Cryptocurrencies are finally being taken seriously by financial markets. Rebecca Campbell looks at the implications of the many different digital currencies
Andrew Bailey, governor of the Bank of England (BoE) said in a press conference in May 2021 that cryptocurrency has “no intrinsic value” and that investors should be prepared to lose their money. His comments, which followed a similar warning from the UK’s financial regulator, the FCA, were in turn echoed by the president of the European Central Bank, Christine Lagarde, who said in a webinar hosted by the European University Institute that she agreed with Bailey and added that some cryptocurrencies are “prone to money laundering activities”.
Many of the concerns from regulators around cryptocurrencies focus on the lack of transparency. CISI chair Michael Cole-Fontayn MCSI, speaking at the Cambridge International Symposium on Economic Crime in September, said that “anything that bypasses bank balance sheets as a means of transmission of value, particularly in the cryptocurrency world … should be a regulated activity”. He welcomes the push from the US Securities and Exchange Commission to treat cryptocurrencies as securities as “a helpful step forward because then they become within the regulatory ambit”.
Public perception is mixed. A global Cryptocurrency risk and compliance survey, published in September 2020, conducted by the Association of Certified Anti-Money Laundering Specialists and the UK’s Royal United Services Institute, finds from the 566 respondents that “the only audience to see cryptocurrency as more of an opportunity than a risk” are those working in the cryptocurrency industry.
Beta and alpha
Cryptocurrency first came into the public spotlight in 2009 with the arrival of bitcoin. At the time of writing, there are over 15,441 cryptoassets available, with a market cap of around US$2.3tn. Bitcoin remains the number one cryptocurrency, but others such as binance, cardano, ethereum, and solana are just a few gaining prominence.
For those who do invest, there are several different ways to access cryptocurrency. One option is taking direct custody by investing in physical bitcoin. In contrast to more traditional asset classes, this requires setting up a digital custodian, which can be costly and operationally time-consuming for organisations. Another option is to invest in funds and fund-like products, which fall under two categories: beta and alpha.
“Beta products give direct exposure to crypto [as] the fund holds physical bitcoin or ethereum or indirect exposure through futures,” explains Dr Amber Ghaddar, co-founder of AllianceBlock, a protocol that, according to its website, “bridges traditional and decentralised finance and automates the process of converting any digital or crypto asset into a bankable product”.
Amber says: “The main issue with futures is that most invest in CME [Chicago Mercantile Exchange] futures, which are cash settled and suffer from what is called the ‘CME gap’, since CME futures don’t trade 24/7 and have a closing and opening price. In crypto, CME futures are not representative of futures markets as they represent on average 3% of total volumes and don’t provide exposure to perpetual swaps.”
“The unconventional globalised structure of the market … makes approving a bitcoin ETF a regulatory headache”
Perpetual swaps, which don’t expire, are the largest traded contract in cryptocurrency that enable investors to buy and sell bitcoin without owning any. Another method of accessing cryptocurrency is through the few physically backed exchanged-traded funds (ETFs) and exchange-traded notes (ETNs). These are physically backed by bitcoin rather than futures, and are mainly found in Canada, Germany, the Netherlands, Sweden and Switzerland, with one in Brazil. For US investors, ETFs are yet to be approved; however, a well-known investment vehicle is the Grayscale Bitcoin Trust, an over-the-counter ETN.
“The unconventional globalised structure of the market of this brand new asset class and what it entails makes approving a bitcoin ETF a regulatory headache,” says Amber.
Alpha products are mainly hedge funds with anything from long or short discretionary managed funds to systematic arbitrage funds, she adds. Compared to traditional trading where investors buy and hold cryptocurrency to sell at a later date, investors can perform crypto arbitrage as soon as transactions are complete. However, with this comes ‘know your customer’ restrictions, withdrawal limits, fees, and timing.
A third method of accessing crypto assets is through several substitute ETFs such as the Amplify Transformational Data Sharing ETF and the VanEck Vectors Digital Transformation ETF, which invest in the equity of companies expected to profit from crypto industry development. According to Amber, the best option for investing is through physically backed ETFs, which allows investors to bypass the operational headache of setting up a digital custodian.
