My Thoughts on Cryptoassets

Since the inception of cryptocurrency in 2009 it has taken on a roller-coaster journey of transformation from a currency to buy drugs to a more than two and a half trillion-dollar market. With the emergence of decentralised applications (Dapps) on infrastructures built using distributed ledger technologies (DLTs), cryptoassets could be the cornerstones of the next technological revolution of decentralisation.

Therefore, understanding the crypto asset class is crucial to any investor. Cryptoasset could be a good diversifier and a potential hedge. On the flip side, if it is merely a bubble, one could devise a short position to hedge against it.

I will argue that given the various headwinds the asset class faces and widespread speculation by retail investors, Bitcoin is worthless. Although the Ethereum platform offers bright promises, so did countless internet platform companies in the late 1990s. One has to be wary of overvaluation. I will stay away from the crypto space for now.

Issues that Underpin All Crypto Assets

Limited History

Unlike asset classes such as equities, real estate, bonds, commodities (i.e. gold), with over a hundred years of history, cryptocurrencies have only existed a little over 12 years. Not only do we not have a lot of data on the crypto asset class, there are economic conditions the asset class has simply never experienced before. In crypto's 12 year lifespan, it has never experienced stagflation, deep recession, or successful reflations. Moreover, given the little history Bitcoin does have, the data is too weak to judge Bitcoin's effectiveness to hedge against inflation and to offset portfolio drawdowns.

Upends Power Dynamics

Arguably most DLTs and the coins associated with them base their appeal on being permissionless i.e. they lack a central authority. Their permissionless nature effectively transfers the powers from government and private companies, the traditional centres of authority, to the users of the technologies. This shift in power dynamics will inevitably cause backlash from private companies and governments. Given that many governments, especially authoritarian ones such as China and Russia value control over economic efficiency, many will see DLTs as a threat to their political power. China has already banned all transactions and mining of cryptocurrencies. Similarly, although a rather minor point, many traditional businesses see DLTs as a threat to their business model and will lobby against its wider adoption. Nevertheless, even authoritarian countries are experimenting with DLTs in their own way, but their DLTs' eventual adopting may look very different to what people are currently envisioning.

Many supporters of cryptocurrencies point to El Salvador's official adoption of Bitcoin as what's to come. Yet it doesn't matter how many minor nations adopt crypto as legal tender, as long as major players such as China, Russia, or the EU continues to discredit it, the currency will never become a global currency.   

Environmental Destruction (High Energy Consumption)

Consider this: The process of creating Bitcoin to spend or trade consumes around 91 terawatt-hours of electricity annually, more than is used by Finland, a nation of about 5.5 million. Permissionless DLTs are incredibly more inefficient than centralised servers. Higher energy consumption means more coals and gas burnt and more greenhouse gas emissions. their growth would be impeded by regulators and the environmentally conscious community.

Crude oil and coal are incredibly efficient and thus are key factors to higher profits. However, they are gradually phased out with the growing industry of renewable energy. The renewable energy revolution did not just occur naturally, however, the renewable sectors has been receiving significant levels of funding from governments around the world. Thus, DLT’s environmentally unfriendliness ever looming fault in a world increasingly plague by the consequences of climate change; in a world where environmental consciousness grows ever more important.

Companies do not wish to be seen as not environmentally responsible by accepting payments in terms of ‘dirty’ cryptocurrencies or conducting business through the use of ‘dirty’ DLT infrastructures. Tesla stopped accepting Bitcoin as a form of payment in 2020 for environmental concerns. Although its CEO, Elon Musk, has since announced that Tesla would likely restart accepting Bitcoin, not every CEO is as big of a crypto fan as Mr. Musk.

Cyber Risks

Despite cryptoassets’ promises of security, there have been multiple cases where coin holders have been scammed or hacked. With the most famous hack almost bringing down the ethereum blockchain.

Considering that even the US Department of Defense can be hacked into, one must be naïve to believe cryptoassets are totally cyber risk free. Many scams also occur in coinbanks and wallet managers who are centralised like commercial banks.

Some cryptocoins do not generate any cash flow

Cyptocoins such as Bitcoin do not generate a cashflow outright. Its value comes only from its current or potential usefulness as a means of exchange or store of value. So far it is poor at being either. One has to tell a highly optimistic story on how coins such as Bitcoin can achieve either of its aims in the near future to justify an investment in these coins.

