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Cryptocurrency: a new asset class?

There’s risk associated with any investment, sure, but perhaps even more so when it comes to digital investments – many of which have gained mainstream appeal, even among professionals.

    Written by Scott Tully
General Manager, Investments | Colonial First State

While financial markets have historically been dominated by investments in more traditional asset classes, thanks to blockchain technology, that’s begun to change. The emergence of digital investments – in particular, Bitcoin – has challenged investor perceptions of asset ownership and valuation, as well what constitutes a viable avenue for wealth generation. And now, investment professionals who once called Bitcoin too volatile to be a reliable store of value are saying it’s simply too important to ignore. Here, Colonial First State’s Scott Tully explores the appeal of digital investments and what investors should consider about the new kids on the block (pun intended).

The building block(chain) of investments

Heralded as the future of record-keeping, blockchain was created as a decentralised (ungoverned and peer-to-peer) database that records and encrypts information on digital assets in blocks, and then chains them together in an unalterable, transparent timeline that is accessible in real time. Perhaps the simplest way to think of how blockchain technology works is by considering the way a Google document is distributed to, viewed and editable by multiple people at once.

This technology has had a significant impact on the origin and evolution of digital applications – however, perhaps the best known of all are cryptocurrencies like Bitcoin. With a market cap of more than USD $1 trillion, Bitcoin stands at the forefront of cryptocurrency, which allows funds to be transferred directly between users to buy goods and services without intermediaries, like banks.

The appeal of digital investments

While this might not sound particularly interesting at the surface level, Bitcoin has several other features that appeal to investors. For example, Bitcoin uses blockchain to record transactions – making them public, timestamped and irrefutable. This also lends itself to a degree of security, whereby theft is more difficult for users as everything is stored in a secure blockchain sequence. Investors also enjoy the flexibility Bitcoin has to offer. For instance, without the need for central banks and currency conversion, Bitcoin can be used anywhere at any time by anyone. Soon, its use could be even more widespread; now, companies like Tesla and PayPal are accepting Bitcoin as payment methods. Further, Bitcoin has not only made millionaires of early adopters, but has allowed other investors to capitalise on price swings. To put its growth into perspective, after kicking off in 2009 at $0, Bitcoin surged above USD $1,000 in 2013 and exceeded USD $60,000 in April 2021 – and by month’s end, was up more than 500% over the year.

Source: Factset

Gold vs ‘digital gold’

Hedge funds have realised they can also capitalise on Bitcoin’s price swings and have used it as a speculative instrument. However, Bitcoin has other uses too – such as a portfolio diversifier or a hedge against currency inflation, which seems particularly relevant in an environment where markets are considering the costs associated with the fiscal and monetary policy support deployed during the global economic shutdown. Interestingly, its flexibility and use in portfolios has led some investors to draw comparisons between Bitcoin (dubbed “digital gold”) and physical gold, while others have wondered at the correlation between the uptake of Bitcoin and the declining gold price.
 

But it’s not that simple, as there are some key differences between the two. For example, while its speculative nature makes Bitcoin a higher-risk asset (for instance, Bitcoin reached a record high in April before falling 15% just weeks later), gold is a traditionally safe-haven asset that experiences much less volatility. Unlike Bitcoin, which is relatively new and exists in the highly accessible digital realm, gold has a track record spanning thousands of years as a physical store of value. And as a rare resource, this means gold isn’t subject to the same degree of competition risk as Bitcoin, given there are thousands of cryptocurrencies currently on the market – many of which investors are looking to with the hope of cashing in on the next big thing. This includes Ethereum, the second-largest cryptocurrency, which is up about 1,500% over the past year. With these differences in mind, one could assume that any link between the rising popularity of Bitcoin and the declining gold price is due more to investor sentiment on risk in a given investment environment. For instance, when the economy is normalising and share markets are rising, investors don’t tend to look for defensive assets like gold; instead, they feel more comfortable investing in higher-risk growth assets – including Bitcoin itself.

Source: Factset

New kids on the block

Over recent months, the success of blockchain-driven cryptocurrencies has paved the way for a second wave of digital opportunities – namely, non-fungible tokens (NFTs) and influencer stocks.

For those less familiar, “non-fungible” means unique and non-interchangeable, while a “token” lives on a blockchain. You can think of an NFT like a one-of-a-kind collector’s item – only digital. In short, investing in an NFT provides a blockchain-recorded certificate of authenticity for a digital asset – whether it’s music, a video, or an artwork. But what’s interesting about NFTs is that they challenge the concept of asset ownership. Because when an investor buys an NFT, they don’t own the asset itself – rather, they just own the token and record of ownership registered on a blockchain digital ledger (which they can sell). Regardless, this hasn’t stopped the popularity of NFTs, whose novelty has created a new medium for collectors and a lucrative monetisation opportunity for artists. In the same vein as NFTs, sports fans can access the NBA Top Shot platform, which allows users to buy, sell and trade NBA “moments” or card-like “packs”. One LeBron James moment sold for USD $208,000.