“This has the potential to revolutionise investment in crypto in the same way gold ETFs did gold,” she says.
Investing through synthetic crypto products, such as substitute ETFs, brings no less risk than investing directly in cryptocurrencies, says Pauline Adam-Kalfon, partner of financial services and blockchain leader at PwC France & Maghreb. However, indirect exposure to crypto products created and distributed by regulated financial intermediaries may also provide some benefits that direct exposure might not, she says. For example, it may “indirectly benefit investors on risk management and compliance aspects as these intermediaries must, by law, perform such procedures and are subject to be controlled by regulators and supervisors”.
Impact on the financial ecosystem
According to Ronnie Moas, founder of Standpoint Research, this new asset class is taking market share away from more traditional investments.
“The reason bitcoin has jumped 15x since 2017 and the reason it will probably jump by another 500 to 1,000% in the next few years is because the US dollar is backed by nothing [and] has lost half of its value in the past 20 years,” he adds.
“There is a financial revolution going on under our nose”
Not only that, but bitcoin has a capped supply of 21 million bitcoins, and there are now hundreds of millions of people in the world trying to get their hands on something that is no longer available for sale at a low price.
“There is a financial revolution going on under our nose,” says Hector McNeil, co-founder of HANetf, an independent ETF investment platform. “It’s the ability of the technology to liberate the end investor and their needs and their wants. They are effectively putting their hands up and saying they don’t need governments, they don’t need banks, they don’t need exchanges, they don’t need clearing houses. They can do this themselves because the technology’s there.”
However, the main risk that comes to mind for Dr Amber Ghaddar is the short-term credit market with a potential contagion risk linked to the tether (USDT) stablecoin, a type of cryptocurrency tied to another asset such as fiat to stabilise its price. USDT is, at time of writing, the largest stablecoin by market cap, standing at roughly US$69bn, according to CoinMarketCap and, says Amber, is “backed by around 50% of commercial paper (CP)”.
“This suggests that USDT CP holdings are larger than most prime money market funds in both the US and Europe. A period of general selling pressure in the CP market with a sudden mass redemption of USDT could, hypothetically, affect the stability of short-term credit markets,” she notes.
Global governments fearful of losing control of the money creation process have started to put pressure on the industry. Consequently, several central banks, including China’s, are turning their attention to central bank digital currencies (CBDCs). According to the PwC CDBC global index launched in April 2021, over 60 central banks have been exploring CBDCs since 2014. Regardless, Leighton Hughes, programme and fintech lead at the Centre for the Study of Financial Innovation (CSFI), says that CBDCs remain a “definitional puzzle” and for them to be truly effective, the threshold is high.
“Each central bank would need to agree a framework for their digital corridor and jointly govern its operation.” With hundreds of different currencies worldwide, an arrangement like this would require several separate bilateral agreements, says Leighton.
However, with China looking to CBDCs not only to maintain its hold on its monetary economy, but also to replace cash, the impact of phasing out money needs to be considered. Research from the CSFI points to what is known as a ‘two-tier approach’: the creation of different remuneration rates for new forms of digital money (tier one) versus commercial bank deposits (tier two). As Leighton explains, the model is tiered so that the interest paid on digital money balances above a threshold would decrease. This would also act as an incentive to minimise overall deposit amounts, which would otherwise leave the banking system.
“As [the] theory stands, when it comes to offsetting the initial shock to the financial sector caused by the introduction of a CBDC, the benefits are that this tiering would avoid a crisis,” Leighton adds.
Amber believes that to achieve mass adoption of cryptocurrencies, efforts need to be centralised with more interaction with regulators and governments. Ronnie Moas agrees and says that, “with regulation and taxation, it means the government has accepted this as a legitimate asset class and that’s the direction it’s going”.
The traceability and security features that blockchain may offer could ease financial flow audits and compliance procedures, says Klara Sok, senior manager of the blockchain lab at PwC France & Maghreb.
“The transparency that blockchains may offer could bring asset and liability reconciliation by design,” adds Klara. “Interestingly, both the crypto and traditional finance sectors source product innovation from each other.”
Inflation hedge or store of value?