My Thoughts On Bitcoin, The Phantom Menace

Bitcoin is not only the first ever cryptocurrency, it is still the largest by market capitalisation. It currently represents around 42% of the cryptocurrency market. However, I believe it is most likely a bubble. To prove my point let us examine the causes of Bitcoin's rally in the past two years. 

Forces Behind Bitcoin's Rally

1. Anything Goes When Yields Are So Low

The fact the Bitcoins do not pay yields matters little when real yields have fallen below zero. It is not a coincidence that the recent Bitcoin rally coincides with the unprecedented monetary easing by the Federal Reserve and other central banks. US 10-year bond yields have plunged since early 2020, with real yields falling below zero.

Elon Musk captured this sentiment through this tweet in February 2021:

Bitcoin is the new gold

Due to Bitcoin's limited supply, people argue that it serves as a new store of value.

Nothing will ever come close to gold's status as a store of value due to its long history. Gold has been seen to be valuable since the dawn of humanity, yet Bitcoin has yet to last 20 years. Gold has been through all kinds of economic crises and stayed strong throughout. Bitcoin has such limited history, one cannot guage its performance in crises.

Nevertheless, let us entertain the scenario of Bitcoin becoming a safe storehold of value like gold. The Bitcoin market will become more stable with less speculative activity and more institutional investors such as Blackrock and Vanguard entering. If we view the combined private holding of Bitcoin and gold to be the total holdings of safe assets, at Bitcoin's current price of $50,000, its share of total holdings is at around 28%. I do not believe that such a percentage is justified for something as volatile as Bitcoin but you may think differently. Nevertheless, the table provides a guide to Bitcoin's potential value if you see it as the new gold.

 

Assumes a combined gold and BTC market cap of $3.2tln (this is from Bridgewater's Bitcoin report, so the BTC market has grown since then. Nevertheless, the percentage share remains unaffected), with $2.56tln in private gold holdings, (ETFs, gold bars) and $0.6tln in BTC holdings, and that BTC supply is equal to the total number of coins mined.

2. Surge in Retail Interest

The graph above represents the interest of the search term ‘Bitcoin’ on Google search over time. It has surged since early 2020, the same time Bitcoin’s price began the rise. There could be a few reasons the stimulated Bitcoin’s retail interest:

Bitcoin’s rise puts it on headlines everywhere, generating more retail interest. We see evidence of this on the on and off peaks in search interest from late 2020 to early 2021, relating to Bitcoin's on and off appearances on news headlines.

3. Speculation

 The surge in retail interest leads directly to retail speculation. Bitcoin still has significantly higher turnover than gold, reflecting its speculative nature. There are on average five times more bitcoin derivative trades than spot trades of the coin itself.

4. Sentimentality

There is a growing distaste on banks' and governments' domination on the financial world. We see this sentimentality manifest in the Gamestop squeeze by retail investors on r/wallstreetbets in early 2021. Americans’ trust in their government has reached historical lows. Investment in decentralised cryptoassets is a manifestation of investors' distrust in the current monetary power arrangement. The belief in the rise of the metaverse, and crypto’s role in this new world order also fuels investors' confidence.

What goes up... 

Now we have examined the reasons behind Bitcoin's rise, let's see if they are sustainable enough to continue supporting Bitcoin's high value.

One must consider the case when the economic and monetary landscape contracts. Would cryptocurrencies, being the first beneficiaries of easy money be the first to go bust?  The recent drop in crypto prices has mirrored that of American markets which suffered on December 3rd after the latest monthly jobs report sent mixed signals about the country’s economic recovery.

Bitcoin's speculative nature suggests that its intrinsic value and its liquidity are lower than what people think. Moreover, the dominance of short-term traders in the market renders Bitcoin vulnerable to all kinds of shocks, as short-term traders are more risk-averse than long-term investors. We see this flustered nature when crypto prices dropped following the discovery of Omicron. This brings into question once again, Bitcoin's ability to serve as a store of value and a unit of exchange.

To those who associate cryptos' value on their functionality in the metaverse, I suggest them to think of crypto as nothing more than a risky option. I also warn them of human's inability to predict the future.

