Cryptocurrencies have not failed to write headlines since their recent beginnings. And with more and more attention being directed their way, both private and corporate investors are considering their potential.
Cryptocurrencies as a commodity class – or currency, depending on your point of view – have divided opinion over the course of their short lifetimes.
While some have looked for the potential in cryptocurrencies, others have questioned their efficacy. In the latter camp are a number of high profile executives and bankers, notably, investment bank JP Morgan’s CEO Jamie Dimon, who has famously told conference delegates and journalists that the bank would not be considering cryptocurrencies as a viable investment opportunity. Indeed, many of those who have watched the rise of bitcoin, the world’s first cryptocurrency, sustain exceptional growth in value since it was first produced in 2009, have considered it as enjoying nothing more than a bubble.
In many ways, there has been a war between some of the banks, and the bitcoin banking industry, over the past few years – a power struggle on several fronts. Others, however – including central banks and financial regulators – have seen longer term potential.
With any financial asset class, the intrinsic value is based on the confidence markets place on future returns. Bitcoin, now considered the world’s leading cryptocurrency, had a less than transparent beginning when it was created less than a decade ago by a person or group of persons going by the name of Satoshi Nakamoto – whose identity has remained anonymous. Quickly, however, investor interest across the world honed in on the potential benefits of having a decentralised means of exchanging wealth. At one point, bitcoin was used as a means of exchange in the so-called “dark web”, where illegal goods and services were exchanged. This association, while allowing the cryptocurrency to grow in popularity and circulate around the world with greater speed, may have held back the growth of bitcoin into more legitimised networks.
And while the cryptocurrency has moved into the more mainstream financial markets, gaining traction among bigger banks and established financial players, there are some who still look back to bitcoin’s past and consider the association still valid.
Many of those doubters have been silenced, of late, with what many consider to be the final part in the jigsaw for bitcoin becoming accepted among the global financial elite: over the course of the past year, some of the world’s most recognised exchanges have traded bitcoin, and with it offered the ability to trade derivatives and the futures markets. The Chicago Board Options Exchange (CBOE), and the Chicago Mercantile Exchange (CME), are just two examples of exchanges in the United States that have moved to progress the market. While both exchanges have moved to promote bitcoin and bitcoins associated marekts, they’ve also both recognised that there are perceived risks in the cryptocurrency, and put in place additional margin requirements for firms and investors dealing in the currency.
Risky business
As with investing in any commodity, currency or asset class, there is a certain amount of risk and exposure that the investor must bear in mind and must evaluate how much they are willing to risk on a particular investment.
As well as the financial losses any investor might encounter with the direct result of betting against a rising cryptocurrency market, any firm large or small will consider the opportunity costs associated with investing in one asset over another. While treasury and risk managers will factor this into any investment or financial decision, it’s less prominent among private investors.
However, with cryptocurrencies being still considered a young financial tool compared to other more established investment options across global markets, there are still hazards and risks unique to bitcoin and other cryptocurrencies, such as ethereum.
For instance, financial regulators are still weighing up the various the potential impacts of cryptocurrencies, and digital currency pros and cons. As their processes and opinions take shape, some regulators have moved quickly to direct and shape cryptocurrencies’ impacts on their markets, while others have decided to take the stance that they will allow the market to develop.
In China, for instance, financial regulators moved last year to dampen the cryptocurrency market, as it was growing too fast and potentially overheating which, in the country’s not unsubstantial independent investor market could have spread quickly to other markets. With much cryptocurrency made illegal in China in 2017, bitcoin lost a large amount of value overnight. This quite clearly shows the impact a regulator can have on financial markets should it decide to intervene suddenly, and how those who invest in cryptocurrencies are at risk of feeling such shocks.
Conversely, in the United States regulators still seem to be working out how the bitcoin industry will transpire. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), have suggested that they will monitor cryptocurrency markets closely for violations within their current jurisdictions. But with bitcoin, ethereum and other cryptocurrencies having unique characteristics, there is little to say that market shocks will not occur should those regulators consider more rules are needed.
A further risk to cryptocurrencies from a regulatory perspective is in the fact there are these different rules across national boundaries. One of the main benefits of the digitalised currency markets is that they are global in nature: in theory, they hold no foreign exchange risk. But from the point of view that different jurisdictions will look on the currency or asset in a particular way, it holds the risk that there will be arbitrage, or restrictions, across national boundaries.
There are further risks inherent in trading bitcoin, ethereum, and other well-placed cryptocurrencies. One of the main benefits of digital currencies is that they can be traded anywhere, and access to the many exchanges hosting the coins are prevalent. But those many sites must have sufficient security protections and protocols, lest technological failures occur or the site is subjected to a hack. Further, a number of illegitimate cites have sprung up, in which investors think they are trading bitcoin but the site’s owners eventually pocket their cash. A number of instances such as this have occurred, and while it has not stopped investors from wanting to buy bitcoin and other digital currencies, it has led some to reignite the bitcoin versus banks debate. There have also been a huge number of cryptocurrencies launched in the past couple of years which, while many have not rivalled bitcoin or ethereum in terms of growth or legitimacy within mainstream financial markets, the sheer volume has impacted the reputation and growth rates of some of the more established players. It could be argued that this impact could pose a risk, and be detrimental to those more legitimate digital currencies.
Rewards in the wallet
With the risks, come the rewards, as is the case with any investment opportunity. The returns for those who have invested at the right times in bitcoin have been weighty, in many instances, for those on the cryptocurrency side of the bitcoin versus banks argument winning out.
More and more industries are looking into ways to extrapolate use from cryptocurrencies, with sectors such as energy the latest to look to ways it can use bitcoin to transfer wealth. That can only substantiate the growth of the digital currency. Elsewhere, central banks in some jurisdictions have suggested they are looking at the impact of digital currencies and how they might utilise their benefits. Again, for those who have invested in cryptocurrencies, first movers into digital currencies may enjoy benefits in the future.
Perhaps the greatest benefit of these newer commodities or currencies, is that of diversification – key to any investment portfolio whether it be corporate or private in nature. Risk managers have long espoused the benefits of a diversified portfolio, containing instruments not immediately related to others within the basket. Cryptocurrencies – as yet – do not seem to hold a relation to other assets, so may be a prime example of unrelated, and potentially profitable, assets worth holding.