INFOCUS MACRO COMMENT FEBRUARY 2021 The pros and cons of cryptocurrency investment DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. HIGHLIGHTED IN THIS PUBLICATION: The icons alongside represent our investment process. Through a disciplined provision of investment policy and security selection at GLOBAL STRATEGIC GLOBAL SECURITY ASSET ALLOCATION SELECTION the global level, regional portfolio management teams have the flexiblility to construct portfolios to meet the specific requirements REGIONAL REGIONAL PORTFOLIO of our clients. ASSET ALLOCATION CONSTRUCTION THE 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. 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 2 | February 2021 THE 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 ) 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.