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The world of crypto
Bitcoin, blockchain and the world of crypto assets have gone from the obscure and complex realms only discussed by in the know techies to now becoming a topic discussed by many corners of society. With the value of crypto assets in circulation now well in excess of $1.8 trillion this relatively young asset class is virtually impossible to ignore and has garnered the attention of multi-nationals, institutional investors and central bankers.
So what are crypto assets and should we invest in them?
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What are crypto assets?
Crypto assets can be seen as an all-encompassing term used to describe a family of digital assets that has come to life with the creation of the blockchain technology. Digital assets include things like utility tokens, security tokens, asset backed tokens and cryptocurrencies.
1. Utility tokens such as Ethereum allow users to build smart contracts on the Ethereum blockchain network This can allow for automated settlement of transactions with swift execution and improved efficiency and quality of outcome, disrupting the traditional financial settlements process as we currently know it.
2. Security tokens represent ownership or interest in an associated real-world asset. Instead of receiving a signed subscription agreement or certificate of ownership you receive a token embedded on the blockchain which represents your interest in the asset.
3. Asset backed tokens like Tether or USDC are backed by physical fiat currency and are pegged to the value of that fiat currency. Often referred to as stablecoins, the benefit of these tokens allows users to hold their assets in the digital world without having to convert back to actual fiat currency whilst also avoiding the high volatility associated with many cryptocurrencies.
4. Cryptocurrencies like Bitcoin were initially conceived as a peer-to-peer electronic currency but in fact have become more of a store of value and are often referred to as digital gold.
Chart 1: A New Family of Digital Assets
Source: Fidelity Digital Assets
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What is blockchain?
The revolutionary aspects of the blockchain technology have earned it the lofty title of Web 3.0 as it has the ability to be truly transformative in how it changes the shape of the many industries.
Chart 2: The evolution of the web
Source: Fabric Ventures
Web 3.0 is seen as a leap forward from mobile, social and cloud to open, trustless and permissionless networks.
Distributed ledger
In its simplest form, blockchain is a type of distributed ledger technology that allows a transaction to be recorded without a centralised administrator, as is the case with the traditional financial system.
It has three core features that enable this. Firstly, the ledger is distributed, meaning that data is simultaneously stored and widely accessible by all network participants. Second, it is decentralised and is not controlled by any one central authority. Finally, it is immutable; once a transaction or node has been added to the blockchain it is virtually impossible to change or remove it.
Single source of truth
For these reasons the blockchain becomes the single source of truth as all information stored on the blockchain is tamperproof, resilient to attacks and accessible to all on the network.
Chart 3: Benefits of the blockchain network
Source: BNP Paribas AM
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Blockchain for business
Described as a breakthrough and with a growing number of applications to validate its utility, blockchain is increasingly growing in user adoption. The benefits of this disruptive technology are numerous; we recently heard of a transaction where $1 billion was moved across the blockchain for a fee of roughly $25. This example highlights a couple of key benefits of blockchain – speed of settlement (on average less than one hour compared with the usual two-day settlement period in traditional banking) and cost of transacting (traditional banking charges tens of thousands of dollars for such transactions).
Driverless banking
Smart contracts will significantly enhance transaction efficiency by removing third party brokers and automating previously complex intermediated processes, in doing so reducing time and error. Some have described this essentially as driverless banking.
A consensus record
With distributed ledger technology, blockchain creates a consensus record between all relevant parties to a business transaction which is widely accessible and immutable. This will greatly improve efficiencies in how many industries operate and in practice blockchain technology has already been in use by many industries for some time now.
Supply-chain management
The IBM Food Trust is the only network of its kind to connect participants across the food supply chain through a permissioned, permanent and shared record of food system data which will greatly enhance traceability and safety for industries like fishing and farming and allow consumers to trace their food ‘from bait to plate’ by simply scanning a QR code. If a food safety issue is reported, it is immediately clear who is impacted and who should take action. To promote sustainability farmers, producers and other food actors can automatically digitise and easily share audits, certificates and other records, proving that they utilise and promote sustainable and ethical practices.
Content sharing fairer
In the entertainment industry, musicians and artists are turning to blockchain to make content sharing fairer for creators using smart contracts where revenue on purchase of creative work can be automatically disseminated according to pre-determined licencing agreements. In the charity space, Bitcoin-based charities like BitGive Foundation use a secure and transparent distributed ledger to give donors greater visibility into fund receipt and use.
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The case against direct crypto investment
The inherent volatility of most cryptocurrencies does not reconcile with their potential use as a unit of account nor a store of value. A unit of account requires stability of pricing in order to compare the value of different goods, which is why goods are not currently priced in crypto. Likewise, many businesses would be unwilling to accept crypto as payment or hold it on balance sheet given this volatility, making it a poor store of value.
Medium of exchange shortcomings
As a medium of exchange, crypto also has its shortcomings, with few businesses willing to accept payment in digital currencies. Additionally, it has been noted that even if were to become more widely adopted, scalability issues will arise. Bitcoin, for instance, is limited to around just five global transactions per second, far fewer than that of existing networks (e.g. Visa is capable of handling 65,000 transactions per second and typically processes 1,700).
Valuations challenges
The valuation of cryptocurrencies is another key challenge to consider for investors. Most cryptocurrencies do not generate income, hence cannot be valued by conventional financial techniques such as discounted cash flows. While this is also true of a number of other assets – gold is a good example – their value can be appreciated via a discernible utility; gold has other uses, such as for jewellery. Cryptocurrencies, however, have no alternative utility and hence their value relies on the belief that their use will continue in the future; without this they could be viewed as worthless.
Correlation issues
Finally, from a portfolio perspective, the addition of direct crypto investment will only enhance risk/return measures if it has a low or negative correlation with other asset classes, particularly equities. However, the evidence of this is inconclusive at this stage. In particular, cryptocurrencies experienced a sharp selloff in March 2020, in unison with the equity market and hence were not a useful diversifier through this period of market stress.
For these reasons, we would not recommend a direct investment into a crypto asset.
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The Escala Approach
The most common argument in favour of Bitcoin is its first mover advantage and large current user base. Active user numbers, however, can be very volatile. Ethereum amassed a user base that was 80% of Bitcoin’s within one year given the greater use case for its blockchain technology. If an incumbent fails to adjust to new technological advances they can quickly lose their dominant position; think Myspace and Facebook or Yahoo and Google.
Chart 4: Bitcoin’s market share has fallen over time
Source: Coin Metric
Key to the value proposition for crypto assets is the network effect and ability to grow its user base. As this process is very volatile in the early stages of the evolution of the industry, we believe a more risk adverse approach to investing in this space is to find the companies facilitating the transactions on the networks; the picks and shovels if you will. This would be akin the finding the Apples or the Amazons or the Netflixs that emerged from the internet revolution. On this score we believe it is still early days.
Picks and shovels approach
We do believe there will be many winners in the crypto asset space but equally there will be many losers. To provide some protection against this, we would recommend investing in a fund that has a diversified pool of potential picks and shovels of the crypto world.
