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When You Buy Cryptocurrency, You Own Nothing

Advisor Perspectives

By Scott MacKillop | October 6, 2021

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Cryptocurrency is being repositioned to be more palatable to financial advisors and their clients. If you believe it is in your clients’ best interest to make an allocation to cryptocurrency, make sure they understand the nature of the asset they are buying.

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I am neither for nor against cryptocurrency. If someone wants to use their hard-earned fiat currency to buy bitcoin or ether, go for it. But when you buy cryptocurrency, you own nothing.

This apparently doesn’t bother those who own the thousands of different cryptocurrencies available with a total market capitalization of about $2 trillion. Somewhere between 21 million and 59 million Americans and more than 100 million people globally own crypto, and that number is growing rapidly.

Crypto is so mainstream that denizens of every corner of the financial services industry are looking for ways to profit from its popularity. Product manufacturers, platforms, custodians, fintech firms, and data providers are all responding to the market dynamics.

In the process, cryptocurrency is being repositioned to be more palatable to financial advisors and their clients. Its old image as the currency of choice on the dark web is being painted over to give it a more comfortable quality of familiarity and acceptability.

For example, crypto is being packaged to make it look more like our old friends, mutual funds, ETFs, and SMAs. This will make it almost indistinguishable from other portfolio holdings and reduce anxieties about the operational aspects of incorporating crypto into the mix.

Crypto is now regularly referred to as an “asset class” or an “alternative investment.” Use of this terminology is designed to slip crypto into the tent of respectability and make it seem like just another tool in the financial advisor toolbox.

Likewise, data providers and pundits regularly measure and discuss crypto’s long-term expected return, volatility, and correlations as though it had been around for 100 years. One notable and laudable exception is the Riskalyze program. It labels cryptocurrency as a “young” asset class, thus warning advisors about the lack of reliability of the crypto data.

This is a normal and necessary process as the financial industry embraces crypto and responds to client demand for it. But before you begin treating crypto like just another slice of the asset allocation pie that needs to be filled, let’s examine what it is and understand some of the ways in which it differs from more traditional asset classes. Then, if you still want to commit an allocation of your clients’ portfolios to crypto, you can select from among the options available.

What you get

If you buy shares of Apple Inc., you own a percentage of the Apple company. There is a market comprised of buyers and sellers that determines the value of that stock. But independent of that market, you own something tangible that has intrinsic value. You own a share of Apple’s assets and its income stream.

If you buy a bond issued by Microsoft Corporation, you have purchased a promise by Microsoft to pay you certain amounts of money at various dates in the future. That promise is secured by the assets of Microsoft. Again, buyers and sellers determine what those bonds are worth on a given day. But the promise exists independent of those buyers and sellers, and if Microsoft fails to live up to it, you can go after Microsoft’s assets to secure your payment.

The story is the same with other traditional asset classes, but with slight variations that reflect the nature of the asset owned. If you invest in real estate, you own land or a building. If you invest in gold, you own metal that can be made into jewelry or used for industrial purposes. If you invest in commodities, you own a barrel of oil, a basket of soybeans, or a cow that has utility independent of its market value. Yes, the buyers and sellers that comprise the market set the price, but these assets are tangible, useful, and valuable in their own right.

That is not true of cryptocurrencies.

Let’s use bitcoin as an example, since it is the dominant cryptocurrency, ranging recently from 40% to 70% of total crypto market capitalization.

Bitcoin was created in 2009 by a person or group of people going by the name Satoshi Nakamoto. The number of bitcoin “tokens” was capped at 21 million. About 19 million of those tokens are in circulation. When you buy bitcoin, your tokens are held in a “wallet,” and you are given a “key” to access your account.

This language evokes a mental picture that is at odds with the fact that a bitcoin transaction does not involve any real-life coins, tokens, wallets, or keys. Quite literally, when you buy bitcoin, you get nothing – at least in a physical sense. There is only an electronic record of your transaction maintained in cyberspace using blockchain technology.

Your bitcoin has value only if others are willing to buy it from you. Unlike every other asset class, bitcoin has no independent intrinsic value. And unlike a true currency, Bitcoin is not backed by the full faith and credit of anybody or anything. Mr. Nakamoto will not make you whole if the market for bitcoin dries up. Bitcoin’s value is purely a product of the market for it.

Cryptocurrency proponents often point to the remarkable nature of blockchain technology in support of the value of digital assets. Blockchain technology is remarkable indeed. But you do not gain an ownership interest in that technology when you buy bitcoin any more than you gain an ownership interest in the Internet when you buy a product through Amazon.

How you access the market

The market for bitcoin exists on a decentralized blockchain network in cyberspace. It does not have a physical location and is not controlled by a person or group of executives. It operates solely in accordance with the protocols and processes built into its original architecture.

