Digital Assets - Understanding Digital (Crypto) Currencies
The rise of digital assets over the past few years will not have escaped anybody. Indeed, barely a week has passed without a news report covering bitcoin’s most recent surge in price to levels deemed absurd by all but the most ardent supporters. This is a new world that is little understood by most who do not operate within it. It is also, though, almost certainly going to become an important part of our future as the world continues towards full digitalisation.
Cryptocurrencies were created to achieve a number of outcomes and change the core concepts of how we exchange money. They are separated from traditional centralised institutions (central banks/retail banks/governments) and are thus decentralised, regulated only by their private communities. Guidelines and regulations for cryptocurrencies are based on a group of people and computers that ensure the transparency and safety of the transactions in the network.
This also feeds into the anti-government stance as crypto communities avoid a central regulator dealing with their transactions. Indeed, transactions cannot be cancelled nor frozen upon any government request even if there is suspicion of illegal activities such as fraud and money-laundering.
This also presents one of the main reasons sceptics have used to argue against such assets and is often used to explain the rapid rise in prices, being that a large proportion of trading in crypto assets is for the purpose of illegal activity.
Cryptocurrencies do not require legal identification for buying and investing. However, transactions are trackable as they are registered with a public (and private) key number, but the real-world identity of buyers and sellers remains anonymous. This advantage to the buyer/seller is a major disadvantage to those wishing to better police activities within the crypto markets and remains one of the biggest challenges to overcome in the wider acceptance and usage of cryptocurrencies.
The case for institutional involvement in crypto assets has been made largely based on assets such as bitcoin becoming a digital alternative to gold. This concept has gained traction particularly since the COVID-19 crisis began in early 2020. Crypto enthusiasts have argued that most major fiat currencies (for example the British Pound and US Dollar) are being damaged and devalued over the long haul because of plentiful global liquidity, unprecedented fiscal deficits, and soaring public sector debt ratios.
It is claimed that digital currencies can offer a hedge against uncertainty, currency debasement and/or hyper-inflation, similar to arguments made in favour of gold. There is little evidence to support this hypothesis though, with prices of cryptocurrencies gyrating wildly, with big booms and busts, and often with a high correlation to investor risk sentiment, which would suggest cryptocurrencies such as bitcoin are better defined as ‘risk assets.’
Several central banks are currently working on their own digital currencies based on a similar form of blockchain-based technology that existing crypto assets are built on the blockchain or similar. This of course raises questions of quite how a centralised version of a decentralised concept would work! Most are in the research phase, with the ECB most recently announcing they will explore the concept of a digital Euro to potentially be introduced in the next few years. Many challenges remain, however, before such a step could be taken. Part of the ECB’s research will be to determine if the introduction of a digital Euro would be safe, with the authorities able to stop criminal activities and regulate appropriately. Another important consideration is the impact digital fiat currencies would have on the traditional banking system, which would lose significant revenue without the business of ledgering currency transactions.
The growing demand for online transactions has created the imperative for secure and effective cash transfer networks, setting the stage for the ongoing evolution of digital currencies. Increasing use of e-transactions has meant that the use of physical cash has been steadily declining in recent decades, with the pace picking up notably since the pandemic erupted.
Some variation of blockchain technology will most likely persist with or without the cryptocurrencies in existence today, with the market saturated with cryptos that were deliberate jokes, such as dogecoin. This popularity is impressive, as have been the returns for those who’ve invested, but crypto assets do not yet have a long-term, reliable, or credible track record. It is for this reason that global regulators, such as the FCA here in the UK, have so far not deemed cryptocurrencies appropriate for retail clients, and have even gone so far as to ban the buying of such assets in pension plans.
A&J therefore will not pursue any direct investment in this area until such time as the regulators deem it safe. We may still gain secondary exposure via some of our fund investments, though. Funds such as Baillie Gifford American have previously looked at companies with exposure to crypto and the blockchain but have stayed away from investing at present due to the uncertainty in the market and wild price swings. That institutions such as this are taking this new asset class seriously enough to even look at is a hugely positive step for the longer-term, broader acceptance of cryptocurrencies. For now at least, crypto assets remain highly volatile, largely unregulated, less accessible, reliable, and liquid compared to fiat currencies. It could well be another several years yet before the use of cryptocurrencies becomes more ‘normal’.
General Information The opinions expressed in this update are those of A&J Wealth Management Limited only, as at 7th September 2021, and are subject to change.
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