Investors have also begun accessing another kind of token – one whose value is based on the popularity of public figures. As a crypto social network that monetises celebrities, BitClout allows investors to assign monetary value to public figures by buying Creator Coins which fluctuate in value depending on the popularity of their profiles on the platform. In turn, public figures who “claim” their BitClout profiles (thereby showing their support) are entitled to a share of the profits. However, BitClout has raised some concerns among cryptocurrency specialists. For one, the platform has capitalised on celebrity profiles without their consent. And while investors can transfer funds into the platform, there’s currently no way for them to withdraw them, leading some to question its legitimacy. Wouldn’t be the first time, though, as investors experienced with BitConnect – a Bitcoin investing platform labelled a Ponzi scheme for its pyramid structure and aggressive marketing strategy promising big, fast profits before shutting down its lending and exchange services.

The risks of digital investments

There are a lot of questions about digital investments in general. And that’s because in the scheme of things, they’re still relatively new. This means that for all the opportunities they offer, there are a lot of unknowns and considerations investors need to make – particularly as the conversation and sentiment on digital investments continues to evolve. We’ve outlined a few thoughts of our own:

  1. Consider their purpose in your portfolio
    Unlike investments in shares and property, many digital investments don’t produce earnings or cash flow because they aren’t productive in the same way a company or rental property might be. This means their values are determined not by how productive they are, but by sentiment – that is, they’ll trade at whatever price investors are willing to pay (or ask, if selling) for them, which can cause large fluctuations in value over short timeframes. A good example is Dogecoin (with a market cap of USD $59 billion), another cryptocurrency that initially began as a joke but surged in value based on investor sentiment – and memes. Before making an investment, investors should consider why they’re investing in an asset, how it generates returns and what role it plays in their portfolio.
  2. Understand how these investments work
    Digital investments don’t tend to be regulated in the same way as traditional asset classes. They carry a higher level of risk due partly to the decentralised and intangible nature of blockchain technology-backed applications, which makes decision-making, problem-solving and legal assistance more difficult and less efficient when compared to regulated markets. This means it’s important to learn about how the investment works, the risks it carries, and the legal and tax considerations involved. Further, global regulators have struggled with developing and adopting consistent legislation that defines the rules for how digital investments are handled, classified and taxed. For this reason, seeking financial advice and reading the relevant product disclosure statement can help investors understand how these investments work, as well as the risks and the rules involved.
  3. Learn about the physical impacts of digital investments
    Bitcoin algorithms require massive computational power – particularly when it comes to bitcoin mining, which is fundamental to the network. Simply put, mining involves using sophisticated computers that solve complex problems which enable them to secure the network and process all Bitcoin transactions. In exchange, mining unearths new blocks and enters them into circulation. The amount of energy required for this has been a subject of debate, but remains a consideration for many environmentalists. There are also social considerations for digital investments too. One of the more topical issues is the belief that the decentralised nature of cryptocurrency provides criminal organisations with additional means to commit financial crimes, like money laundering.
  4. Think about how these investments might evolve
    While it gained a lot of attention through Bitcoin, blockchain is a more widespread application – in fact, its interest and integration has increased significantly across various companies, from Amazon to Spotify. For this reason, new investment options have been developed that aim to capitalise on blockchain infrastructure, including digital asset transfers and storage solutions. This suggests the industry sees future potential in the digital realm beyond Bitcoin, NFTs or influencer stocks – and in new ways that don’t involve trading these investments directly. Before investing, investors should consider how investments might evolve and the options available for accessing them in future.

Colonial First State’s view on digital investments

The resilience, interest in and adoption of digital investments like Bitcoin have led some to believe that it’s less a matter of if than when they’re considered an official asset class. Whether this is realistic remains to be seen, though it does suggest that the uptake of digital investments could continue in the future. One of the main caveats, however, is that a lack of clarity on and regulation for investments of a decentralised digital nature will cause confusion for the industry and may also pose risks to investors – whether they’re established funds or individuals making these investments.

For these reasons, Colonial First State is not including digital investments in our portfolios. However, as developments continue to unfold, the Investments team will continue skilfully monitoring the risks and opportunities of financial markets – including the evolving digital investment landscape.

About Colonial First State Investments

Colonial First State has an investment team with extensive portfolio expertise. The team specialises in constructing and managing Multi-Manager Multi-Sector, Multi-Manager Single-Sector, Multi-Index, Index Single-Sector, Index Multi-Sector and Lifestage portfolios that offer a convenient and simple way to diversify investments.

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