There are arguments for and against on both sides. In Ronnie’s view, bitcoin is not just a hedge against inflation, but is also a store of value that is designed to appreciate over time. “I don’t know any asset class that is as attractive right now,” he adds.
A recent ‘Buttonwood’ (financial markets) column in The Economist looks at how bitcoin could be used as part of a diverse portfolio, speaking of insight revealed by economist Harry Markowitz, who said that “it was not necessarily an asset’s own riskiness that is important to an investor, so much as the contribution it makes to the volatility of the overall portfolio – and that is primarily a question of the correlation between all of the assets within it.” Buttonwood selected four random time periods over the past decade and saw that the ideal allocation of bitcoin in a portfolio was between 1% and 5%. “This is not just because cryptocurrencies rocketed: even if one cherry-picks a particularly volatile couple of years for bitcoin, say January 2018 to December 2019 (when it fell steeply), a portfolio with a 1% allocation to bitcoin still displayed better risk-reward characteristics than one without it,” the report adds.
Amber, however, says that you first need to differentiate between bitcoin and other cryptocurrencies. In her view, the division is similar to that of gold and oil, gold being bitcoin and oil being ether. The first, she notes, is considered by many as a store of value, while the other is the main fuel driving the crypto economy.
“I prefer to look at bitcoin as a high-volatility, high-return investment driven by its idiosyncratic characteristics and delivering portfolio diversification, rather than a pure hedging tool in a portfolio,” she says.
While the crypto market has certainly shown its volatile side over the years, it’s also experienced tremendous growth.
“The impact on monetary policy could become material if cryptocurrencies were to be widely accepted by merchants and tax authorities”
Yet, while this is impressive, it still represents a relatively small portion of the broad monetary base globally: less than 2% in 2020, according to the Money Project. Not only that, but a large portion of cryptocurrency investment is not converted into fiat money, which may limit their impact to the real economy for the present moment.
“The impact on monetary policy could become material if cryptocurrencies were to be widely accepted by merchants and tax authorities as fiat is,” says Pauline. “Then, cryptocurrency supply could likely impact real asset prices and could bring further inflation into the economy.”
Crypto’s ESG impact
Another consideration for investors is the broader environmental, social, and governance impact of cryptocurrency. The impact of bitcoin, for example, was further highlighted when Tesla CEO Elon Musk said in May the company would no longer accept bitcoin over climate concerns. Another source that has pushed bitcoin’s energy consumption to the forefront of discussion is the University of Cambridge, which compiles an index on the crypto asset. Since the origination of bitcoin, it has consumed around 129.45 TWh per year, putting it just behind the electricity consumption of Egypt.
Yet, according to Amber, and stated in the index, comparing bitcoin mining to the energy consumption of a country is like comparing apples with oranges. A better comparison would be to look at bitcoin’s energy consumption versus that of other industries.
“A recent research report by Galaxy Digital [a financial services and investment management company that focuses on the digital assets, cryptocurrency, and blockchain sector) shows that bitcoin consumes overall almost 50% of what the gold industry and banking industry consume,” she says. “Our own research, however, shows that for each dollar added to the economy, bitcoin costs 4.20 times more energy than gold for a market price of US$48,000. If bitcoin prices moved north of US$200,000 today, it will have the same consumption as gold for the production of US$1 of value.”
While these numbers assume that all of the energy consumption comes from non-renewable sources, which is not the case, the current backlash has, nonetheless, served as a wake-up call for the sector. There has been an increase in bitcoin miners using green energies, which could ultimately see most industries moving towards renewables in the near future.
Yet, much still needs to be achieved before cryptocurrencies can become legal currency in all countries. Whether there will eventually be some form of middle ground with the aid of CBDCs remains to be seen, but for now, while crypto assets are impacting bond markets and the finance ecosystem, they are mostly being used for investment purposes rather than as a unit of account. This, in turn, limits their scope, reducing the full impact on financial markets.
The full article was originally published in the October 2021 edition of The Review.
The flipbook edition is now available online for all members.
All CISI members, excluding student members, are eligible to receive a hard copy of the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
Once you have read the print edition, keep coming back to the digital edition of The Review, which is updated regularly with news, features and comment about the Institute and the financial services sector.