INFOCUS MACRO COMMENT

FEBRUARY 2021

The pros and cons of cryptocurrency investment

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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. e

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 31 December 2015 = 100, log scal 2 Diversification and gold Not all cryptocurrencies are the same 1 2016 2017 2018 2019 2020 2021 Limited supply of individual Unlimited supply of cryptocurrencies 3 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.

Protection against currency Poor store of value due to volatility and 4 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

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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 ) 2 20 of bitcoin activity in 2019. 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 Bitcoins in circulation (millions impossible to know for what purposes they are being used. And there are an increasing number of institutional investors 0 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 ) 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 20 the Fed’s balance sheet has expanded by 8x, the ECB’s by a Bitcoin walets (millions 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 | 3 THE 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 and the minimum -37.6%. In addition it is worth noting that in 10 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 Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan in 25. 18 18 18 19 19 19 19 19 19 20 20 20 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 2021 THE 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 Furthermore, a country’s own currency has a special status 40 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 % 25 monetary policy rules and trust in elected government. ange 20 In contrast, because cryptocurrencies are not backed by aday r 15 anything other than faith in the system, damage to that faith Intr 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 | 5 THE 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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