Cryptocurrencies part 1 - Cryptocurrencies as an investment

Blockchain, cryptocurrencies and Bitcoin are increasingly in the news and raise questions among investors. This is not so strange, as the prices of cryptocurrencies have been very volatile this year and news reports speak of a new digital, decentralized financial world, which runs parallel to the current financial world.

It is also claimed that in the future this world of decentralised finance (DeFi) will have a major impact on our daily lives. Comparisons are even made with the birth of the internet. Although such processes are gradual, it is good to look at the developments in this area. We will do this in three parts.

In this first part, we look at the investment issue and whether cryptos belong in an investment portfolio. In part two, we look at Bitcoin in detail and in part three, we discuss tokenisation and the other cryptocurrencies. In these parts, issues such as sustainability, valuation and the different forms of cryptocurrencies will be discussed.

For the time being, ABN AMRO does not offer the possibility to invest or trade in cryptocurrencies. The bank also does not currently advise on cryptocurrencies. At the same time, there are no plans as yet to include cryptocurrencies in the investment portfolio or in the investment policy.

If cryptocurrencies can already be defined as a new asset class, it is a very young asset class. This means that there are many uncertainties. These uncertainties not only cause high volatility and a high risk, but in the case of cryptocurrencies, the market is also not transparent and usually not regulated. In the Netherlands, cryptos do not qualify as a financial instrument and do not fall under the supervision of the Netherlands Authority for the Financial Markets. Due to the lack of regulation and transparency, cryptocurrencies still have a highly speculative character, which means there is a chance of large losses. ABN AMRO pursues a very thorough risk policy for its customers and considers the risk associated with cryptos undesirable from an investment perspective for the time being.

When discussing cryptocurrencies (or crypto coins, tokens or crypto currencies), it is important to clearly distinguish between the technology (such as blockchain, a distributed ledger technology), cryptocurrencies and Bitcoin. These things are easily mixed up in discussions. Sometimes, for example, people talk about the advantages of one while referring to the other. Knowing how to clearly distinguish between them is essential, especially when making investment decisions.

This ties in with one of the most important lessons of investing: 'Know what you are investing in.' Not every detail is important, but some understanding of what matters affects value and price. For many cryptos, that is still difficult to answer and the valuation issue is a problem. Also, the quality of the information is often poor. For example, it is still difficult to find exact trading volumes.

Because the future valuation of crypto coins is still difficult, it is also difficult to add them to investment portfolios. Valuation models will be based on future use cases: the function that a token has, what service it wants to provide, what its purpose is and what possibilities it offers. However, it is precisely there that the uncertainty lies, making it difficult to determine the intrinsic or economic value of many cryptos.

There have been quite a few studies, but much of it focuses only on Bitcoin. Bitcoin is often seen as digital gold with a store of value. Bitcoin has the longest history among crypto currencies. Because of this history, Bitcoin has the most data and is often used in benchmarking studies. However, it is not wise to use Bitcoin as an example for all cryptocurrencies, because many crypto currencies have a different use case (a different function) or underlying protocol. In addition, the history of most crypto currencies is still short.

When constructing an investment portfolio, expected return, risk, diversification, correlation and volatility are important issues. General investment theory assumes that with an additional asset class in the portfolio, diversification increases, the expected return increases, while the risk remains the same. At the same time, it is important that in a portfolio the different investments do not all react in the same way or move in the same direction. This means that the correlation (or coherence) between the asset classes should not be too high. How do cryptos behave in terms of the above factors?

We should be cautious about whether cryptocurrencies belong in an investment portfolio. Looking at different studies, the empirical evidence for diversification is mixed and the results regarding correlation are also not unanimous. In addition, the characteristically volatile prices of cryptocurrencies are a sign of uncertainty and therefore risks. Although volatility has decreased somewhat over the years, it is still very high. For example, according to asset manager Robeco, Bitcoin's average annualised realised volatility is 114%. That is almost 10 times higher than the volatility of stocks and gold. This is one of the reasons why Robeco qualifies Bitcoin as an extreme asset class and assigns it a maximum weight of 1% in the portfolio.

The results on correlation are somewhat different. Research institute CFA concludes in its study that the correlation of Bitcoin with other asset classes is low and that the Sharpe ratio (which says something about the return per unit of risk) improves if the Bitcoin position in the portfolio does not exceed 2.5% and is rebalanced quarterly.

