October was a big month in cryptocurrency land. Bitcoin reached an all-time high of nearly $67,000, and the first exchange-traded fund (ETF) focused on bitcoin began trading. The rapid rise in the price of bitcoin has had a polarizing effect on many investors. Some investors remain very optimistic about bitcoin and cryptocurrency investments in general while others see cryptocurrency investments as speculative or dangerous. We see reasons for a more encompassing view. In this memo, we share our current thinking on cryptocurrency investments.
Bitcoin is part of a broader cryptocurrency landscape.
Bitcoin is often used as shorthand for the entire realm of cryptocurrencies and should not be. The recent market value of all cryptocurrencies is roughly $2.7 trillion in aggregate, and bitcoin accounts for a little less than half of this value. Bitcoin’s origin is as a peer-to-peer electronic payments system. More recently, proponents of bitcoin have touted the electronic money’s role as a potential store of value and an alternative to holding wealth in “fiat” currencies such as the U.S. dollar. One of the features of bitcoin’s design is that the total future supply of bitcoin is limited to 21 million bitcoins, which is in contrast to the supply dynamics of fiat currencies (i.e., governments can create more).
Think of bitcoin as digital gold.
Due to the limited supply of gold and its reputation as a store of value, it is increasingly common to see comparisons between bitcoin and gold. Bitcoin clearly has an advantage in terms of portability and ease of storage. However, gold has served as a store of value for thousands of years versus a little over a decade for bitcoin.
We believe that an investment in bitcoin can be appropriate for someone who already owns gold as part of their portfolio. The rationale for owning gold typically is as an alternative store of value and to hedge risks to more traditional financial assets (e.g., geopolitical instability, currency debasement, etc.). Bitcoin may prove to be a similar hedge and could potentially have greater upside than gold due to increased future adoption. However, for investors looking to bitcoin to provide a hedge against severe stock market declines, it is worth noting that bitcoin’s price also declined precipitously during March 2020 as the stock market entered a bear market.
Avoid the new bitcoin ETFs.
The U.S. Securities Exchange Commission (SEC) has approved ETFs that gain exposure to the price movements of bitcoin through futures contracts. A full explanation of futures contracts is beyond the scope of this memo. The important point is that the performance of these funds that are “linked” to bitcoin will not match the actual performance of bitcoin. We expect costs due to the nature of the underlying investments to detract from the returns of these funds.
What about other cryptocurrencies?
More than 100 cryptocurrencies today have market values in excess of $1 billion. The second largest behind bitcoin is called ether, the native cryptocurrency on the Ethereum blockchain. Whereas bitcoin may be thought of as a digital store of value, ether and other cryptocurrencies like it may be thought of as a bet on a decentralized version of finance. Decentralized finance could reduce the middleman cost and processing times of today’s financial system. For example, a wire transfer to a bank overseas can involve multiple financial institutions, currency exchanges, several days of processing time, and various fees and expenses.
The stakes involved in the future inner workings of the financial system are immense. However, it is not clear which technologies and cryptocurrencies will emerge as the leaders. It may be best to think of cryptocurrencies like ether as venture capital investments in nascent decentralized finance technologies.
Something for the skeptics.
If you tend to think of digital currencies with skepticism, one way to keep an open mind is to consider the accumulation of talent and resources aimed in this general direction. Famed venture capitalist Marc Andreessen and his firm Andreessen Horowitz have launched their third crypto fund and raised more than $2 billion. In a recent Bloomberg interview, Andreessen commented that “many of the smartest people in computer science are going into this field, and they’re pushing it forward at a really rapid rate.”
In August, Wal-Mart announced that they are hiring a cryptocurrency expert responsible for “developing the digital currency strategy and product roadmap”. Their announcement came several weeks after a similar job posting at Amazon. Consider the implications of the future of payment processing to retailers as large as Amazon and Wal-Mart.
It is possible to be unsure of the value of cryptocurrencies, even suspect that some may have no value at all, and yet recognize that something important is going on here.
Let us know if you are interested in learning more.
We are not cryptocurrency experts, but we are paying attention and are continuing to learn. We can share some resources that we have found helpful. We have also identified a firm through which clients can invest in and custody cryptocurrencies.
If you are considering an investment in cryptocurrency, please assess some unique risks not shared by other investment assets. Cryptocurrencies lack government backing and could face regulatory or political risks that could damage their values. Investments in cryptocurrencies face unique cyber security risks. Cryptocurrencies also are very volatile. Unlike traditional investment assets like bonds, stocks, or real estate, cryptocurrencies do not produce cash flow, which means that investors cannot use traditional valuation methods for estimating a reasonable price.
At this time, we are not recommending cryptocurrencies to clients. We expect cryptocurrencies to be a feature of the future world of finance, but it is very difficult to assess which cryptocurrencies will win, how to balance the risks, and what might be an appropriate price to pay for them today. If you are interested in a conversation on this topic, please contact us at your convenience.