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The crazy world of

cryptocurrency

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David Lerche

Senior Investment Analyst

There’s been a lot of buzz around cryptocurrencies over the past few weeks, with the value of the market for alternative digital currency surging beyond US$70 billion at one point. Some have warned that the speculative frenzy and meteoric price rises in what is an unregulated market are unsustainable, predicting a bubble in the making. In our view, cryptocurrencies are a novelty that may well grow in value in the future, but the risks are extreme. We see them as a curiosity rather than a tool for serious investors.

The price of a bitcoin – the original cryptocurrency launched in 2009 – is up 134% year-to-date and has increased 18 times over the past four years, which means the total value of bitcoins in circulation is now in the region of US$36.7 billion. This is the value of South African equity market stalwarts Sasol and Anglo American combined, but is still only 0.015% of South Africa’s M3 money supply (the broadest definition of cash in the economy).

Bitcoin is the largest and most liquid cryptocurrency, accounting for roughly half the global value of such currencies, of which there now about 840. Other notable digital currencies include Litecoin, Peercoin and MikeTheMug.

Are cryptocurrencies an asset class worth considering in a diversified portfolio? It’s important to note that they’re a currency just like any other – a medium of exchange and a store of value. The key differences are:

  • Alt-coins, as cryptocurrencies are known, are not backed up by gold, gross domestic product (GDP), government promises or a central bank, but rather by technology through a widely distributed, theoretically tamper-proof ledger of transactions.
  • There is a fixed limit to the number of alt-coins that will ever be in circulation, so new coins can’t be created beyond a certain point. There are already 16.4 million bitcoins in circulation and only another 4.6 million will ever be ‘mined’.
  • Alt-coins are highly divisible into smaller fractions.

Like any currency, the value of a cryptocurrency is simply the level at which a willing buyer and willing seller will transact. The value of a US dollar can only be defined in terms of other currencies (for example, US$1 = €0.89) or goods (US$1 = a quarter of a Big Mac or US$1 = 0.02g of gold).

Just as the value of a US$100 bill or R100 note exists only because someone else is willing to accept it in exchange for something, the same is true of cryptocurrencies. As yet, their acceptance is limited to internet shopping, mostly via intermediary gateways, but it’s growing. This acceptance will likely continue to expand to facilitate more transactions, which should theoretically drive the price higher.

The greatest usage remains for investment demand (likely more than 90%) and as a non-traceable medium of exchange for criminal activities. This investment demand may well be the precursor to greater use as a medium of exchange, but it could also be a bubble given that 99% of exchange-traded volume is in Chinese yuan.

Much of the hype around cryptocurrencies is due to the meteoric rise in the price of bitcoin, from US$0.06 in July 2010 to US$2 217 today. While bitcoin has mitigated the risk of inflation associated with other currencies, it’s only eight years old, so trust in the alt-coin is well behind that of the 232-year-old US dollar. Cryptocurrencies have no intrinsic value like gold or other commodities, they don’t earn interest like cash in a bank and they certainly don’t have ‘beauty’ value like fine art.

The best way to value an alt-coin is like one would an option, but even this requires a major assumption about the ‘bigger fool’ who may accept cryptocurrency in exchange for goods or services in future. Alternative digital currencies didn’t exist during the financial crisis, so investors have no way of knowing whether they’ll work effectively as a store of value in a crash. We suspect not.

While cryptocurrencies may be viewed by some as an investable asset, we view them as a tiny niche. The total value of all investable assets globally is around US$500 trillion, excluding derivatives, so a perfectly diversified global portfolio of US$1 million would hold only US$73 of alt-coins.

The South African regulatory environment doesn’t allow financial service providers to invest client money directly into cryptocurrencies, but various internet platforms are available to individuals with an appetite for speculation. In our view, they should be approached with extreme caution – buying alt-coins is a bit like taking a bet at the casino: it may work really, really well, or it may turn out very badly.

There’s a mountain of information on the web for those who feel brave enough to go the cryptocurrency route. Readers who’d like a more detailed view on bitcoin’s investability can find an interesting research white paper here.

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