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INFOCUS
M AC RO COM M E N T
FEBRUARY 2021
The pros and cons
of cryptocurrency
investment
DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. HIGHLIGHTED IN THIS PUBLICATION:
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flexiblility to construct portfolios to meet the specific requirements REGIONAL REGIONAL PORTFOLIO
of our clients. ASSET ALLOCATION CONSTRUCTIONTHE PROS AND CONS OF CRYPTOCURRENCY INVESTMENT
The price of one bitcoin in US dollars quadrupled last year, gaining over 160% in Q4 alone.
This meteoric rise sparked widespread media and investor interest in bitcoin specifically
and in cryptocurrencies more generally. Moreover, many payment platforms such as BitPay,
Square and PayPal have started accepting payments in bitcoin and other cryptocurrencies.
At the same time it is becoming easier to trade cryptocurrencies on established platforms.
This Infocus by Daniel Murray and Joaquin Thul sets out the pros and cons for investing in
cryptocurrencies to help investors make a more informed decision about its prospects.
There is a lot of terminology associated with of high returns becomes even more attractive in the context of
cryptocurrencies. To avoid confusion, definitions of some very low government bond yields. Furthermore, high potential
common terms are included in the Appendix. returns are appealing for those who believe equity returns will
be lower for a while following strong performance last year.
For convenience, Figure 1 sets out a summary of the
main Advantages and Disadvantages of investing in 2. Bitcoin vs. S&P 500
cryptocurrencies as we see them. The main body of the text 10000
discusses each of these in more detail.
31 December 2015 = 100, log scale
1000
1. Main advantages and disadvantages of cryptocurrency investment
Advantages Disadvantages 100
High volatility, large potential losses
1 High potential returns
Not all cryptocurrencies are the same
10
Positive correlation with equities
2 Diversification and gold
Not all cryptocurrencies are the same 1
2016 2017 2018 2019 2020 2021
3
Limited supply of individual Unlimited supply of cryptocurrencies Price of 1 bitcoin in USD S&P 500 Index in USD, net dividends reinvested
cryptos in general
Source: Bloomberg, EFG calculations. Data as at 29 January 2021.
4
Protection against currency Poor store of value due to volatility and
debasement and inflation restricted usage
2. Potential diversification
Diversification has also been mentioned as a potential
Unregulated and exposed to
5 Growing acceptance and usage
unscrupulous behaviour benefit of investing in cryptocurrencies, with some saying
Source: EFGAM it is an alternative to gold to use as a hedging tool in a
portfolio context. For example, the S&P 500 declined in 17
We start with some of the potential advantages. out of the 60 months to end December 2020, of which the
price of bitcoin rallied in seven. As noted above, a portfolio
Advantages invested entirely in the S&P 500 (in USD, net dividends
reinvested) would have generated compound annual
1. Potential for high returns returns of 14.5% in the five years to end 2020. A portfolio
One of the main arguments in favour of cryptocurrencies is consisting of 10% invested in bitcoin and 90% in the S&P 500
the potential for high returns. For example, in the five years would have generated compound annual returns of 26.8%.
to 31 December 2020, the S&P 500 index of large cap US Moreover, the ratio of the compounded annual return to the
equities has compounded at an annualised growth rate of annualised volatility– a simplified information ratio – rises
14.5% (in USD, net dividends reinvested); over the same time from 0.95 for the S&P 500 on its own to 1.5 for the portfolio
period the price of bitcoin in USD has compounded at an in which 10% was invested in bitcoin.
annualised growth rate of 131.5% (see Figure 2). The prospect
2 | February 2021THE PROS AND CONS OF CRYPTOCURRENCY INVESTMENT
3. Limited supply According to people holding these views, bitcoin and other
A particular feature of bitcoin is that there is a maximum of 21 cryptocurrencies offer alternatives that cannot be debased
million coins that can be created or “mined”. At the moment in the same way, partly because supply is capped and partly
around 18.5 million bitcoins have been mined (see Figure 3), because cryptos are not subject to the same political and
leaving less than three million still to come into existence. economic pressures as national central banks e.g. central
A related feature is that the rate of production of bitcoins banks intervening in currency markets (such as the Bank of
slows over time via a process known as halving – every so Japan and Swiss National Bank), central banks being obliged
often according to pre-determined conditions the number to support the economy during times of stress by purchasing
of bitcoins paid for mining a block halves. Whereas in 2009 government bonds. A corollary is that proponents of this view
each block mined was worth 50 bitcoins, the value is now 6.25 believe cryptocurrencies will provide much better protection
bitcoins per block following the latest halving in May 2020. against rising inflation. Such individuals find cryptocurrencies
Additionally, it is thought that around 20% of existing bitcoin attractive precisely because they are insulated from
supply has been lost or is inaccessible as a result of lost government interference.
