The Case For Censorship-Resistant Alternative Currencies
In light of the recent trends in the crypto market, analysts have declared that the “crypto winter” is over. (1) Facebook’s public announcement of project Libra and the price of bitcoin surpassing $10,000 for the first time since 2017 have also generated much interest in Bitcoin. Cryptocurrency communities online have also grown in the recent months, and some members of the communities are fondly recalling the exuberant market two years ago, when investments in initial coin offerings (ICOs) returned 82% on average, over an average holding period of 16 days (2). Regulators have since clamped down on ICOs and released new guidelines. Apart from the vastly different regulatory landscape, there are two key differences between the crypto market today and in 2017: both the recent level of interest in Bitcoin and its trading volumes are significantly lower than those of 2017. Some analysts have suggested that these divergent trends are indicative of institutional investors entering the market (3) – a sign of the market maturing.
The change in sentiments in the crypto market come as uncertainties over Brexit and the U.S.-China trade war continue to loom over the global markets at a time when interest rates are at historical lows. More recently, the Federal Reserve Chairman Jerome Powell acknowledged the delicate state of the global economy, hinting at the possibility of an interest rate cut (4). Jim Reid, the head of global fundamental credit strategy at Deutsche Bank, said that central banks cutting interest rates will make alternative currencies “more attractive,” a plausible explanation for the boom in the crypto market in the recent months.
Cryptocurrencies are gaining recognition as a new asset class. Regulators all around the world are working actively to understand them and regulate them effectively without stifling innovation – more urgently now with Facebook’s announcement of Libra. There are also an increasing number of firms offering crypto-related products and services, with many citing high demand from their clients as a motivation.
Here are 4 reasons why you should invest in crypto:
1. Portfolio Diversification
A survey of financial advisors conducted by Bitwise Asset Management found two leading responses to what attracted investors to add crypto exposure to their portfolios:
their low correlation with the returns of other asset classes, and
the prospect of high returns.
A study by J.P. Morgan found that the returns on cryptocurrencies have historically exhibited near-zero correlation with other asset classes, but the Japanese Yen has proven to be a more consistent hedge than cryptocurrencies during periods of acute market stress in the equities market, as in the flash crashes of August 2015 (both S&P500 and bitcoin fell by about -11% in a week) and February 2018 (S&P500 fell by 8% and bitcoin by 45% in a week).
Bitwise also conducted a back test of a tolerance-based portfolio rebalancing strategy from January 2014 to March 2018, which found that a portfolio of 5% bitcoin, 57% equity and 38% fixed income had strong risk-adjusted returns. However, the market capitalization of the crypto market is still tiny compared those of conventional assets, with a value of less than $300B at the time of writing. This may be a challenge for large institutional investors in allocating even a percentage of their portfolio to crypto.
2. Censorship Resistance
The censorship resistance of cryptocurrencies also makes them a great flight-to-safety asset class as they insure against financial crises, the monetary policies of dubious central banks, fiscal dominance and expropriations. In the aftermath of the 2008 financial crisis, Cypriot banks had to be bailed out after taking a haircut of over 50% on their large holdings of Greek debt. In an initial proposal plan to bail out the banks, the Cypriot government would freeze accounts and tax the deposits at a rate of up to 10%. The proposal never came into fruition as its announcement triggered a bank run before it could be voted on. The financial crisis of 2013 in Cyprus highlights the value proposition of cryptocurrencies, which also increased the demand for bitcoin in affected countries like Greece and Spain (5), driving up bitcoin prices six-fold from February to April.
This attribute of cryptocurrencies is what defines them as a unique asset class. They enable individuals to escape governments’ grip of the financial systems. In the same vein, they offer corporations an alternative to offshore accounts, a hedge against the risk of their accounts being frozen (6). But the same attributes that makes cryptocurrencies so valuable can and are being used for nefarious activities, as is the case with other technologies. Apart from its use in dark markets and subverting capital controls among other things, GRU, Russia’s intelligence agency, used bitcoin to fund their operations to meddle with the U.S. presidential election. Investors should be aware of the regulatory risks facing cryptocurrencies.
3. Highly Secure Long-term Store of Value
Bitcoin and a few established cryptocurrencies have proven to be a great store of value over long periods of time. The Winklevoss twins and Mike Novogratz, among other prominent investors, have compared Bitcoin to gold, highlighting Bitcoin’s fixed supply of 21 million bitcoins in contrast to gold’s scarce supply, difference in cost and ease of securing each asset, as well as the ease of transmitting bitcoin as compared to the cumbersome process of transporting gold, among other factors. Comparing their market capitalizations, the gold market which is estimated to be worth $7T dwarfs bitcoin’s market cap of $120B, suggesting that Bitcoin remains significantly undervalued.
Cryptocurrencies that have survived over the years can also offer high security. New tokens with shorter histories may not offer the same level of security as their securities have yet to be tested. As the token gains value, hackers will be incentivized to exploit any bugs in their codes. Bitcoin, being the first cryptocurrency ever, is arguably the most secure, not to mention decentralized. (7) Bitcoin is built on the Public Key Infrastructure (PKI), which practically cannot be manipulated with the existing technology. As such, for cryptocurrencies whose transactions are accessible to the public, the value of the largest wallet can be a proxy for its network security. The largest Bitcoin wallet holds over $1.6B at the time of writing.
4. Alternative Decentralized Currencies
In their efforts to reduce trade deficits, the Trump administration imposed sanctions and tariffs against nations and corporations, effectively weaponizing the dollar by excluding the sanctioned entities from accessing the dollar-dominated markets. China and Russia are looking to curtail their reliance on the U.S. dollar in response (8). As Ray Dalio notes in his latest memo, the prevailing economic environment is reflationary and heavy in debt, against a backdrop of political and economical conflicts. He asks the question “what will be the next-best currency or store of wealth to have when most reserve currency central bankers want to devalue their currencies in a fiat currency system.” Cryptocurrencies offer codified monetary policies beyond the reach of any government and with no problems of time consistency.
Special Thanks to Our Contributor
Permian Capital Management, LP seeks to maximize risk-adjusted capital appreciation through disciplined, diversified investment in digital assets and blockchain based technologies.