a great deal of emotion on both sides; it has its zealots, and it has its critics. But in between these poles of opinion are a great number of people who simply want to know more; to understand the risks as well as the potential rewards, and why, how and where to invest. In this document we have gathered together the most frequently asked questions about cryptocurrencies to help provide some clarity around this much debated asset class.

The scale of volatility with Bitcoin and Ethereum is not akin to the kind of volatility that most investors are used to; it is at a magnitude of four or five times that of equities. While they have been on an upward trend, the journey has been rocky. There have been several occasions where the peak-to-trough price of bitcoin has gone down between 70% and 90%, and sometimes even more. Even if the longer term trajectory does turn out to be positive, you have a high potential for drawdown.

Linked to the volatility, is the market’s underlying liquidity. While there seems to be a lot of trading activity, underneath that what you see is that it is a lot of the same assets that are being traded, and it is actually a relatively small amount that is being circulated with a great deal of frequency. Indeed, about 2% of accounts control 95% of supply, with most coins being held and not traded. Under the surface, it is more illiquid than investors might initially realise, so those that do invest need to manage that risk accordingly, namely through position sizing.

In the past there were a number of stories of money being lost on exchanges due to hacking. But there are two important elements to note here; one is that this is a fast evolving market. Over the past few years an institutional framework has developed around cryptocurrencies, with funds, custodians and auditors that are equipped to manage and oversee these assets. The second thing to note is that where we have seen hacking, it has not been the security of the cryptography that has been the problem, it has been human error in not storing codes securely. Today, there are more sophisticated methods of increasing security, such as cold storage, secure password safes, and – in the case of fund investing – multi signature security systems.

While the overall security risk has been decreasing, there is still a risk that assets like Bitcoin could go to zero, and that comes down to the mathematics that underpin a great number of modern security applications, from credit card payments to other online transactions. While the cryptography is very secure, there is an outstanding mathematical problem to solve, and that is the P versus NP problem. If P=NP, then you could prove that there may be a solution to breaking the code. Now in that case there would be far more problems for the wider world than the value of cryptocurrencies, but as the risk exists, it is something that you have to factor into the investment case.

This is often top of the list of people’s concerns about cryptocurrencies, and understandably so. On the one hand there are countries that have gone down the route of regulating and trying to ban it, but on the other hand there has been a lot of taken on by institutions, and countries like the US are increasingly looking at ways to take advantage of the technology, not to regulate it out of existence. What’s more, they don’t seem to view it as a competitor to fiat currency. There are also benefits to regulation, as it can increase the user base by making people feel more comfortable with it as an established asset. Similarly, the public listing of exchanges like Coinbase – companies that can track who their users are and where the money flows – helps to legitimise and broaden the take-up of these assets. All of that being said, regulatory surprises can and do happen; gold was once banned in the US. So again, this is an important risk that we do have to take on board.

This is often where you hear the more emotional attacks, but its important to put these concerns in context. There is no doubt that Bitcoin, for example, uses a lot of energy to solve the hard computational problems for mining. You may have seen statistics that show Bitcoin as using up more energy than countries like Argentina, but so does putting up the Christmas lights in the US. If we’re looking to reduce energy use, then Bitcoin and Ethereum combined make up around 0.1% of greenhouse gases, while meat production uses around 200 times that amount. It is also more dynamic as an energy user; so Bitcoin for example will go to where the energy is cheapest, and even where it may have otherwise gone to waste.

Simply put, cryptocurrencies are nowhere near as widely used for nefarious purposes as the US dollar – the world’s reserve currency – is. What’s more, one of its strengths from a regulatory perspective is the transparency of the transactions. Cryptocurrencies can also have social benefits; in countries where you have banking clampdowns and asset seizing by governments for example, they can help people store and transmit money. It can also make overseas remittances a lot cheaper. So overall, it is fair to say that the ESG case around these assets is both nuanced and subjective.

Although prices have increased a lot in cryptocurrencies, we are still potentially at the early stages of broad take up. The risk that it goes to zero is not negligible, but it is asymmetric with the potential reward. There is a genuine chance that we see very high returns from these assets. What that depends on, is the level of acceptance. We have already seen how powerful network effects are in the social media and tech giants that so dominate markets today; cryptocurrencies benefit from the same principle. The value of cryptocurrencies lies in the network; in the number of people who use it, believe in it, trust it. This is clearly on an upward trend, and as adoption increases so too does the price. If you look at the Bitcoin price alongside the number of users, the two series go up very closely together.

Bitcoin is talked about in different ways, sometimes as a means of exchange, sometimes as a currency, but really one should view it as digital gold. Its ultimate value depends on whether it is going to become a store of value for a large number of people in the future. If you compare it to gold, it is only a fraction of the size in terms of value, which does leave it room to go up dramatically.

The best way to view cryptocurrency investment is to view it as an option. When you have asymmetric pay-outs and a real chance of capital loss, you size the position accordingly. You keep it to a relatively modest size, but at such a size that it can still have a positive impact on your portfolio given the high potential upside.

If we look at the macroeconomic backdrop, it is no surprise that alternative assets are rising in popularity at the moment. We are in an environment of low expected returns and low interest rates, and a lot of major asset classes look relatively unappealing. When the opportunity cost of capital is so low, investors look to other asset classes to seek alternative drivers of return. One of the strengths of cryptocurrencies is that the technology is creating digital scarcity. We know that there will only be 21m Bitcoins in existence, so having that fixed supply in a world of expansive fiscal and monetary policy (where we could see currency debasement), unsurprisingly carries an appeal for multi asset investors.

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