The first cryptocurrency, bitcoin, is now more than a decade old. Over the past twelve months it has gained considerable attention by soaring in price from around USD4,000 in March 2020 to over USD40,000 this year before falling back towards USD30,000 (see chart).
Bitcoin’s staggering rally is on a par with the great investment booms of the last few decades including gold in the 1970s, Japanese equities in the 1980s, internet stocks in the 1990s, oil prices in the 2000s and technology companies in the 2010s.
But cryptocurrencies are still very unlikely to replace national currencies as any economy’s principal medium of exchange. Instead, digital money over time may partially displace gold by offering an electronic - rather than physical - store of value.
In this note we argue that cryptocurrencies must still overcome important hurdles including trust, volatility, regulatory acceptance and reputational risks. But once these disadvantages have been addressed, digital currencies may play a modest but still useful role in investor portfolios as a potential safe-haven asset.
Introduction
Money has three core functions: to be a medium of exchange, a unit of account and a store of value.
Source: Bank of Singapore, Bloomberg
The original vision of the first bitcoin holders was to have a privately issued digital currency of limited supply that could not be debased by governments in the same way that fiat or paper currencies could through quantitative easing, excessive money creation and inflation.
Thus, cryptocurrencies would come to rival national currencies as a medium of exchange, a unit of account and a store of value.
Medium of exchange
Privately issued cryptocurrencies, however, are very unlikely to replace government issued national currencies in future because of their flaws as a medium of exchange.
First, bitcoin, like gold, is too inefficient to make cross-border payments in a competitive manner.
Ethereum is a digital currency with the capacity to undertake faster transactions but it is still far behind SWIFT - the Society for Worldwide Interbank Financial Telecommunication - and other conventional payment systems.
Second, digital currencies - often limited in supply like gold - are unable to facilitate growing economic activity if their ‘velocity of circulation’ does not rise correspondingly.
This was the crucial disadvantage of the gold standard when governments linked their national currencies to the precious metal in the decades leading up to the 1930s Great Depression. Scarce reserves of gold constrained the supply of money, holding back economic growth and causing bouts of deflation.
Third, governments will not tolerate any direct challenges to their monetary sovereignty.
For example, Facebook’s digital currency, libra, faced very strong regulatory resistance as soon as the technology firm announced its plans.
Governments are very wary of any technology that could potentially displace national currencies. This would reduce the ability of policymakers to print money during economic crises or to benefit during ordinary times from ‘seigniorage’ - the financial gain from issuing fiat currencies at face value less the cost of producing notes and coins.
Notably, several central banks are launching digital currencies using their own blockchain technology. But the new electronic money will still be denominated in each central bank’s domestic currency.
Unit of account
Cryptocurrencies are likely to be gain more traction over time if goods and services become quoted in bitcoin, ethereum, etc. In that case, digital money will act as a ‘unit of account’ allowing consumers to compare the prices of different products in cryptocurrency terms.
This will still require shopkeepers to offer wares in more than one currency. But enterprising sellers will take the opportunity. The rise of the offshore yuan (CNH) over the last decade was initially spurred by Hong Kong storeowners being ready to accept onshore yuan (CNY) from Chinese tourists visiting from the mainland.
Store of value
The most likely role for cryptocurrencies, however, is as an alternative store of value. Digital money may compete in future with gold as a potential safe-haven asset.
Cryptocurrencies have some clear advantages over gold. Digital money is more popular with younger people. It is also easier to hold bitcoins and other electronic money in digital wallets.
In contrast, precious metals are unwieldly to use for everyday transactions and need to be stored in secure, physical locations.
Cryptocurrencies also have several similarities to gold.
Neither earn any yield or interest. Both assets’ prices are largely determined by investor demand and financial speculation - though precious metals have underlying, real demand from jewellers and industry. Further, some cryptocurrencies - including bitcoin but not ethereum - are limited in supply like gold.
For example, gold holdings above ground are estimated to be around 198,000 metric tonnes with another 57,000 metric tonnes still below ground according to the World Gold Council.
Thus, at current prices of USD1,870 an ounce, total gold supply is worth around USD16.8 trillion. Similarly, total bitcoin supply is limited to 21 million coins of which almost 90% have already been ‘mined’. At current prices around USD30,000, existing bitcoin supply is worth USD567 billion.
In contrast, the supply of fiat currencies is much greater than that of gold or cryptocurrencies. The Federal Reserve estimates America’s broad money supply, M3, stands at USD18.8 trillion.
