The rise of digital currency

It seems that barely a week has passed this year without cryptocurrencies stealing the headlines in some way. Their valuations have garnered particular attention since they soared to record highs in early 2021 – but they have also experienced some notable periods of market volatility. A number of individuals have profited as a result.

What’s more, certain developments have seemed to suggest that digital currencies might finally be entering the mainstream. In February 2021, electric car maker Tesla revealed that it had bought $1.5 billion worth of Bitcoin. Two months later, US cryptocurrency exchange platform Coinbase listed on the Nasdaq stock market, with a valuation of $75.9 billion. Some of the world’s largest financial institutions, including Citi, Goldman Sachs and Morgan Stanley have either already introduced, or are looking to introduce, cryptocurrency-related services in response to growing client interest.

Cryptocurrencies offer investors the potential to make big gains – and losses – fast. They are also intriguing because of their trailblazing and enigmatic history. Bitcoin, generally considered to be the original cryptocurrency, was intended to democratise the global financial system. In theory, it was invented by Satoshi Nakamoto, a Japanese computer programmer, but no one has ever seen him in public. In fact, no one has heard from him at all in more than a decade. The name Satoshi Nakamoto is widely believed to be a pseudonym for another programmer, or group of programmers, not necessarily of Japanese descent.

Buyer beware

While cryptocurrencies may seem appealing, the risks of investing in them were starkly highlighted in May 2021 when Andrew Bailey, Governor of the Bank of England, warned that they have “no intrinsic value”. He stated that anyone who invests in cryptocurrencies should be prepared to lose all their money. Investor Warren Buffett has previously denounced Bitcoin as “probably rat poison squared”.

Policymakers and regulators are also paying close attention to cryptocurrencies due to their association with money laundering and terrorism financing. If rules around the currencies are tightened, that could damage their future popularity – and therefore their value to investors.

In recognition of the growing popularity of cryptocurrencies, we have considered at length whether to include them in our investment portfolios. As we are prudent investors, our investment process incorporates strict examination and analysis of any investment opportunity, before we would consider it for inclusion in our investment portfolios. We therefore decided that we would not invest in any cryptocurrencies on the grounds that we cannot find a methodology, using fundamental analysis, to properly value them in the way that other assets can be valued.

Furthermore, cryptocurrencies have very poor environmental credentials. The process of generating Bitcoin, for example, currently consumes nearly as much electricity as Argentina. We do, however, consider investment opportunities in US and UK software firms that develop the technology underpinning cryptocurrencies – this is the virtual ledger technology known as ‘blockchain’.

The case for blockchain

A blockchain is a digital ledger of transactions that is duplicated and distributed across a computer network. Benefits of blockchain technology include speed, security, traceability and transparency. As such, it can potentially be used for a wide range of purposes that extend well beyond cryptocurrencies. These include financial transactions, insurance contracts, real estate, voting and even selling art.

“Companies that develop blockchain technology can be valued, analysed and researched in the same way that a pharmaceutical company, industrial company or bank could be valued.”
Robert Alster, Chief Investment Officer

Additionally, the Bank of England and other central banks around the world are looking to launch their own digital currencies, known as central bank digital currencies. These currencies would be denominated in the same way as existing banknotes and coins, and they would be used alongside, rather than instead of, physical currencies. The UK’s proposed digital currency, which would be issued by the Bank of England and used by both households and businesses, has already been dubbed ‘Britcoin’. Central bank digital currencies will almost certainly rely on virtual ledgers, such as blockchain, because of the high level of security that they provide.

Alster says that blockchain and other virtual ledger technologies do not inherently have the same negative environmental impact as cryptocurrencies.

“Blockchain technology in itself doesn’t involve the mining of cryptocurrencies or the huge computing power and electricity consumption required to generate the next line of Bitcoin. I’d expect them to have the same carbon footprint as any other technology company.”
Robert Alster, Chief Investment Officer

Where next?

Looking to the future, Alster believes that digital currencies will continue to grow in popularity, especially once central bank digital currencies are launched. At the same time, he argues that blockchain will be used by a wide range of sectors that want to settle transactions securely, or provide a transparent view of asset ownership.

Certainly, there’s plenty of enthusiasm for blockchain in the world – enthusiasm that appears to be very well founded. In his book, The Evolution of Everything: How New Ideas Emerge, respected science writer Matt Ridley says: “The ‘blockchain’ technology behind Bitcoin could prove to be an ingredient of an entire new world of technology, as big as the internet itself.”

 

A brief history of cryptocurrencies

• 2008 - Satoshi Nakamoto, a mysterious Japanese computer programmer, publishes a paper called Bitcoin: A Peer-to-Peer Electronic Cash System. This paper sets out a vision for an online payments system that bypasses financial institutions.
• 2009 - The first Bitcoin transaction occurs when Nakamoto makes a transfer to another programmer.
• 2011 - Rival cryptocurrencies, including Litecoin, Namecoin and Swiftcoin, start to emerge. Nakamoto sends his last message to other developers, saying he has moved on to other projects.
• 2012 - Cryptocurrency exchange platform Coinbase is founded. It grows to become the largest cryptocurrency exchange in the US by trading volume.
• 2014 - Microsoft starts accepting payments made with bitcoin for Xbox games and Windows phone apps.
• 2015 - A new cryptocurrency, Ethereum, goes live with an initial supply of 72 million coins.
• 2016 - Swiss national railway system SBB announces that it will start selling Bitcoin through its ticket kiosks.
• 2018 - A crash in the value of cryptocurrencies leads to the price of Bitcoin falling by 65% within the space of a month.
• 2020 - Online payment services provider PayPal allows its customers to buy and sell virtual currencies using their PayPal accounts.
• 2021 - In April 2021, the total market capitalisation of cryptocurrencies surpasses $2 trillion for the first time. A month later, a massive crash wipes $1 trillion off their market value, with the price of Bitcoin plummeting by 30% in just one day.

 

Important information

The information contained in this document is believed to be correct but cannot be guaranteed. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall as well as rise and is not guaranteed. An investor may not get back the original amount invested. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Where links to third party websites are provided, Close Brothers Asset Management accepts no responsibility for the content of such websites nor the services, products or items offered through such websites.