Whether institutional investors welcome it — or even realize it — cryptocurrency is having an impact on their portfolios.
The immense size of the crypto ecosystem — about US$ 1 trillion — and its disruptive effects are being felt across capital markets. In its various forms, it’s changing the way businesses operate. Financial analysts see the potential for banks to adopt new technology making banking faster and more secure.
Retail analysts are watching for signs that cryptocurrency is shaping the purchase of goods and services. Those in the technology sector see companies — both large, established firms as well as small startups — put distributed ledgers to work across health care, cloud computing, cybersecurity and supply chain management among many other applications. This is influencing the risks and opportunities that are being identified across the investing landscape.
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It seems that blockchain and the technology behind the new cryptos will have significant economic potential. Monitoring the potential of individual cryptos remains important.
The risk and return characteristics of crypto should discourage institutional investors from including it in their portfolios, especially given the extraordinary level of speculation and volatility in many crypto markets. Nevertheless, cryptos are having an impact across capital markets and understanding the how and why of this impact is of vital importance.
A recent forum on cryptocurrency hosted by T. Rowe Price, debated the tough questions, such as the relative merits and applications of the underlying technologies involved, market sentiment and how to value cryptocurrencies.
While the question of whether cryptocurrencies might eventually have a place in select portfolios wasn’t resolved, consensus was reached on two points — that cryptos appear to be in the developing stages of one day becoming a transformative technology and they’re unlikely to soon supplant traditional currencies in most retail transactions, particularly in large, developed markets.
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Trust in centralized currencies is eroding in many emerging markets and recent signs of inflation are encouraging more interest in crypto alternatives. Privacy concerns and the freedom from government control are also driving interest in cryptocurrency. As one international economist colleague put it: “Some people like owning something that no central authority can manipulate or devalue.”
Of course, some users desire privacy to hide illicit activity, but many others are simply attracted to a system outside of government control. While regulators have been, in general, lackadaisical about addressing cryptos, recent ransomware attacks demanding payments in cryptocurrency are likely to spur action.
Much can be gleaned about its potential by keeping an eye on how governments are responding to the crypto revolution — though, at this point, many regulators are, to quote a colleague, “still just sharpening their pencils.”
Another development that may push regulators to more seriously address cryptos is that many central banks are exploring the idea of developing their own digital currencies. While these would have none of the privacy benefits of current cryptos, they would hold the promise of promote financial inclusion — likely allowing unbanked people to conduct transactions using a smartphone or a digital card.
Read: Are institutional investors moving into cryptocurrency?
Should governments choose to strictly regulate or even ban cryptos outright poses a risk to current investors. On the other hand, clarity from governments about future regulations could also invite opportunities. Properly regulated cryptocurrencies could become less volatile and more environmentally sound.
Whether or not central banks or regulators become more involved in cryptos, it’s inevitable that there will be a shakeout. Currently, there are already some 1,000 different currencies in circulation and there’s increasing speculation. Yet, just as the implosion of prominent early dot‑coms didn’t doom the internet, the potential demise of any prominent digital tokens may not doom cryptocurrency.
The past few months have demonstrated that Bitcoin may not remain the dominant cryptocurrency. Technology experts observe that other digital tokens have faster processing speeds and the proof-of-work computing resources needed for Bitcoin mining are coming under scrutiny for their electricity usage and environmental impact. Alternative methods for ensuring chain integrity may favour competing currencies.
Read: Institutional investors taking closer look at Bitcoin, gold amid inflation fears
Given the ability of some virtual currencies to facilitate payments at relatively low fees, applications in banking, payment processing and financial services are being vigorously pursued. This has already led to a growing adoption of cryptocurrencies for cross‑border payments, such as remittances.
Smart contract cryptocurrencies like Ethereum take this a step further by giving rise to decentralized finance, which aspires to recreate the entire traditional financial ecosystem, including lending platforms and exchanges. The main selling point is its strictly code‑based enforcement mechanism, which dispenses with the need for a centralized intermediary between transacting parties.
Oracle cryptocurrencies, such as Chainlink, connect with the smart contract ecosystem by feeding it with real‑world data such as market prices — thereby enabling real‑world use cases for the smart contracts themselves.
The technologies and tokens that dominate the future may not even yet exist. Indeed, the growing diversity of cryptocurrencies should be as intriguing as opportunities in any single coin.
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There are significant network effects in cryptos, as elsewhere in the digital world. Identifying the strongest systems will be key, though this may take years to become clear. Here may be an investing opportunity for active managers that can better understand the longer‑term viability of certain currencies — but the risks are very high. Bitcoin, for example, has had five crashes of 80 per cent or more since its inception in 2009.
The rise of many cryptos may as a symptom of heightened speculation in markets, fed in turn by fiscal and monetary policies that have created an environment where more money is chasing fewer investments. Whatever the risks and opportunities, its very size makes the case for treating it seriously as an asset class.