or forgotten passwords.1 The scarcity of bitcoin adds to its
appeal for some investors – if demand for bitcoin increases 5. Growing acceptance and usage
further and supply is capped that would potentially drive the As noted in the introduction, a growing number of payment
price higher. More generally, this supply-cap is a feature of platforms are now allowing transactions to take place in
many cryptocurrencies. bitcoin and other cryptocurrencies. An article from last year
claimed that Coinbase had seen $135 billion in cryptocurrency
3. Total number of bitcoins in circulation vs. maximum merchant transactions in 2019, a 600% increase over 2018.
25
That same article cites a Chainalysis report that alleges
payment processors saw approximately $4 billion worth
Bitcoins in circulation (millions)
20 of bitcoin activity in 2019.2 Furthermore, another article
quotes survey data that suggests at least a third of US small
15 businesses accept cryptocurrencies as a means of payment.3
Separately, it is notable that there has been a significant
10
increase in the number of bitcoin electronic wallets
created over the past few years (see Figure 4) although it is
5
impossible to know for what purposes they are being used.
0
And there are an increasing number of institutional investors
2009 10 11 12 13 14 15 16 17 18 19 20 21 who are looking to invest in cryptocurrencies, the latest
Number of bitcoins in circulation Maximum being Blackrock and Bridgewater. Grayscale Investments,
Source: Blockchain.com, EFG calculations. Data as at 29 January 2021. a self-proclaimed “trusted authority in digital currency
investing”, reported that in 2020, 86% of the $5.7 billion in
4. Protection from debased currencies and the threat of
rising inflation 4. Number of bitcoin wallets
The Global Financial Crisis (GFC) of 2008/09 was a catalyst 70
for central banks around the world to engage in unorthodox
60
monetary policies, notably large scale asset purchases. For
Bitcoin walets (millions)
example, since the GFC began, the balance sheets of the US 50
Federal Reserve and the ECB have each expanded by over 40
US$6 trillion while the Bank of Japan’s balance sheet has
30
expanded by a little less than US$6 trillion. Proportionately
the Fed’s balance sheet has expanded by 8x, the ECB’s by a 20
little under 4x and the BoJ’s by nearly 7x. 10
0
Some people are concerned this will result in a massive 2011 15 17 18 2019 2020 2021
debasing of national currencies, as happened in the Weimar Number of bitcoin wallets
Republic in the 1920s when the mark became worthless. Source: Blockchain.com and EFGAM. Data as at 28 January 2021.
1
‘Lost passwords lock millionaires out of their bitcoin fortunes’, The New York Times, 14 January 2021. https://nyti.ms/3sgR63x
2
https://www.coindesk.com/bitcoin-usage-among-merchants-is-up-according-to-data-from-coinbase-and-bitpay
3
https://www.businesswire.com/news/home/20200115005482/en/HSB-Survey-Finds-One-Third-Small-Businesses-Accept
February 2021 | 3THE PROS AND CONS OF CRYPTOCURRENCY INVESTMENT
inflows received into their products came from institutional 2. Correlations
investors, mostly asset managers.4 It was previously noted that of the 17 months the S&P 500 fell
over the five years to end 2021, the price of bitcoin went up in
We now look at the disadvantages of cryptocurrency seven. An alternative way of saying the same thing is that of
investment, many of which directly counter the advantages. the 17 months the S&P 500 declined, bitcoin also went down
in 10 of them, which is slightly less flattering.7 Of the five worst
Disadvantages months for the S&P 500 the price of bitcoin declined in four
of them – one could argue that bitcoin has a poor record of
1. High volatility and potential for large losses providing diversification benefits when they are most needed.
The annualised volatility of the monthly percent change in the
price of bitcoin in US dollars is about 90% as measured over 5. Rolling 30-month correlations
the past five years. This compares to annualised volatility of 40
the monthly percent changes in the S&P 500 and the gold 35
price of 15.3% and 13.4% respectively. To give some idea of 30
what this volatility might mean for an investor it is useful to 25
consider the range of returns: the maximum monthly bitcoin 20
%
return over the 60 months to end December 2020 was 76.1% 15
10
and the minimum -37.6%. In addition it is worth noting that in
5
12 of those 60 months – 20% of the time – the monthly bitcoin
0
return was worse than -10%. Whereas the S&P 500 generated
-5
negative returns in 17 of those months, the price of bitcoin fell -10
in 25. Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May
18 18 18 19 19 19 19 19 19 20 20 20
Jul Sep Nov Jan
20 20 20 21
Bitcoin-S&P 500 Bitcoin-gold
So investors need to be aware that the potential for large Source: Bloomberg, EFG calculations. Data as at 28 January 2021.