Although research does not provide definite conclusions, in purely theoretical terms, crypto currencies should provide diversification and low correlation in an investment portfolio. Whereas the value and price of stock, bonds, commodities and real estate are mainly determined by the state of the economy and interest rates, this is different for cryptocurrencies. Theoretically, the value and price of crypto currencies should be determined by the way in which the technologies develop, the course of events in the field of regulation and the degree in which the security and performance of the networks improve. However, in reality this is different. Due to a lack of transparency and regulation, supply and demand are regularly influenced by price manipulation, partly through messages on social media. Elon Musk's tweets are a good example of this and would often fall under market abuse in a regulated market. In the longer term, when cryptos may become more common and regulated, correlation and volatility will be determined by other things, such as use cases.

Studies of correlation of crypto assets within a portfolio have produced somewhat mixed results. But during the corona crisis in February and March 2020, the biggest global recession in the last decade, it was noticeable that correlation increased sharply: many investments dropped in value and cryptocurrencies such as Bitcoin did not escape. Bitcoin even lost more (-63%) than equities and gold, for example. The MSCI All Countries World Index in local currency, for example, fell by 35% and gold by 8%. While Bitcoin is not representative of all other crypto currencies, from a diversification point of view and the 'store of value' argument attributed to Bitcoin, such correlation within a portfolio is not desirable.

As described in our 2018 report, cryptocurrencies, if they can be classified as an asset class at all, are best compared to a venture capital investment. Cryptocurrencies have more or less the same risk/return ratios as venture capital. Venture capital is a form of private equity and focuses specifically on investing in a young company. Cryptocurrencies involve investments in a very young technology and industry. Both have yet to prove themselves. The risk is therefore very high and, if successful, the return may be high, but the outcome is initially very uncertain. Cryptocurrencies, just like venture capital, fall under alternative investments and therefore have a very small weight in the investment portfolio. The addition often aims at diversification.

For the time being, ABN AMRO does not offer the possibility to invest or trade in cryptocurrencies and does not yet advise on this. This is due to the fact that valuation is still generally difficult and that the world of crypto currencies is insufficiently transparent. It is important to make a good distinction between the technology and between the different cryptos. Looking purely at cryptocurrencies as a possible investment, their risk-return profile is closest to that of venture capital. Theoretically, cryptos as an asset class should lead to lower correlation and to diversification, because other things influence the value and price than in classical asset classes such as stocks or bonds. Yet studies on correlation and diversification are not unanimous in their conclusions. Moreover, research is currently mainly conducted on Bitcoin, which is not representative of all cryptos. Because of this, we should be cautious about whether cryptocurrencies belong in an investment portfolio.

Ralph Wessels
Head of Investment Strategy ABN AMRO

Sources:

• Tokenization of Assets, Nov. 2020 – EY
• Cryptoassets: The guide to Bitcoin, Blockchain, and Cryptocurrency for investment professionals, Jan 2021 – CFA
• Our Thoughts on Bitcoin, Jan 2021 – Bridgewater
• The rise of Bitcoin, Jan 2021 – UBS
• Bitcoin: A Solution In Search Of A Problem, Feb 2021 – BCA Research
• Bitcoin, Gold, Or Fiat?, Feb 2021 – Evergreen Gavekal
• Bitcoin At the Tipping Point, Mar 2021 – Citi
• The Bitcoin Experiment, Mar 2021 – Neuberger Berman
• Understanding Bitcoin, Mar 2021 – Fidelity
• The Case for Cryptocurrency As an Investable Asset Class in a Diversified Portfolio, Mar 2021 – Morgan Stanley
• Digital currencies: What are they and why do they matter?, Mar 2021 – HSBC
• The future of Bitcoin, Apr. 2021 - Rabobank
• Why Cryptocurrencies Are Here To Stay, Apr. 2021 – BCA Research
• Bitcoin as digital gold – a multi-asset perspective, Apr. 2021 – Robeco
• How To Short Bitcoin, Or Anything Else, Without Losing Your Shorts, Apr. 2021 – BCA Research
• Bitcon No More, Apr. 2021 – Evergreen Gavekal
• Covcoins: The digital currencies that matter, May 2021 – The Economist
• How fintech will eat into banks’ business, May 2021 – The Economist
• The Crypto Impossibility Theorem, May 2021 – BCA
• Buy The Crypto Dip?, May 2021 – Gavekal Research
• Bit by bit, May 2021 – The Economist
• The rise of crypto laundries: how criminals cash out of bitcoin, May 2021 – Financial Times