by Martin de Bruyn, CFA, CFP®

Please note that anyone can invest in cryptocurrencies, but it is unregulated and as such nothing written here should be construed as advice. It is merely meant to enlighten the reader as to the opportunities and risks in this space. SARS, SARB and the FSCA is currently working on how best to regulate cryptoassets.

In part 3 and the final part, we look at the opportunity, risks, and a conclusion.

As of 2 September 2021, bitcoin was trading for $50,082.67. Considering the current circulating supply of approximately 18.8 million bitcoin, this would imply a total market capitalization of $935 billion.

Is that a lot or a little?

The question of how to appropriately value cryptoassets is one of the most complex, chal­lenging,  and disagreed-on aspects of the crypto­market. The five most widely used cryptoasset valuation techniques are the following approaches:

1. Total Addressable Market
2. The Equation of Exchange (MV = PQ)
3. Valuing Cryptoassets as a Network
4. Cost of Production Valuation
5. Stock-to-Flow Model

The unfortunate reality is that none of the pro­posed valuation models are as sound or aca­demically defensible as traditional discounted cash flow analysis is for equities or interest and credit models are for debt. This should not come as a surprise. Cryptoassets are more similar to commodities or currencies than to cash-flow-producing instruments, such as equities or debt, and valuation frameworks for commodities and currencies are challenging. Cryptoassets add another wrinkle in that they are still extremely early in their development, and we are still uncov­ering the utility that these assets can provide.

In the end, most investors approach cryp­toassets as some combination of commod­ity, currency, and early-stage venture capital investment, borrowing techniques from each approach and emphasizing long-term holding periods. This makes precision challenging but might be enough to justify or reject the idea of adding a cryptoasset allocation to a portfolio.

Risks

The cryptoasset market is early in its develop­ment, and investors accessing the space face material risks. Here are some of the possible risks:

– Custody Risk (theft, lost keys/password, custodian risk).

– Tax Treatment Risk (income or capital gains tax).

– Regulatory Risk (China banning cryptos, other global government regulations).

– Technical Risk (Bugs on blockchains which exposes security flaws).

– Investment Risk (high volatility, behavioural errors due to high volatility).

Conclusion

The goal of this series is to provide an introduc­tion to cryptoassets: what they are, what they are not, and what they might become in the future.

Our view is that the key to understanding cryp­toassets lies in understanding the fundamental idea behind blockchain databases. All the hopes, dreams, excitement, disbelief, and risk that accrue to the cryptoasset space exist because of the breakthroughs that this novel database design provides.

The designer of the first blockchain—Satoshi Nakamoto—created a system that birthed a significant new possibility into the world: the ability to have a distributed database that is controlled by no individual party but maintains a verifiable public record of “the truth.” This breakthrough allowed money and other items of value to move onto the internet in a native fash­ion for the first time and created the possibility of digital scarcity, programmable money, and the rapid settlement of financial transactions between any two parties without the need for a trusted intermediary.

Making this leap introduced trade-offs. Blockchain databases are not as fast as tradi­tional databases, they do not scale as well, they are more challenging to regulate, AML and KYC protections are difficult to enforce, system upgrades and payment protections are chal­lenging to implement, and so on. And as with any new technology, the introduction of block­chains and cryptoassets to the world has been messy, with instances of fraud, overexuberance, scams, and criminal activity.

Despite these drawbacks, the space has grown by leaps and bounds. For early-adopter inves­tors, cryptoassets have been a boon, providing a rare and impactful combination of high returns, low correlations with other assets, and intraday liquidity. Even a small allocation to crypto has had a significant positive impact on portfolio returns.

As we march further into the second decade of crypto’s existence, the question becomes, What should we watch for on the horizon?

Will the incredible investment that has occurred in crypto infrastructure—including the devel­opment of regulated custodians, the launch of regulated futures contracts, and the creation of cryptoasset funds—turn crypto into a popular allocation in institutional portfolios?

Will cryptoasset-powered blockchains continue to penetrate their unique use cases, whether that is digital gold, decentralized finance, pay­ments, or other areas?

Will the accommodative stance of regulators continue to progress and develop?

Perhaps most importantly for investors, will crypto’s historical pattern of returns persist into the future, or will returns flatten or even reverse?

These are the questions investors and observ­ers must wrestle with in the years to come. We hope that this document has provided a founda­tion and a framework for doing that. One thing is for certain: The emergence of a new asset class and financial ecosystem is a rare event, and the potential for cryptoasset-pow­ered blockchains to move the world forward is exciting.

Sources:

Cryptoassets: The guide to bitcoin, blockchain and cryptocurrency for professionals. CFA Institute Research Foundation.