gains is offset to some extent by the possibility of large
losses – the timing of an investment in bitcoin or other Moreover, changes in the price of bitcoin are positively
cryptocurrencies will have a significant bearing on the returns correlated with changes in the S&P 500 index and to a
achieved. Indeed, on 11 January 2021, the UK’s Financial greater extent than gold; the correlation coefficient between
Conduct Authority issued a statement warning investors in monthly % changes in the price of bitcoin and the S&P 500
cryptocurrencies that they should be prepared to lose all index is 20.4% over the five years to end December 2020
their money given the highly speculative characteristics of whereas the correlation between monthly % changes in
the asset class.5 Days later, ECB President Christine Lagarde gold and the S&P 500 is 17.5%. And on a rolling basis there
also labelled bitcoin as a speculative asset, calling for central are times when the correlations between bitcoin and the
banks to regulate the cryptocurrency to prevent its use for S&P are even higher (see Figure 5). A final point to highlight
money laundering activities.6 And India recently announced a in this regard is that, as with the returns achieved, the
plan to ban all private cryptocurrencies. impact of owning a cryptocurrency in a portfolio will vary
enormously dependent on which one is chosen.
We further note that not all cryptocurrencies are the
same. Whilst bitcoin and some other cryptocurrencies did 3. Endless potential supply
indeed perform strongly last year, others did less well. For Whilst it is true that the number of bitcoins produced
example, the cryptocurrency EOS is less well known and less will eventually be capped at 21 million and many other
widely traded than bitcoin but it is relatively large and well cryptocurrencies also have limited supply built into their
established, being one of the five cryptocurrencies that make protocols, there is currently nothing to stop an ever-growing
up the Bloomberg Galaxy Crypto Index. In 2019 the USD value number of new cryptocurrencies from being launched.
of EOS fell by 1.5% and in 2020 it declined by 0.2%. Crypto Therefore, cryptocurrency supply is potentially limitless.
performance can and does vary significantly dependent on Bitcoin is currently the favoured cryptocurrency but over time
which version is selected. fashions and tastes may change, possibly very quickly and for
4
https://grayscale.co/insights/grayscale-q4-2020-digital-asset-investment-report/
5
https://www.fca.org.uk/news/news-stories/fca-warns-consumers-risks-investments-advertising-high-returns-based-cryptoassets#:~:text=The%20FCA%20is%20
aware%20that,cryptoassets%2C%20that%20promise%20high%20returns.&text=Consumers%20should%20be%20wary%20if,too%20good%20to%20be%20true.
6
https://www.reuters.com/article/us-crypto-currency-ecb/ecbs-lagarde-calls-for-regulating-bitcoins-funny-business-idUSKBN29I1B1
7
This is an example of the behavioural framing bias in which the way information is presented has a significant bearing on how it is interpreted by the audience.
4 | February 2021THE PROS AND CONS OF CRYPTOCURRENCY INVESTMENT
no apparent reason. It is possible that once the bitcoin supply basis. This lack of stability reduces the attractiveness of
limit has been reached this will encourage flows into other cryptocurrencies as a store of wealth.
cryptocurrencies, precipitating a fall from favour for bitcoin.
This is not a prediction but merely identification of one way 5. Unregulated and unbacked
in which cryptocurrency market dynamics might change. It is Cryptocurrencies are a construct of the private sector
also worth noting that several central banks are exploring the with no official oversight or regulation. This means that
possibility of launching their own digital currencies, another cryptocurrencies are wide open to being exploited by
potential catatlyst that may take the shine off privately- criminals who in turn are able to use cryptos as a means
managed versions.8 to scam unwary investors. This is no doubt one reason
why central banks and regulators are keen to get involved.
4. Poor store of value and limited acceptance There are of course perfectly legitimate ways and means of
Whilst bitcoin and some other cryptocurrencies are now investing in cryptos but the lack of regulation makes them
accepted across a growing number of payment platforms, the an attractive playground for less law-abiding members of
number of places where one can exchange cryptocurrencies society. A 2019 academic study found that 25% of bitcoin
for real goods or services is very limited. Other perhaps than users are involved in illegal activity and that 46% of bitcoin
in Venezuela, one cannot generally go into a coffee shop or transactions are associated with illegal activity.9
restaurant (lockdown rules permitting) or other store and
pay using a cryptocurrency – most places would not accept Whilst traditional financial systems and the currencies they
it. This is not least because cryptocurrencies are so volatile- use are certainly not faultless, they are at least heavily
the revenue will vary wildly when converted back into a regulated. This not only deters criminal activity but it means
currency in which the merchant usually conducts business. that if there is a problem there are a set of rules (often
The challenges here are compounded by the huge amount of embedded in law) and organisations in place to help deal
intraday variation (see Figure 6). If a lot of people pay using with it. For example, most modern banking systems have
cryptocurrency this may result in a large mismatch with the some sort of deposit insurance in place, while credit and
merchant’s cost structure. debit cards also typically provide a degree of insurance
against fraudulent activity.
