Bitcoin – fool’s gold or digital Mecca?

With the cryptocurrency increasingly in the spotlight, we consider its role in a multi-asset portfolio.

• As cryptoassets continue to gain ground, the involvement of respected endowments and prominent hedge funds has led to an assessment of Bitcoin’s potential place in a diversified portfolio.
• Bitcoin has received robust regulatory scrutiny, and its inclusion in a portfolio is hard to justify or explain without a clear valuation methodology.
• Its volatile and turbo-charged performance would appear to make it more suited as a return-seeking asset rather than as a stabiliser like gold.
• Nevertheless, there are likely to be years of experimentation and regulatory responses to navigate, while there are also important environmental, social and governance (ESG) issues to consider.

Bitcoin burst onto the world stage in 2008 when Satoshi Nakamoto, its mysterious inventor, published a white paper describing a novel, decentralised peer-to-peer network based on blockchain technology. This marked the beginning of a new era: one of a decentralised cryptocurrency that would be outside of the control of governments and central banks. While Mr Nakamoto himself has since disappeared from public view, the cryptocurrency he created has been propelled increasingly into the spotlight, in part owing to its wild price gyrations, but perhaps more importantly as questions have arisen about what role it could play in the panoply of instruments available to investors.

Having been dismissed by many as speculative froth, the involvement of major, respected endowments such as Harvard, Yale and Stanford universities, as well as prominent hedge-fund figures such as Paul Tudor Jones, has given pause for thought and led to an assessment of Bitcoin’s potential place in a diversified portfolio. Indeed, cryptoassets as a whole continue to gain ground with a combined market capitalisation of c.US$350bn, of which Bitcoin represents approximately two thirds. While it is eclipsed by the size of the gold market – an asset to which Bitcoin is frequently compared – Bitcoin bulls claim that the Bitcoin market’s current size at a mere c.US$210bn (versus US$13 trillion for the precious metal) indicates significant scope for growth.[1]

The ‘Wild West’ of assets

Regulators have responded robustly to Bitcoin’s ability to attract both sophisticated and unsophisticated investors, highlighting its unregulated nature; indeed, the cryptocurrency is often depicted as the ‘Wild West’ of assets. At her last press conference as chair of the US Federal Reserve in 2017, Janet Yellen described Bitcoin as “a highly speculative asset” and “not a stable store of value”.[2] In the UK, the Financial Conduct Authority has banned the sale to retail clients of derivative instruments that are referenced against cryptoassets, emphasising that Bitcoin has no intrinsic value, making it effectively worthless since it is not backed by anything of value.

This highlights an important dilemma: without a clear valuation methodology (calculating the cost of ‘mining’ the cryptocurrency or valuing Bitcoin based on its risk contribution relative to gold are not viewed as credible alternatives), how can its inclusion in a portfolio be justified or explained to clients? The allure of investing in an asset that sits outside the mainstream financial system would quickly wane if the fragile supply and demand dynamic tipped in the wrong direction.

Government-backed cryptocurrencies?

For Bitcoin to represent a substantial challenge to the currency system and monetary policy, it would need to be a medium of exchange adopted by the wider population. Future generations may have a preference for a digital currency and opt for Bitcoin as a hedge against fiat money debasement – indeed this generational aspect could prove to be significant – but central banks and governments are watching its development closely. Against a backdrop where state intervention and the power of government are increasingly prominent, unfettered growth is unlikely to be left unchecked. There has already been talk of government-backed cryptocurrencies based on blockchain technology, thereby enabling the authorities to maintain control and diffuse the risk of the traditional banking system being undermined.

However, it is indisputable that, with each heady rise in Bitcoin’s price and its more widespread adoption – PayPal, for example, recently announced that it would begin enabling transactions with Bitcoin, although only converting the cryptocurrency into fiat currency rather than transferring the Bitcoins to the vendor – it could be viewed as a diversifier in a portfolio. However, setting aside its absence of intrinsic value and lack of cash flows, Bitcoin’s price gyrations are striking, and the volatility and risk associated with it are of an order of magnitude greater than those linked to gold.

This begs the question as to what role Bitcoin could play in a multi-asset portfolio. While gold has often occupied a stabilising role in a portfolio context, it is difficult to view Bitcoin in this vein, given the turbo-charged nature of its performance, both upwards and downwards, making it more akin to a high-octane equity. Steely nerves are required in what may turn out to be a wild ride! This would make it (or its derivatives) more suited to the return-seeking portion of a portfolio with some proven inflation-hedging properties, although there are likely to be years of experimentation, inevitable failures, price volatility and regulatory responses yet to be navigated.

Consuming more energy than Finland

Finally, in a world where environmental, social and governance (ESG) credentials are increasingly under scrutiny, how does Bitcoin fare? Unsurprisingly, here there are conflicting considerations. According to the Cambridge Centre for Alternative Finance, Bitcoin’s annual energy consumption – vast computing power is required to ‘mine’ Bitcoins – exceeds that of Finland. Moreover, the countries from which the processing power is derived have a high CO2 emission intensity.[3] While its profile could be improved by the adoption of renewable-energy sources, this is not currently the case. The association of Bitcoin with criminal activities such as money laundering is an additional concern, although scrutiny is intensifying on this front. Such negatives are counterbalanced by the positive effect of the social benefits of access to cryptocurrencies to those parts of the world’s population which do not have access to bank accounts.

In conclusion, Bitcoin opens a Pandora’s box of issues to contend with which cannot be given justice in a single blog. Such considerations go right to the heart of the meaning of money and its role in society. The current Covid-19 predicament we find ourselves in, with the abundance of monetary and fiscal stimulus, has made Bitcoin the poster child of liquidity-induced euphoria. Whether its place in history is limited to that, or whether its role will become more meaningful from a portfolio perspective, only time will tell.

[1] Source: CFA Institute Research Foundation, Cryptoassets: The Guide to Bitcoin, Blockchain, and Cryptocurrency for Investment Professionals, 2021.

[2] Source: Financial Times, Bitcoin has ambitions for gold’s role, 10 January 2021.

[3] Source: Bernstein analysis, November 2020.

Authors

Catherine Doyle

Investment specialist