In our opinion, institutional investors are better served focusing on investing in companies seeking to profit from the development and adoption of blockchain technology and “fintech” (financial technology) more broadly than holding cryptocurrencies directly.
The stunning rise in the price of bitcoin in 2017 has thrust cryptocurrencies into the spotlight and sparked heated debate about their suitability for institutional investors. To proponents, the rising price of cryptocurrencies reflects their growing adoption as a medium of exchange, given their potential lower transaction costs (due to disintermediation of the banking system), their anonymity (due to the lack of reliance on the banking system), and their ability to be a better store of value (due to their limited supply). Thus, despite the over 900% rise in the price of bitcoin this year (to almost $10,000), proponents argue that tremendous upside remains, as cryptocurrencies have the potential to take more market share from government-backed currencies and “disrupt” the existing bank-centric global payments system.
While this sounds compelling, we are skeptical. As a medium of exchange, cryptocurrencies are a solution in search of a problem. Visa processed an average of almost 4,500 transactions per second in 2016, while today it is estimated that the bitcoin blockchain can only process up to four transactions per second. In China, the rise of mobile phone–based payment systems WeChat Pay and Alipay, neither of which currently involves cryptocurrencies or blockchain technology, has already driven a shift in China away from physical cash and credit cards as the preferred payment methods, processing an estimated $5 trillion in transactions in 2016. Given current volatility and latency issues, it is hard to see cryptocurrencies becoming a widely accepted medium of exchange.
In our opinion, much of the interest in cryptocurrencies is simply speculation, with new entrants drawn in by the allure of rapidly rising prices. Rising transactions likely reflect the purchasing of these coins/tokens as an asset for hoarding in the hope of appreciation, not a currency for the purchasing of goods and services. As we recently wrote, we think cryptocurrencies are displaying the classic signs of an investment mania.*
Institutional investors considering holding cryptocurrencies need to think carefully about what they actually want exposure to. While cryptocurrencies utilize blockchain technology, they are not “the blockchain” and have no fundamental source of economic return. The potential application of blockchain technology across a wide range of industries—from financial services to health care to logistics—suggests that it may generate economic returns for firms that successfully adopt the technology or facilitate its spread/development. As the old adage goes, in a gold rush, the real money is made by selling picks and shovels.
All blockchain-related investments are subject to a high degree of risk as the technology is still in its early days. Yet, the risk/return profile for cryptocurrencies seems binary given the lack of an economic source of return, meaning investors must be able to tolerate massive volatility and potential for permanent loss. Instead, we think investors are better served investing in companies trying to benefit from the spread of blockchain and fintech more broadly.
* Please see Aaron Costello et al., “Cryptocurrencies: Boom or Bubble?,” Cambridge Associates Research Note, October 2017.
Aaron Costello is a Managing Director on Cambridge Associates’ Global Investment Research team.