Is Bitcoin or any other crypto a good investment?

01 May 2018

By Daniele Bianchi

Unless you have been living in a cave you could not have missed ‘Bitcoin mania’ sweeping the world in 2017 as its price rocketed 500 per cent.

Trading in the cryptocurrency reached such a frenzy one day in December that the price of Bitcoin surged $2,000 on Coinbase, the most popular trading exchange for cryptocurrencies, to reach $19,000 for one Bitcoin only to drop to $15,000 by the close of business.

The frenzy even saw people taking out mortgages to buy Bitcoin. Demand left some trading exchanges struggling to cope as the hype about this new currency grew.

Is it a bubble? Well yes, Bitcoin saw 40 per cent of its value wiped off in a week at the end of March 2018, but was that the bubble popping? It is hard to tell, but this is no normal asset class. In fact investing in Bitcoin is more like investing in a technology start-up, akin to the dot-com bubble at the end of the 1990s.

Bitcoin was the first cryptocurrency, invented by the real or imagined Satoshi Nakamoto and released onto the web via open source software in 2009. It is a peer-to-peer currency, that uses blockchain technology - a digital shared ledger that logs sales at the same time across multiple sites - to do away with the need of a central bank.

It may have started out as a currency, but it has quickly been copied with more than 1,500 in existence now and that number is growing all the time. It is seen more now as an investment, but as my research has found Bitcoin is like no other asset class and my advice would be not to invest, at least any serious money, in it.

My research looked at 14 of the biggest cryptocurrencies, including Bitcoin, from April 2016 to September 2017. Despite the vast number of cryptocurrencies being produced I found transactions in Bitcoin made up almost 80 per cent of the overall traded volume before early 2016, then declined to about 40 per cent by September 2017.

Indeed by September 2017 the market capitalisation of Bitcoin and Ethereum - a cryptocurrency using smart contracts and also a platform to launch Initial Coin Offerings (ICOs) - alone was about $65 billion and $28 billion, respectively.

This is the size of a large cap stock in the US, yet the end-of-sample median market capitalisation across the 14 cryptocurrencies, which made up 85 per cent of the total market capitalisation of cryptos, was about $850 million, which is more the size of a small cap stock. 

Bitcoin rules: Bitcoin's market capitalisation (left) and its average traded volume (right) as fractions of the total market

I compared the cryptos with standard asset classes, like corporate bonds, equities, treasuries and commodities. The only thing that is slightly related is gold and everything else is uncorrelated.

But are they a store of value? Probably not as they are just too volatile. The only correlation to gold is that when there is a positive price change  there is a positive move in Bitcoin, but the relationship is very low, only moving together to some extent.

Gold is seen as a safe haven but cryptos can no way be seen as that, not in the short, long or medium term despite what some investors tell you. Predictions of Bitcoin rising to $30,000 are not based on any evidence, it is pure speculation.

Should Bitcoin be used as a hedge?

Is Bitcoin a good hedge? No, because it is not correlated with anything else, typically a hedge should be negatively correlated with your position. For now, they are just a risky investment. To use it as a hedge would be crazy to me.

Cryptos are uncorrelated with the fundamentals of a market economy. So you might think you have an exposure to the UK stockmarket and you will buy Bitcoin because it is unrelated, but it is not negatively correlated - it is not correlated to anything - that is not a hedge, it’s another risk. It is very difficult to predict where it is going in terms of price, in the short term especially.

I tried to see if it was related to economic fundamentals, like inflation expectation or interest rates, but I found there is no relationship. Demand is essentially driven by past prices; that is people invest in it because they see the price going up and put momentum into it, which is why bubbles exist, though it is a rational bubble.

Red alert: Bitcoin was bought almost totally by Chinese Yuan until 2017

The data showed that the majority of the currency used to buy Bitcoin was Chinese Yuan, and in 2016 the majority of the miners - the computing process where transactions are added to the blockchain and new Bitcoins created - were in China, until the crackdown of the Chinese Government.

