By William Je of Hamilton Investment Management Ltd
Financial institutions and investors alike have been dividedon the topic of whether cryptocurrencies should be considered asan asset class.
This isn’t surprising considering thatthroughout the course of recent history cryptocurrencies went from regarded as a channel for money laundering to becoming a serious proposition for investors very quickly. It now is not just for the opportune amateur investors that’vegotcaught up in the media hype as even big businesses and knowledgeable entrepreneurs including Elon Muskhave their eyes on the digital currency and manyconsider it as genuine form of payment as a result.
Now, we can see major banks testing the crypto waters as they’re simultaneously entering the race to set up their crypto-related operations.Amongst these are the likes of Morgan Stanley and Bank of America launchingtheir own crypto-focused research divisions. State Street revealedtheir dedicated digital finance division to the public, and following this, JP Morgan and Goldman Sachs have started rolling out their own crypto trading assistances and services.
Our traditional understanding of an asset in finance termsis generally anything of worth to an individual or company, or more specifically it can be regarded as a resource ‘of value’ that can be, in turn converted into cash. Typically, an asset can often generate cashflows. For instance, stocks can provide dividends, bonds can provide coupons, loans can provide interest, etc.
However, there are assets in existencethat don’ttend to produce cashflows, but they’restill regarded as an important asset class. For instance, this can include assets such as gold, wine, and even art. Gold is widely considered to bean important asset class by many. This is the case considering, Ithas limited industrial usedoesn’t generate cashflows. The collective thought is that gold is valuable, and this is what provides the value to the asset; an inflated artificial value that we give to a shiny lump of metal.
In matter of fact, this canin turnapply to any fiat currencyas money is only a credit that a currency’s user gives to the issuer.Thereby, for a currency to prosper, beliefand confidence is the most important factor for its success. The issuers of fiat currencies are sovereign entities which are deemed to be the most trustworthy. If an economic crisisoccurs that leads to governmental distrust, the value of the fiat currency has the potentialto drop substantially.
In the past, financial institutions and investors have primarily recognised only “traditional” asset classes. They regard cash and equivalents, bonds, and stocks asthebig three. However, since the rise of cryptocurrency (a decentralised means of digital currency) in our society many have questioned whetheralso be regarded as asset class. This debate more important now, than ever before, especially as legislators and policymakers have continued to ponder upon taxing cryptocurrency in line with other assets.
Professionals must now begin to change their outlook on cryptocurrencyand adapt processes to enable investors to deal with cryptocurrency more effectively. Gone are the days of solely dealing with traditional assets.
There is a broad consensus thatBitcoin is the most valued—and thereby appealing—cryptocurrency on the market.Experts have largely accredited this toits scarcity, Bitcoin in particular benefits from investor confidence because of its snowballing popularity. Just as people in society believe in the value of diamonds because others believe in it, Bitcoin shares this artificial value.
Bitcoin was the first scarce digital asset ever created. Societies have always based the price of a currency on this concept of scarcity, which is why precious metals have been the pillar of many economies for centuries. Bitcoin supply had low inflation built in from day one. To ensure that the issuing of bitcoin would eventually cease completely, its creator Satoshi Nakamoto encoded a way to halve Bitcoin’s mining reward roughly every four years; the bitcoin supply will thereby never exceed 21 million coins.
But what is driving that faith?And what is underpinning the huge increases in the value of cryptocurrencies? This is more to do with its ability to store worthrelative to other asset classes. Widespread social adoption, together with their privacy, security, and transferability, make cryptocurrencies an significant asset class to store values.
Cryptocurrencies do not follow the same rules as fiat currencies, or even secured assets; instead matters tend to get complicated. Given that a cryptocurrency does not generate or support cashflow, it needs to be valued against potentialand —critically—future prices. That then opens the door to several different valuation methods and guess what—our old friend gold is back. Amongst the differing valuation models now available—the stock-to-flow method, institutional participation method, and high-net-worth participation method—we find the gold valuation method.
But let’s not forget this is a new asset class, so we would expect investors will consider a range of valuation methodologies to estimate future value. This is, however, not risk free. It is a new asset class, and one that does not exist physically. It is not gold, as we have repeatedly said. Risks do exist and they are well known, and some would argue, substantial. We are therefore firm believers that the financial industry needs to address—and support—government initiatives around regulation.
The key questions remain:Should institutional investors dive in, and is this in fact a dedicated new asset class?
El Salvador became the first country in the world to adopt Bitcoin as its national currency, allowing people to use a digital wallet to pay for everyday goods. Many countries are considering issuing their own central bank digital currencies. All these developments tell of cryptocurrencies’ future potential in line with an asset class.
The primary reason why some do not regard cryptocurrency as an asset class is because of its unclear regulatory environment and high volatility. However, more and more institutional investors use cryptocurrencies to hedge against inflation and currency debasement, and to diversify their portfolios in the pursuit of higher risk-adjusted returns.
This is without doubt, a new asset class and one that will increasingly gainacceptance and the participation of institutional investors as time goes on.