Cryptocurrencies - a wild west industry?

The Treasury Select committee1 recently described BitCoin and other digital currencies as a “Wild West Industry” and called for the regulator to have greater oversight and influence. This latest reminder helps to underline the decision in July by Brown Shipley’s Investment Policy Committee that “Crypto-Assets” have no place in a well-managed, risk targeted investment portfolio.

Between July 2010 and the peak of the market last year (16 December 2017) the value of one BitCoin increased by 32 million per cent2. In cash that means £1 would be worth around £322,238. It has since fallen almost 70%.

The rise and fall of digital currencies has generated plenty of column inches already but given the continuing media buzz in this area we wanted to expand on our thinking and also demonstrate that we do not discount any ideas without serious consideration. For simplicity we will focus on BitCoin but almost all of the issues discussed below are shared (or more pronounced) with the ever growing menagerie of digital currency alternatives.

Is BitCoin an alternative to Real Money?

This is the most obvious route to credibility and was almost certainly the intention of the mysterious creator Satoshi Nakamoto who included the following quote from the Times in the very first block of the block chain (the so called genesis block) “03/Jan/2009 Chancellor on brink of second bailout for banks3. A bailout funded by Central Bank money printing of course. The desire to have money that is free from central bank control continues to be the principal reason for Cryptocurrencies in the eyes of many evangelists. Unfortunately BitCoin fails on some of the fundamental properties required for a reliable currency. Perhaps most crucially it is not a particularly useful medium of exchange, as most of the world's retailers do not accept it as a form of payment. In fact Morgan Stanley estimated the number of companies adopting BitCoin payment is falling4.

So if BitCoin fails as a currency, should we consider it an asset? In theory anything anybody is willing to buy is an asset. Assuming there is no benefit to holding the asset, like some form of income (which there isn’t), this is simply a judgement on whether you will be able to store your asset (usually at a cost) and ultimately sell it to somebody else in the future. This dynamic has drawn comparisons with commodities, particularly Gold, which exhibits this type of market. Here we encounter another series of problems:

  1. Liquidity. BitCoin is still a difficult to trade. The market is highly fragmented and although the global daily volume traded is estimated to be $2bn-$5bn the largest exchange has less than a quarter of deals, and there are easily over 100 alternatives5. Some of the biggest exchanges have also been accused of faking up to 90% of their trades which could easily knock $2bn off that total figure if true6.

  2.  Security. Recent history is littered with thefts and scandals (see the box below). Currently the safest storage method (a “cold wallet”) is the equivalent of writing your password on a post-it note and putting it in your drawer. This means the private key(s) to your BitCoin(s) (essentially a password) is stored digitally offline. This is because “hot wallets” stored online are ultimately hackable and if you lose your key then you can never get it back, just ask the unfortunate souls who threw away hard-drives containing hundreds of millions of pounds of BitCoin keys.

    Major thefts involving BitCoin - 2012 – 20177
    December 2017, NiceHash, a marketplace for crypto-mining reported $63 million worth of BitCoin stolen
    November 2017, $31 million worth of tether tokens reported stolen and converted to BitCoins
    April 2017, 4,000 BitCoins stolen from the YouBit exchange in April
    August 2016, about $65 million worth of BitCoin stolen in the Bitfinex hack
    May 2016, $2 million worth of BitCoin and ether stolen from the Gatecoin exchange
    January 2015, $5 million worth of BitCoin stolen from the Bitstamp exchange
    February 2014, the Mt. Gox exchange reports $480 million worth of BitCoin missing
    September 2012, the BitFloor exchange reported about $250,000 worth of BitCoin stolen.

  3. Regulation. Part of the security risk stems from a lack of control and while nations around the world have taken different approaches (exchanges are banned entirely in China), recognition from central banks would come with regulation and “rules” and that would undermine one of the fundamental drivers of demand.

  4.  Social. When the FBI shut down the darkweb drug market place known as Silk Road in 2013 they seized 144,000 BitCoins (worth over $800m in today’s money2). When the “WannaCry” ransomware attack shut down some NHS services last year the ransom was demanded in BitCoin. The unfortunate fact is that the meteoric rise in BitCoin value made a lot of criminals a lot of money. While this is hardly the fault of good intentioned BitCoin “investors” the willingness to exchange hard currencies for BitCoins also facilitates the conversion of ill-gotten coins into real world assets.

  5.  Environmental. The increasingly concerning issue is the environmental impact. As the calculations required to maintain the Blockchain become ever more complex so too do the “mining” operations powering them. There are now vast warehouses filled with energy hungry computers doing nothing but converting megawatt hours into BitCoins. The estimates as to the energy used vary wildly but it almost certainly measured in the magnitude of average size US cities8.

What about the technology itself? Well that is a different story. The distributed ledger system that Blockchain has pioneered offers a whole range of potential uses, not least in the asset management industry. Indeed many major global businesses are already experimenting with this technology.

At Brown Shipley we are aware of the potential these innovations may present but we just believe we can capture it through our existing research processes, whether that be via specialist Technology funds who are on the ground in the silicon valley, through private equity who provide the venture capital for exciting new projects or even via large cap equities who will benefit from the efficiencies and savings that this technology can provide. So while we acknowledge the exciting developments that the cryptocurrency bubble has generated the digital coins themselves are not the way to gain exposure. We will continue to monitor developments in this area but for the near term at least Cryptocurrencies will stay in the realm of the speculator.

Alex Brandreth

Deputy Chief Investment Officer









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