Thinking Through Cryptocurrencies | Part 3
It seems like everyone nowadays is talking about cryptocurrencies. Whether it’s the proselytizers on CNBC or the techie next door, it feels as if everyone is either talking about or buying into this next big thing.
Trying to adequately explain an emerging technology and it’s economic impact in less then a few thousand words is bound to neglect certain facets of the subject. This series attempts to cover the technical specification of cryptocurrencies, how they can be viewed in an investment environment, the narratives that accompany this new technology, and the future impact, applications, and risk of the cryptocurrency universe.
If you missed Part 1 or Part 2, check them out. In Part 3, we consider what the future could look like.
What Might the Future Look Like?
Cryptocurrencies are experiencing a golden age where new types of assets and new uses for blockchain technologies are emerging every day. However, in this case, widespread use does not automatically translate to amazing long-term investment returns. Sustaining long-term high investment returns requires a combination of low supply and high demand.
When it comes to low supply, there is certainly a limit to the amount of a given cryptocurrency. However, new cryptocurrencies can and have continued to be created. Dogecoin was launched in 2013 and now has a circulation value which has exceeded $80B. Polkadot was launched in 2017 and has a circulation value that has exceeded $10B. When supply dwindles and prices rise, entrepreneurial spirits enter markets and create supply, especially when the barriers to entry are relatively low.
Cryptocurrencies have a few hurdles ahead of them. The most notable of these is the possible environmental impact of cryptocurrency mining. According to Digiconomist, the annualized carbon footprint of Bitcoin mining is comparable to the country of Hungary and is growing every year. As more and more individuals flock to the cryptocurrency space, the power necessary to rectify transactions grows. There are new cryptocurrency assets such as Cardano that seek to use optimized protocols to decrease the power required. However, because most cryptocurrencies utilize a proof-of-work methodology, there is a lower limit on the computation required for the cryptocurrencies to remain secure. This means that there will always be a certain energy requirement for these cryptocurrencies.
Bitcoin has also made a name for itself in non-reputable markets such as money laundering, drug trade, and even human trafficking. Blockchain analysis company Chainalysis tracked just under $930,000 worth of Bitcoin and Ethereum payments to specific addresses associated with child sexual abuse material. This was a 32% increase in payments from 2018 and a total of a 310% increase since 2017. Financial institutions in the U.S. filed over 2,000,000 suspicious activity reports (SARs) in 2019. The increasing use of cryptocurrencies in illegal transactions makes it harder for U.S. organizations to trace the financial trail.
Chainalysis also reported on Bitcoin use in terrorism financing. Known terror organizations would create campaigns to “donate to the jihad” with QR codes leading to Bitcoin addresses.
It’s important to point out that while these illegal organizations did use Bitcoin, there are other non-cryptocurrency methods that they could have used. Before Bitcoin, and even today, many black-market or illicit deals are done in cash. Former Treasury Secretary Larry Summers endorsed an idea published by Harvard president emeritus Peter Sands to all but get rid of cash. A case study in Missouri looked at the mid-1990s transition from distribution of federal welfare via cashable check to a preloaded debit card. Researchers found that crime in areas that moved away from cash dropped roughly by 10%.
Another inherent risk to the cryptocurrency markets that has increased its probability of late is Bitcoin or other cryptocurrencies becoming illegal to own. China has recently banned financial institutions from offering services involving cryptocurrencies. The U.S. government also showed its ability to pursue Bitcoin transactions after the Colonial Pipelines hack in spring of 2021. The hack, which yielded hackers $4.4 million was recovered as the government pursued the digital addresses associated with the hackers. The combination of Chinese regulation and the ability of governments to track and recover stolen or ransomed cryptocurrency assets is a direct blow to the claim that cryptocurrencies are outside of government control.
So where does this leave the average investor when it comes to Bitcoin? As an emerging asset class, it’s possible that the Bitcoin narrative is a self-fulfilling prophecy. In a period of low interest rates and inflation concerns, there are some good arguments as to why putting a small portion of a portfolio in cryptocurrency assets might provide some benefit, just as a small allocation to gold can provide benefits in certain macroeconomic environments.
Cryptocurrencies are volatile and may provide some correlation benefit with a small, value-tilted portfolio. The recent rapid increase in price across the cryptocurrency universe is fairly concerning as no other time in history has seen an asset class that has grown at such a rapid rate relative to inflation. It is also important to remember that in the case of gold rushes, it was the merchants who traded in goods who on average made the most profit, not the miners themselves.
We at Merriman do not shy away from new or emerging asset classes. Historically, we have either started new funds or have been some of the first investors in an asset class. The research and portfolio management team at Merriman has been monitoring the cryptocurrency market for many years.
As long-term investors, we try to develop our portfolios to maximize the probability of getting higher returns than the market. While Bitcoin and other cryptocurrency assets have shown extremely high returns for the past decade, this is not necessarily indicative of future returns. As said on almost every investment document, “Past performance is no guarantee of future results.”. At this moment in time, the cryptocurrency market is too risky and speculative to recommend in our portfolios. This stance may change in the future are the market evolves. Even though we do not recommend holding cryptocurrencies in our portfolio, it is OK to buy a little with some play money. It’s fine to play roulette at a casino as long as you only bet what you are willing to lose.
At Merriman, we will continue to monitor and research cryptocurrency assets so that if an expected return benefit appears, we can implement it for our clients.
Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.
It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Opinions expressed by Merriman are based on economic or market conditions at the time this material was written. Economies and markets fluctuate. Actual economic or market events may turn out differently than anticipated. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.