This is just one country’s paper currency. Moreover, the Fed is currently expanding the supply of dollars by printing money and buying USD120 billion a month of domestic bonds to support the US economy through quantitative easing.
Digital money, however, has some clear disadvantages versus gold or paper currencies.
Bitcoin is highly volatile as its rally over the past year from USD4,000 to over USD40,000 and then back towards USD30,000 shows. One-month volatility is over 90 vols. In contrast the same measure of implied volatility for the EUR and for gold are around 6 vols and 16 vols respectively.
Bitcoin is also correlated with stocks and other risk assets rather than trading as a counter-cyclical safe-haven.
In a financial crisis, cryptocurrencies are more likely to be dumped by investors during a market meltdown as occurred at the start of the pandemic in March 2020. In contrast, gold has been used since ancient times as a store of value and a hedge against inflation.
Cryptocurrencies are at risk of theft from digital wallets as well as from fraud.
There are also clear reputational risks as bitcoin and other privately issued electronic currencies may be favoured by drug dealers, money launders and other criminals for their anonymity.
Last, gold only faces competition from silver as a safe-haven precious metal. In contrast, there is nothing to stop new enhanced cryptocurrencies from being launched in future, devaluing all other digital currencies already in existence.
Risks
To become a feasible asset for portfolio diversification - particularly to compete with gold as a safe-haven hedge in future - cryptocurrencies need to overcome several significant hurdles.
First, investors need trustworthy institutions to be able to hold digital currencies securely.
Since bitcoin first appeared in 2009, the risk of holders losing the keys to electronic wallets or suffering theft from exchanges has been significant. In 2014, Mount Gox, an exchange in Japan, was hacked, resulting in customers losing around 850,00 bitcoins according to Bloomberg.
Second, liquidity needs to improve significantly to reduce volatility to manageable levels.
Even a decade after cryptocurrencies first started circulating, market action still often seems inexplicable and poor data on prices makes it hard to analyse current trends or make forecasts.
In future, increased participation by institutional investors - asset managers with longer-term time horizons compared to hedge funds and retail investors - would help to increase liquidity, lower volatility and result in price action being driven more by fundamentals than by speculation.
Third, regulators need to become more accommodative of digital currencies to allow broader participation by institutional and retail investors.
In October 2020, the UK Financial Conduct Authority banned the sale of derivatives referencing cryptocurrencies to retail customers. The FCA warned of the difficulties of valuing such products as well as the risks of market abuse, cyber-theft and the extreme volatility of prices.
In contrast, US regulators may become more favourable to cryptocurrencies. Gary Gensler, a former head of the Commodity Futures Trading Commission (CFTC), is due to become the next Chairman of the US Securities and Exchange Commission. The SEC has been sceptical about electronic money. But Gensler has recently been teaching at the Massachusetts Institute of Technology (MIT) on financial technology and digital currencies and may thus be willing to allow broader investment in cryptocurrencies.
Fourth, government agencies need to curtail criminal activity to reduce the reputational risks for holding digital money.
The US Treasury is proposing that cryptocurrency custodians and exchanges should collect and report information that identifies large transactions involving ‘un-hosted wallets’ - cryptocurrency accounts held outside financial institutions - to protect national security and to clamp down on money laundering and other crimes.
But the Treasury’s proposals to stamp out illicit transactions are currently facing strong opposition from the industry.
Milestones
The above hurdles show that digital currencies still have clear barriers - trust, volatility, regulatory acceptance and reputational risks - before becoming widely suitable for investor portfolios.
An important milestone here would be if the SEC approved an exchange-traded fund (ETF) for bitcoin or another cryptocurrency. This would, offer a trustworthy, reliable investment vehicle, allow fresh participants to enter digital currencies, improve liquidity, lower volatility and help deal with reputational risks.
In November 2004, the New York Stock Exchange launched the SPDR Gold Shares ETF. It was backed by physical gold and began trading when the yellow metal was at USD400 an ounce.
The availability of a gold-linked ETF helped widen the range of bullion investors and supported a multi-year rally in prices. Last year gold hit a record high of USD2,075 an ounce.
Conclusions
Cryptocurrencies are likely to have a modest but still useful role as an alternative asset in future.
Privately issued electronic currencies are very unlikely to replace government issued fiat currencies as a medium of exchange.
But digital currencies may partially displace gold over time by offering an electronic - rather than physical - store of value once important hurdles including trust, volatility, regulatory acceptance and reputational risks have been overcome.
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