Furthermore, for those who think of their investment as playing a part in decentralising the world's economic order, they should not underestimate governments' influence in the market, especially those of authoritarian nations. The more crypto infringes on governmental monetary control, the more pushback it will face.

Lastly, Bitcoin being the first cryptoasset, has one of the most primitive design. Cryptocoins that emerged after it have and will have better functionalities, one example being the Ethereum blockchain. Particularly in the case of DLTs, the infrastructure is fixed in place, rendering evolution difficult. Therefore, even if the blockchain technology proves to be valuable, Bitcoin may not be the one that best leverages the technology. Recall the fates of Netscape and Myspace, despite being one of the first actors.

For these reasons, I believe Bitcoin possess little advantages either as a store hold of value of a unit of exchange. Therefore, I don't think it is valuable at all.

Ethereum: A New Hope

While I fail to find value in Bitcoin, Ethereum creates value in its coin Ether by allowing the coin to do work. While Bitcoin’s infrastructure is designed solely to record transactions in a decentralized way, Ethereum expands the use of distributed ledger technologies to enable the deployment of smart contracts and decentralized applications (dApps). It is an ecosystem for Decentralized finance (DeFi) applications, for the creation and exchange of non-fungible tokens, and many more types of dApps.

Its currency Ether is used to run commands on the platform. Different from Bitcoin, Ether’s value does not only come from collective trust. Its value comes from the functional value of the Ethereum ecosystem. Furthermore, I can see wider adoption of dApps due to their potential to improve efficiency and enhance resilience. In trade finance, smart contracts could replace letters of credit and create a record of ownership at each step. In the insurance business, smart contracts could be designed to trigger a pay-out when a flight was delayed.

There are infinite other potential uses of dApps. One can claim that we are standing at the dawn of a technological revolution similar to the internet revolution in the 80s - 90s.

A Look at History: The Dot-com Boom and Bust

There's no great company [or sector] that can't be turned into a bad investment just by raising the price.

-        Charlie Munger

To me the current crypto boom seems eerily similar to the dot-com boom in the 1990s, despite their differences in sizes relative to the market. The crypto market is still relatively small. The root cause of the internet bubble is not its technology. The issue lies with the growing disparity between company cashflows and their market values. Given that the technology had not matured at the time, investors had little idea on how exactly companies can leverage the technology to generate value. Legendary behemoths such as Amazon.com and Google have indeed formed during that boom, yet Amazon.com's share price still crashed by more than 90% in the two years following the bust.

Crypto's high valuation is equally a castle in the air. Too many promises on what "will eventually materialise", be it the metaverse, governments' eventual support (following El Salvador), or fiat currency's imminent doom. Many cryptoassets have no value if those scenarios do not play out. Similar to the 90s, there is a broad bullish sentiment among retail investors, fueling crypto-based derivative securities. Moreover, from my personal conversations with crypto bulls, I have noticed that their investments are fuels mainly by their fear of missing out. Most do not even have a coherent story on how the above scenarios could play out.

Finally let's say some DLT business/asset eventually proves successful in the long term (such as Amazon.com in the dotcom bubble), given that there are considerably more losers than winners, how do we differentiate one from the other? Even if DLTs, Dapps and the Metaverse are indeed our future. How does one know if these cryptocoins are overvalued or not when their underlying technology is so immature?

Conclusion

Given the nascent nature of the crypto/DLT market, investments in cryptoassets should only be seen as a call option at best. Having said that, I do believe in the potential benefits offered by DLTs. Yet given the level of speculative activity, unless one very thoroughly understands the given cryptoasset, it is best to wait until the market matures before investing heavily in the field. Although I would like to short the current crypto market as a whole, I worry about reflexivity and I nevertheless believe DLTs potential to create value.

For the people who claim that waiting could mean missing out on great investment opportunities, I urge them to consider this motto from Buffett:

Know what you know and what you don’t know

I do not know much about DLTs and cryptoassets. This is the primary reason of staying away from it. Investing is a creative venture, heaps of other assets generate high returns. One should not suffer from tunnel-vision. Instead of the DLT market, I will focus my attention on equities, bonds, commodities, and perhaps the Addidas Yeezys.

Finally, I would still love to learn more about this interesting field. Please share your thoughts on my analysis and your thoughts on the crypto market in the comments below