Rational investors will stay clear of it, the people investing in this are essentially retail investors and hedge funds. Regular pensions or mutual funds are so regulated they can’t invest in it, but small hedge funds, who are completely opaque, they can do what they want. They can take the risks and that is part of their attraction, taking big bets for big returns. It is a way of making some money quickly.

CME Group and Cboe Global Markets, large US financial market companies operating in options and futures exchanges, have opened futures exchanges for Bitcoin, but I think they are cashing in on the hype. I am pretty sure it will be a blood bath as there is no way of predicting the price, but with a market capitalisation of a few billion dollars Bitcoin is very lucrative for CME and Cboe.

Which cryptocurrency will be the Amazon of the future?

Having said all this, I think there is value in the underlying technology of some of the cryptocurrencies, like Ethereum. If you look at Amazon, at the beginning before the dot-com bubble burst, Amazon went from $25 to $100 and back to $25 when the bubble popped, but now it is around $1,400.

As soon as the technology was fixed and the flaws ironed out, it became popular and its value grew. I wouldn’t be surprised if the same thing happens for cryptos, as soon as the problems have been fixed and the bad press dies away - because there are a lot of scams going on - it can happen again.

Bitcoin is supposed to be this peer-to-peer payment system, which is falling apart because people have realised it is slow and very expensive. It is the same with Ethereum, everybody was excited about its smart contract technology - a computerised verification process of contracts that eliminates the need for third parties - but people have found it is full of holes in the code.

If these technologies are fixed there is a good chance prices will climb up again, but that is a big if. Central banks like the Bank of England and financial services companies in particular are very wary of cryptocurrencies and from their perspective you can see why.

A large fraction of the ICOs are scams. Up to a year ago it was just a matter of having a nice website, a clean white paper and you could raise £2 million, but to do what? If you lose all the money there are no questions asked.

It was the Wild West, but now it is maturing, with professional people moving into the marketplace so you have to be careful. Indeed, there are now websites that give ratings and rankings on the ICOs like Morningstar does for mutual funds. It is probably why prices are collapsing, because it is stabilising a bit.

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Also the many exchanges will be attracting high frequency traders - computers automatically trading assets, typically stocks, in fractions of a second - who are taking advantage of arbitrage. If you look at the bid-ask spread - the amount by which the ask price exceeds the bid price in a market - some exchanges’ are big and some are small depending on the liquidity of the exchange, so then you can arbitrage, that is buy in one and sell in another.

I think it is very possible ‘algo-traders’ are moving in, you already have python codes for it available to download and ideally it could help provide efficiency in the price of cryptocurrencies in the future, smoothing out the volatility somewhat.

Another concern for banks, though, is that the underlying technology could see them bypassed. If you don’t need any more financial intermediaries, J.P. Morgan and the like would lose everything, and if you take monetary policies away from central banks what do they have left?

So they have been predictably critical, but I know for a fact that the UK Government is looking at the blockchain technology to solve the productivity puzzle and to move the economy forward after Brexit. There is real interest in this technology and from many areas.

Blockchain can be used in supply chain management, insurance, and even ridding the world of plastic waste. With supply chain management, for example, you can track food from where it has come from, so if there is some health problem you can find where it has come from instantly and shut down that supplier.

But the one crypto I think with most potential is Ethereum because of its smart contract technology, there is some fundamental value behind it. It can be used in other areas, like derivatives, property contracts, financial services, legal processes and just about anything involving a contract.

Cryptocurrencies are a very risky investment and I don’t think anybody can say the opposite. It is going to be like the dot-com bubble with a crash and a few winners emerging from the wreckage. But at the moment it is very difficult to see who will be the Amazons of the cryptocurrency craze.

Daniele Bianchi is Assistant Professor of Finance and teaches Empirical Finance on the MSc Finance.

Follow Daniele Bianchi on Twitter @WhitesPhD.

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