6. Cryptocurrrency intraday trading range
40
Furthermore, a country’s own currency has a special status
as legal tender meaning that a creditor is legally obliged
35
to accept it as payment for a debt. This fundamental
30
characteristic underpins financial systems, augmented by
Intraday range %
25
monetary policy rules and trust in elected government.
20 In contrast, because cryptocurrencies are not backed by
15 anything other than faith in the system, damage to that faith
10 will leave the cryptocurrency highly vulnerable.
5
There are already, according to Coinopsy, over 1,800
0
Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec Jan cryptocurrencies that have failed10 and there are other
2020
Range as % of previous day's close examples in history of private currencies having failed
Source: Refinitiv and EFGAM. Data as at 1 January 2021. when trust was lost. In a 2019 presentation, St. Louis Fed
President James Bullard noted that in the 1830s 90% of US
For similar reasons the volatility inherent in cryptocurrencies money supply was represented by private currencies; he
makes them a poor store of value. The value of described it as “a state of affairs that has existed historically
cryptocurrency savings when converted back into an but was disliked and eventually replaced.”11 Markets also lose
individual’s base currency – that in which they conduct most faith in traditional currencies when the monetary systems
of their transactions and in which their assets and liablities and governments stop functioning properly, such as recently
are expressed – will swing about wildly even on an intraday occurred in Zimbabwe or Venezuela. However, this is highly
8
See EFG Infocus ‘The Surge of Central Bank Digital Currencies’, 7 January 2021.
9
‘Sex, Drugs and Bitcoin: How Much Illegal Activity is Financed Through Cryptocurrencies?’ by Sean Foley, Joanthan R Karlsen and Tālis J Putniņš, Review of
Financial Studies, vol 32(5), pages 1798-1853.
10
www.coinopsy.com/dead-coins
11
Public and private currency competition, James Bullard presentation, 19 July, 2019
https://www.stlouisfed.org/from-the-president/speeches-and-presentations/2019/public-and-private-currency-competition
February 2021 | 5THE PROS AND CONS OF CRYPTOCURRENCY INVESTMENT
unusual for countries with long established and stable to a portfolio is based on each individual’s assessment of the
monetary and political systems. balance of advantages and disadvantages, the main ones of
which we have tried to highlight in this note.
Conclusions
We have tried to identify the main advantages and Separately and distinct from a discussion on the merits
disadvantages of investing in cryptocurrencies although of investing in cryptocurrencies, we note that there are
we do not claim this list is exhaustive. Whilst we have a number of potential advantages in utilising blockchain
no view on the direction of the price of bitcoin or any technology more broadly within the financial system. Perhaps
other cryptocurrency, we draw the reader’s attention in paradoxically given the current lack of regulation of cryptos,
particular to the potential for large losses. Supporters of blockchain could be a powerful regulatory tool, as noted in a
cryptocurrencies would argue that this downside risk is recent BIS paper.12 Blockchain could also be used as a means
offset by the potential for large returns and that the risks of cost reduction to make the financial system more efficient.
can be managed by appropriately sizing a cryptocurrency However, a broader discussion on the potential merits of
position within a portfolio of other investments. The overall blockchain is beyond the scope of this note.
decision on whether or not to add cryptocurrency exposure
APPENDIX - DEFINITIONS
Digital currency is a loose term referring to electronic money that has no physical form. The definition is a bit woolly as
many transactions and payments these days take place in electronic form, a trend that has been exacerbated by heightened
concerns about physically handling cash in the midst of a pandemic. However, whereas it is possible to own notes and coins
representing traditional currencies, a pure digital currency exists only electronically.
A cryptocurrency is a type of digital currency that is decentralised and operates on an independent platform – you don’t
need to go through traditional intermediaries such as banks to trade or transact in a crypto. Cryptos are stored in a digital
wallet (or similar) accessible only through electronic devices.
A digital token is a digital asset the value of which is tied explicitly to the value of another asset. A stablecoin is a particular
type of token, the value of which is directly linked to a currency or a basket of currencies.
DLT is an acronym for Distributed Ledger Technology. In traditional models there are a small number of record keeping systems
that are regularly reconciled and that serve as the official log of transactions and ownership. In an environment that uses DLT
there is a decentralised system of records with no single authority over it. Blockchain is a type of DLT that verifies transaction
and ownership information via a series of encrypted data blocks.
12
‘Stablecoins: risks, potential and regulation’ by Douglas Arner, Raphael Auer and Jon Frost, BIS Working Paper No. 905, Nov-20.
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