The rollout of several crypto-oriented ETFs has fanned the flames of this investment trend over the last few weeks. In accordance with what’s being allowed by the SEC at this time, the new ETFs invest in bitcoin futures contracts, as opposed to the actual currency. More on that distinction towards the end.
With crypto being such a new technology, it’s been difficult for many investors to understand what they’re actually buying. This complicates the assessment of potential return and risk involved. This is not an endorsement or condemnation of the asset class. We’ve discussed this topic periodically in the past, but it might be helpful again to cover the highlights. Firstly, it’s important to break the asset down into its component parts.
- Blockchain technology, which is what cryptocurrencies and transactions are based on, appears to have some commercial promise in its own right. Although there are practicalities to be worked out, it’s feasible for blockchain digital ledgers to replace outdated recordkeeping systems (like paper) for contracts, such as property deeds, or other assets requiring the maintenance of an ownership chain. That doesn’t mean the technology itself will necessarily end up being hugely profitable. Historically, many new technologies have created efficiencies and lowered costs for consumers, without resulting in investment windfalls for the providers.
- Cryptocurrencies represent digital units traded via blockchain, which allows for the tracking of ownership changes and is assumed to avoid duplication. Bitcoin is the oldest and most liquid of these currencies, and is what the new ETFs are tracking, so we’ll use that as the primary example, but thousands of other cryptocurrencies have been created. Unlike currencies issued and backed by world central banks, these are not backed by any government.
What is the appeal of crypto?
- Anonymity. This refers to the ability to transact privately, akin to exchanging briefcases of untraceable cash. Unsurprisingly, demand has come via illicit transactions, or tax avoidance, but also presumably from those just wanting high levels of secrecy. According to recent reports, though, the U.S. government has apparently been able to locate and retrieve stolen and ransomed bitcoins, so these transactions may not be as ‘private’ as once thought.
- (Assumed) Scarcity. There has been a set cap of 21 million total units of bitcoin to be ever produced, although it’s been debated whether that can be verified practically for various cryptocurrencies. That also assumes other digital currencies don’t emerge that are superior in technology or gain popularity for other reasons. This is a historical attribute common of all currencies: if there is unlimited money printing, each unit will lose proportionate value. Traditional currencies tend to have an advantage here, since individual nations (or blocs) tend to only issue a single currency, which results in a limited universe of possible options, rather than thousands. Then again, recent massive spending and money creation by the U.S., Europe, and other regions in response to Covid has caused many to wonder about the eventual impacts on these currencies as well.
- Avoidance of or protection from the financial system. This would be similar to the hoarding of gold or silver bars, for example. In fact, bitcoin has been referred to as the ‘digital gold’. The drawback is that, like with gold/silver, the price of bitcoin itself is extremely volatile. That erodes a lot of its safe-haven appeal. Moreover, rather than acting as a ‘risk off’ asset as precious metals have, bitcoin has started to act more like a ‘risk on’ asset similar to stocks, which provides even less diversification against sell-offs in other assets which some buyers have hoped it would protect against. Due to its short history, the track record versus inflation is also inconclusive.
Coming to the question of investment merit, we also have to ask: What is a currency? And, what do we expect from currencies?
- Medium of exchange. Bitcoin and Ethereum (the second most popular) have been offered for use by some vendors, but availability is far from widespread. There are literally thousands of crypto coins available (including some developed originally as a joke) that can’t be accepted anywhere for payment—which limits their use to speculation. There is some network effect present for bitcoin, due to its first mover advantage, but for any asset to hold its value in theory, there have to be at least some willing buyers and sellers (and preferably many). The volatility of bitcoin has caused problems as a payment medium, not unlike the constant repricing of goods required during periods of historical currency debasement, notably Weimar Germany in the 1920s.
- Unit of account. Bitcoin and others qualify since they have a numerical value, so can be mathematically counted and tracked. Then again, other than the rough parameters around bitcoin’s capped number of creation units, there is little transparency about limitations on other currencies.
- Store of value. Does bitcoin hold its value? That’s could be under debate, since its price has fluctuated wildly between $10,000 to $60,000 over the course of a few months. That volatility is more reflective of a speculative asset. The argument against crypto is that there aren’t underlying characteristics, usefulness, or long historical legacy that give digital currencies any fundamental value—we really don’t know if the true worth should be $1,000,000/coin or zero—it’s entirely based on popularity. The relative attractiveness of common currencies such as the dollar, pound, yen, euro, etc. is that they’re backed by large governments with substantial asset holdings, such as land and natural resources, taxing power, military might in most cases, as well as the ability to uphold rule of law (important for the predictability of settling commercial contracts). That’s not saying inflation won’t erode a currency’s value over long periods, but that’s the rationale for investing in other assets such as stocks, bonds, real assets, etc.
- Bitcoin, being the first, and mostly well-known, may score better on some metrics than others, including its larger network effect. Although, there are still questions about what a person physically owns (electronic bits). For the remainder of cryptocurrencies, it’s becomes harder to extract value from a real asset standpoint. What makes the 1001st currency unique from the 1000th? If anyone can create a cryptocurrency, and without a market for it, does it have any value?
If an investor desires crypto exposure, how can it be approached?
- Directly. From a longer-term standpoint, this is purest and likely lowest-cost method. But this is not the end of it. As with any asset not under traditional custody, one needs to be cognizant of operational risks involved with online storage (such as hacking/theft risk, which has happened many times already). Some experts seem to think the best and most private method is ‘cold storage’, which is essentially downloading one’s crypto onto a drive for secure physical storage (safe, safe deposit box, etc.), just as one would collectable coins, computer files, or important documents. An investor still needs to worry about security, lost passwords, etc., since that’s often the only way to retrieve the coins.
- Indirectly. This is would be through financial futures contracts or one of the new ETFs (which own bitcoin futures, not the actual coins). As with commodities, owning futures contracts provides exposure to an asset, but the price of the futures (or ETFs based on contracts, due to their own market price vs. net asset value dynamics) can drift from the actual spot price of the asset. Futures are prone to the familiar ‘contango’ or ‘backwardation’, due to the use of near-term expiring contracts, and the need to continually replace them (this is referred to as ‘roll risk’). This may get less noticeable as ETF products become more popular or spread the operational risk of ETF position limits, or it may not. There are also management fees to consider, which look to be just under 1% level so far. Given that list of caveats, if someone wants liquidity, ease of use, or just a way to speculate without needing much precision in the short-term, owning an ETF is obviously more convenient than going through the crypto exchange and cold storage process noted above.