Cryptocurrency Asset Pricing and it’s Minimal Institutional Utility

 

On October 31st, 2008, Satoshi Nakamoto published his design paper outlining the fundamental principles of a decentralized peer-to-peer electronic cash system known today as Bitcoin[i]. It’s difficult to say whether or not future asset pricing courses will feature this paper as a segway into material with the same distinction professors of today’s courses introduce Harry Markowitz’s modern portfolio theory.  However, the document served as the effective birth certificate of an idea that in under 10 years grew to lay the foundation to a new class of assets with a current market capitalization of $154 Billion[ii].

The cryptocurrency had initially faced heavy scrutiny from all major financials institutions, and media outlets labeled a mere trend with a grim prognosis – nobody worth their Wallstreet credibility even thought of considering the currency could one day hold its own weight in their portfolio. There would be no quantitative easing, no borrowing, no authority to legislate the monetary transactions, or to back the currency in conventional ways that any other asset is insured[iii]. The currency ultimately was considered a “storage of speculative value”, where users (investors) held the currency for its hyped deflationary value rather than used it[iv]. Of course, at the time there was a very limited way in which the currency could be spent by the average user. The Economist quoted in 2011 (16/7/2011, BTC = $13.62)

“As wild swings in their dollar price have demonstrated, [Bitcoin] is young and illiquid—only 6.5m units are currently in circulation among some 10,000 users (including several hundred merchants who accept payment in Bitcoins).  Attracting enough users to smooth such volatility seems unlikely in the foreseeable future.” [v]

Currently, there are more than 16 million user wallets in existence, and although it is impossible to gauge the amount of unique users, an individual may hold more than a single wallet, estimates lie in the millions[vi]. Furthermore, there is now an estimated number of 46,000 merchants including industry giants such as Microsoft, Paypal, and DISH Network[vii] [viii].

 

So, what has the growth of cryptocurrency meant to institutional investors?

Bitcoin dominated for years in the cryptocurrency market facing practically no competition as individuals still tried to understand the concept and application of cryptocurrency. Early investors in the cryptocurrency market were stuck with a single asset with no chance for diversification. The asset was governed merely by circumstantial news reports, economists’ predictions and criticism, and wild speculations[ix]. The standard deviation of Bitcoin’s price in 2013 peaked at 14.59% – enough to send M.A. Rothschild spinning in his grave. Not only had it presented itself to public as a unique case of a virtual currency walking on the threshold of crashing, but also as an asset that was eight times more volatile than the S&P 500[x].

The high volatility has since subsided to much more moderate (5.41% – 60 days[xi]) – yet, still high – rate, which generally should warrant additional attention from financial institutions. Another factor that has since brought utility to many cryptocurrency traders is the rapid inception of even more cryptocurrencies in the market.

Cryptocurrency Market Capitalization

While Bitcoin remains the industry leader, with 45.8% market capitalization, Ethereum, and Ripple have both become key players in the cryptocurrency market amongst more than 900 in existence and circulation[xii]. Ultimately this prompts curious investors with a very difficult capital allocation decision, should they decide to invest in cryptocurrency, and an even more difficult security selection decision when they begin choosing which currencies they wish to include in their portfolios. Despite the contrasting expansive list

of cryptocurrencies – today, investors must realize that this does not insinuate a reasonable margin for diversification, especially on the institutional level.

The high Beta associated with most crypto-assets leaves no space for conventional passive investors or corporations, even while every average cryptocurrency investor dreams of making the next highly volatile trade. After all, one of the factors that contributed to Bitcoins recent upwards trend was the mere idea of breaking the $4000 speculative barrier set by economists, and trying to capture the opportunity to exponentially increase their initial investment. Many early traders of the cryptocurrency have made profits exceeding comprehendible trading norms, one of which is rumored to be Mr. Nakamoto – himself, who is claimed to own 5% of circulating Bitcoins; an estimated $3.5 billion[xiii].

 

Technical analysis aside, cryptocurrency continues to gain popularity with individuals that trade at lower volumes and remain less risk averse. This has led to many social trading platforms, and online brokerages to list several cryptocurrencies along with other traditional FOREX instruments allowing users to diversify according to their own intuition without holding a wallet on a different exchange. Most recently, social trading platform, eToro released a Crypto CopyFund[xiv]; a hedge fund-like platform that allows users to invest in a diversified crypto portfolio. Time and the price discovery process will tell the fate of sustainability for such funds and other cryptocurrencies, however it is without doubt that cryptocurrencies can no longer be ignored and must be respected as instruments of the global economic market.

 

 

Sources below.

[i] https://bitcoin.org/bitcoin.pdf

[ii] https://coinmarketcap.com/all/views/all/

[iii] http://www.economist.com/node/21563752

[iv] https://www.theatlantic.com/technology/archive/2013/04/todays-bitcoin-crash-shows-why-its-not-really-currency/316407/

[v] http://www.economist.com/node/18836780

[vi] https://blockchain.info/charts/my-wallet-n-users

[vii] http://www.businessinsider.com/5-big-companies-that-currently-accept-bitcoin-2017-7/#overstockcom-1

[viii] https://www.coinbase.com/clients?locale=en

[ix] http://cs.stanford.edu/people/eroberts/cs201/projects/2010-

[x] https://www.buybitcoinworldwide.com/volatility-index/

[xi] https://www.buybitcoinworldwide.com/volatility-index/

[xii] https://coin.dance/stats/marketcaphistorical

[xiii] http://fortune.com/2017/05/30/bitcoin-biggest-investors/

[xiv] http://www.newsbtc.com/2017/08/03/success-stories-etoro-crypto-copyfund-investors-safe-cryptocurrency-investment/

 

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