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Cryptocurrencies: a complicated risk

For financial professionals only

What are they?

Cryptocurrencies is the all-encompassing phrase used for a wide range of unregulated, digital investments. Whilst they’re often based on blockchain[1] technology, this isn’t always the case. When you compare different cryptocurrencies, you’ll often find you’re not comparing apples with apples. This is just one of the reasons why cryptocurrencies can be very difficult for both the investment industry and the general public to understand.

Are they a scam?

There’s no doubt there are many outright scams that fall under the term “cryptocurrencies”. The proliferation of such scams is just one of the issues with an unregulated market. Almost any risk that you can imagine in relation to unregulated markets is present and abundant in the cryptocurrency ecosystem, from front-running and spoofing to market manipulation and misrepresentation.

But, are they all scams? In short, no. There are some cryptocurrency projects that provide real-world benefits that take advantage of their unique value proposition to generate sustainable growth and/or income. However, even these projects carry existential[2] risks and volatility far beyond what we are used to from traditional investments. This is captured in the chart below where BTC represents the annualised volatility of Bitcoin. While we’re not making any judgements on whether Bitcoin provides real-world benefits here, we’re simply demonstrating that these instruments can carry significant risks. We also recognise that individual stocks often show greater volatility than an index such as the S&P 500. Over its history Bitcoin has displayed similar levels of volatility as in the chart below, with several periods of sharply increased risk, but in general volatility has fallen slightly over time.

Source: Kaiko.com, 2020 (Accessed 13/08/2021)

Even if we were to become comfortable with these newer forms of investments, and consider it a risk worth taking for the potential benefits, how would we identify the projects with fundamental value? To be honest, this is where it becomes tricky. There’s been very little support from the investment industry to date in this regard. The consensus is that these investments are too complicated for retail investors, and there’s merit to that argument. If the FCA does regulate cryptocurrencies, it shouldn’t come as a surprise if they’re deemed as complex investments. Despite this, in recent years the majority of investment in the space has come from retail investors, which in itself is worrying. Whilst institutional investment has increased over the last year, ongoing retail investment remains significant, as shown below in the chart of Bitcoin purchases.

Source: Coindesk, 2021 (Accessed 13/08/2021)

Health warning

In order to fully understand cryptocurrencies we would recommend strong foundational knowledge in mathematics, economics, computer science and investments before undertaking deep research into the history and developments across the blockchain and cryptocurrency ecosystem. We would also stress the need for utmost caution. Some of the smartest people in the world are working together to make advancements in game theory, cryptography and distributed networks, to name just a few of the disciplines that are harnessed to develop cutting edge cryptocurrencies. It’s hard to keep up, and truth be told, the majority of the investment industry does not have the skill set today to invest or advise on these investments. It’s truly a minefield.

Parmenion’s view

Our solutions only invest directly in regulated products. This means, none of our solutions currently have any direct exposure to cryptocurrencies. We continue to observe the growth of this market, with a mind to monitoring the potential disruptive effect the technology could bring to established industries, the capture of market share relative to assets with similar characteristics (such as gold and inflation linked bonds) and the journey towards regulation if this transpires. This topic is under continual discussion, but any new investment being considered would need to be assessed via our long term risk framework. There are no cryptocurrencies we would consider suitable for direct investments at this time.

[1] How does a blockchain work? https://www.youtube.com/watch?app=desktop&v=SSo_EIwHSd4&ab_channel=SimplyExplained

[2] An investment with existential risks can lose all of its value if those risks transpire. It is a common term for cryptocurrency investments due to the number of ways in which the investments could fail e.g. including uncertain regulatory standing, chain attacks, smart contract risk etc.  Whilst the failure rate of cryptocurrencies is high, it is by no means unique – startups also have a high rate of failure.