To access the buyers and sellers who assign value to your bitcoin, your transaction must pass through a world-wide network of independent “miners” who use the blockchain to perform tasks essential to the maintenance and development of the blockchain ledger. Anyone can mine bitcoin if they have sufficient computing power to compete with the other miners.

The bitcoin blockchain is unregulated. It was set up that way intentionally to protect it from political pressure and governmental interference. Power is meant to be distributed among all the stakeholders in the bitcoin community.

This is fundamentally different from the way other exchanges provide access to buyers and sellers. The New York Stock Exchange is located at 11 Wall Street in New York. Its president is Stacey Cunningham. Trading is conducted by licensed brokers and dealers, primarily through computer systems owned and maintained by the exchange. The NYSE is regulated by the SEC.

Whether one system or another is better is in the eye of the beholder. But they are two very different ways of accessing the buyers and sellers who comprise the market and determine the value of the assets being bought and sold. Advisors must understand the differences.

Capital market assumptions

Bitcoin, the first cryptocurrency, was introduced 12 years ago. The first commercial transaction using bitcoin took place in 2010 when bitcoin enthusiast, Laszlo Hanyecz, purchased two pizzas for 10,000 bitcoins. At today’s prices those pies were worth over $400 million.

Ether, the cryptocurrency with the second highest market capitalization, did not appear until 2015. In their early years of adoption, both bitcoin and ether grew slowly compared to the last couple of years. After a spike from 2017 through 2018, crypto market capitalization broke loose in 2020 and 2021 as adoption skyrocketed and financial institutions became interested in crypto.

Thus, cryptocurrency is relatively new, and its performance history is brief and streaky. Determining meaningful long-term expected returns, volatilities, and correlations of cryptocurrencies to other traditional asset classes is simply not possible. There is not enough data and the market for cryptocurrencies has yet to reach anything approaching steady state.

Based on its history, there is no reason to believe that its past performance will look anything like that going forward. Cryptocurrency has moved beyond its infancy when it was viewed primarily as a payment mechanism for criminals, drug dealers, and cyber-geeks. It has grabbed the attention of sovereign governments, which are taking vastly different approaches to it. China is very inhospitable to digital assets, while El Salvador has adopted bitcoin as legal tender. The SEC and regulators globally are deciding how, if at all, to set rules and boundaries around this new phenomenon. And all the while, cryptocurrency gains in popularity and acceptability among individuals and institutions alike.

In this environment, measuring and quantifying its history will tell you little about crypto’s future. Yet to incorporate cryptocurrency into portfolios using the traditional approach, you need to develop reasonably reliable expectations about it future returns, volatility, and correlations to other asset classes. Today, these are all guesses.

That does not mean that cryptocurrency should not be included in a client’s portfolio. But it does mean that doing so cannot reasonably be done using traditional optimization techniques.

Crypto needs to be assessed using a new frame of reference

Cryptocurrency stands in a class by itself, unlike traditional asset classes. It shouldn’t be grouped together with them and can’t be analyzed in the same way.

Crypto’s essence is supply and demand. In the absence of demand for it, it is worthless and does not exist. It is nothing in the absence of a willing purchaser.

Having said that, the number of willing purchasers is large and is predicted to get much larger. Statista reports that the global user base of cryptocurrencies grew 190% from 2018 through 2020. Crypto.Com reports that the number of crypto users doubled in the first half of 2021. Looks like there is some momentum there.

As I write this, bitcoin’s recent price has ranged between $40,000 and $50,000. Its high in 2021 was more than $63,000 in April and its low was just under $30,000 in July.

But Thomson Reuters technologist and futurist Joseph Raczynski thinks bitcoin will hit $150,000 by 2025. Ark Invest’s CEO, Cathie Wood, thinks bitcoin will surge to $500,000 in five years.

On the other hand, Vanguard’s chief economist, Roger Aliaga-Diaz, said, “There is no enduring economic or investment rationale to expect cryptocurrencies to generate positive real returns.” JPMorgan Chase chairman, Jamie Dimon, called bitcoin a “fraud” – “worse than tulip bulbs.”

Who’s right? Time will tell.

What should you do?

If you believe it is in your clients’ best interest to make an allocation to cryptocurrency, don’t try to determine the size of the allocation using the traditional approach. Your optimizer will produce gibberish. Treat crypto as a high-risk, high-volatility asset and allocate accordingly.

Many sources recommend a 1% to 2% allocation. Few recommend more than 3% to 5%.

But there is no science behind any of those recommendations.

Gauge the level of interest expressed by a client. Are they merely curious, or are they fanatic crypto fans? Assess their tolerance and capacity for risk. Crypto is not for the faint of heart. It is the Takabisha of roller coasters (Google “scariest roller coaster”).

Then make sure they understand the nature of the asset they are buying. They are buying nothing but the hope that someone will buy their digital asset back from them for more than they paid for it at some time in the future. If they are okay with that, enjoy the ride.