Like all speculative assets, the risks of Bitcoin are multi-faceted while the long-run investment implications are yet to be determined. Morgan Stanley Research recommends investors educate themselves before they consider embracing the arrival of cryptocurrencies to the investing landscape.
Bitcoin is back in the headlines after a three-year respite. Its popularity along with other cryptocurrencies has surged, and political figures, financial gurus and regulatory officials are repeatedly asked for their opinion.
At this point, much attention has been focused on what Bitcoin is and how it works, but that in some ways, is the easy part. Assuming the underlying blockchain technology works, is Bitcoin or any other of the cryptocurrencies something investors should consider for their portfolios? That’s the more difficult question.
Cryptocurrencies are virtual currencies that operate on a peer-to-peer basis without a central authority. They are digital and, unlike the Australian dollar, they have no physical form and no central repository. The decentralised nature of cryptocurrencies requires computers to use cryptography and computerised encoding and decoding of information to verify transactions and prevent counterfeiting.
Unlike traditional currencies, which use a trusted third party such as a credit card company or bank to verify that the funds are available to complete a transaction, cryptocurrencies rely on a network of computers to confirm the transaction and that the spender has the coins to transfer. When a transaction is initiated, it is broadcast to the network where it awaits verification from computers that solve an algorithm to determine if the transaction is legitimate.
While Bitcoin is by far the largest cryptocurrency, there are 10,000 alternatives including nine which have market capitalisations of more than US$14 billion. Bitcoin was the first cryptocurrency, designed in 2008 by an anonymous person or group named Satoshi Nakamoto, and launched Jan. 3, 2009. Today, there are thousands of cryptocurrencies, crypto assets and crypto commodities, though Bitcoin still accounts for roughly 55% of the value of the entire asset class (see Exhibit 1). Importantly, Bitcoin demonstrated how a decentralised store of value and payment system could replace a centralised system.
Exhibit 1: Bitcoin is by far the largest cryptocurrency (USD)
Investors’ reasons for interest in Bitcoin and other cryptocurrencies typically centre on one or more of three investment theses:
- Bitcoin could act as digital gold, a "safe haven" from fiat currency debasement. The COVID-19 pandemic-driven government deficits, aggressive monetary policy and a lack of appropriate alternatives have made this argument more convincing to many. Investors with similar thinking might be interested in Morgan Stanley Research’s comparison of the valuation of Bitcoin to the valuation of gold and the case study of gold’s 18-year rise from an illegal investment to part of a conventional portfolio in the 1980s. Speak to a Morgan Stanley financial adviser to find out more.
- Cryptocurrency could be a new asset class that will increase in value as more institutional investors incorporate it into their portfolios. Advocates of this theory see the rise of Bitcoin in the light of the disruption occurring in other sectors and industries. When penetration in a large addressable market is low, an investment in a disruptive innovator can have attractive returns as long as market penetration continues to increase.
- Bitcoin and other cryptocurrencies are seen as an uncorrelated, volatile asset appropriate for diversification under Modern Portfolio Theory. Morgan Stanley Research’s recent report showed hypothetically how a small Bitcoin allocation to a conventional portfolio of 60% stocks and 40% bonds would have fared from 2014 through September 2020. A number of firms (CoinShares, Bitwise, Galaxy) have performed variations of this analysis in the past several years using different Bitcoin allocations, different time periods and different rebalancing frequencies. In general, they found that small allocations of Bitcoin tended to improve hypothetical performance of a traditional portfolio. A key assumption with these analyses is that correlations remain low.
Cryptocurrencies are an emerging asset class, with no guarantee that any particular currency will last. Volatile price movements, lack of support from central banks and no physical collateral could ultimately be a detriment. While there are many risks, the three biggest risks for Bitcoin and other cryptocurrencies according to Morgan Stanley Research are as follows:
- Encryption breaks – Increased processing power and new techniques such as quantum computing could eventually crack the encryption, opening the possibility that owners’ “wallets” will be hacked. Bitcoin would likely suffer a serious price decline even if encryption only appears to be broken. While the chances are low in any given year, over 100 years, this risk is likely to emerge.
- Flawed code– Bitcoin had two bugs that resulted in inflation―meaning more coins minted. The first incident was in August 2010, which allowed 184 billion unauthorised Bitcoin to be minted. This flaw was discovered quickly, purged from the supply and the code was patched. Another less severe bug appeared in 2018, allowing malicious miners to create two transactions with the same transaction ID in the same block, and thus were able to spend money twice. This bug was never exploited. Such events have happened only twice in 11 years and have had limited impact; nonetheless, they expose a significant risk. Other cryptocurrencies, such as Ethereum, have also had transactions that were rolled back.
- Government action – There is also risk of a government attack on Bitcoin and other cryptocurrencies. Because the Bitcoin network is global, actions by a single large country or a group of countries could disrupt the working of the network. This could occur through regulations or an outright attack. A regulatory offensive could take place, possibly banning the use of Bitcoin or imposing high taxes on Bitcoin transactions. A direct attack might find a sovereign country trying to corner the market on mining power. Such attacks would be costly
So how should investors begin to think about this speculative asset class in the context of portfolios? The embrace of cryptocurrency as an asset class should not be misconstrued as a recommendation for any one coin. Like other new emergent technologies before it, first movers may not turn out to be the best or most long-lasting movers.
Certainly, Bitcoin is currently dominant in cryptocurrencies, but the ways in which crypto can be used continue to evolve at record speed. Morgan Stanley Research believe coin trading remains in its infancy and issues around finding true price discovery and best execution are still to be addressed.
Morgan Stanley’s recommendation is that investors get educated and consider how and whether to get exposure to this bourgeoning asset class in their portfolio. We suggest investors become familiar with the unique crypto terminology, with use cases, investment arguments, valuation regimes, investment product alternatives and risk.
Are cryptocurrencies a new currency, a new type of gold, or a speculative fad? People value and define cryptocurrencies in different ways. Regardless of classification, cryptocurrencies remain an experimental concept that is not regulated or backed by any central bank worldwide and has no tangible intrinsic value. Regulatory concerns around cryptocurrencies will remain in focus and will need to be sorted out over the coming years. Amid the concerns are anti-money laundering issues due to the anonymous nature of cryptocurrencies. Real issues and challenges exist around cryptocurrencies including governance, transparency, exchangeability, anonymity, volatility, fraud, manipulation, and hacking.
For more on investing in cryptocurrency, or to read the full article ‘Investing in Cryptocurrency’ (14 April 2021), speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.