Cryptocurrency: Not Physical Gold, But Maybe Digital Gold?

Oct. 22, 2021, 7:00 AM

It is a safe statement to make that many financial institutions have in recent years been torn as to whether cryptocurrencies are an asset class. This is unsurprising as, over time, cryptocurrency went from being widely seen as a conduit for money laundering to becoming a serious proposition for investors.

It is not just novices that have got caught up in the cryptocurrency hype—large established companies such as PayPal have in turn dabbled with the digital currency as a genuine form of payment.

Major banks have also been rushing to set up crypto-related operations recently, with Morgan Stanley and Bank of America establishing crypto-focused research divisions. State Street announced the launch of a dedicated digital finance division, and JP Morgan and Goldman Sachs are also rolling out crypto trading services.

Our Understanding of a Traditional Asset Has Changed

An asset is anything of value or a resource of value that can be converted into cash. Traditionally, an asset can often generate cashflows: stocks provide dividends, bonds provide coupons, loans provide interest. However, there are assets that do not really produce cashflows but are still considered as an important asset class—gold, wine, and art are some examples. Gold has long been considered an important asset class. It has very limited industrial usage and does not really generate cashflows; it is only collective thinking that gold is valuable that makes it so.

In fact, this also applies to any fiat currency. After all, money is only a credit that a currency’s user gives to the issuer. For a currency to thrive, trust is the most important factor. The issuers of fiat currencies are sovereign entities which are deemed to be the most trustworthy. If there is a currency or economic crisis that means the people do not trust the government, the value of the fiat currency will drop significantly.

So an asset’s value will depend on the collective belief and trust of the people dealing with it. This is still an early stage to conclude that investors believe and trust in the value of cryptocurrency, but the trend is definitively positive.

Throughout the course of history, we have become accustomed to recognizing “traditional” asset classes. Many investors regard cash and equivalents, bonds, and stocks as conventional financial investing’s big three.

However, since the rise to prominence of cryptocurrency—a decentralized means of digital currency—many have started to question whether cryptocurrency should be regarded as an asset class.

This debate is as important as ever as legislators and policymakers ponder taxing cryptocurrency in line with other assets.

Jumping on the Crypto Bandwagon

It does not take too much research to see that small to medium-sized enterprises, family-run businesses, corporates, asset managers and more, are all investing in the crypto market. There is, however, the hurdle of learning new terminologies and understanding a new process. This can seem daunting, and is certainly a barrier to entry for some. However, this is not a reason to ignore what could potentially be an immensely fruitful asset pot.

Professionals must now start to change their perspective on cryptocurrency, particularly in relation to what institutional investors consider to be an asset class, and adapt processes to enable investors to deal with cryptocurrency more effectively. Gone are the days of solely dealing with traditional assets.

There are an enormous number of crypto assets now available and certainly the Covid-19 pandemic appears to have played a key role in driving increasing demand from both retail and institutional investors.

Scarcity Increases the Value of an Asset

It is not a secret that Bitcoin is the most valued—and thereby attractive—cryptocurrency on the market. Experts have largely credited this to its scarcity. Bitcoin in particular benefits from investor confidence because of its snowballing popularity. Just as people in society believe in the value of diamonds because others believe in it, cryptocurrency shares this artificial value.

This further accentuates the power of supply and demand to dictate price. As hype is artificially created as a societal construct, it causes people to jump on the bandwagon. Combining this with our tendency to want what we cannot have, it is only to be expected that the price of Bitcoin is so high.

Bitcoin was the first scarce digital asset ever created. Imagine that—a digital product with a fixed total supply of 21 million coins. Societies have always based the value of a currency on this concept of scarcity, which is why precious metals have been the backbone of many economies for centuries.

Bitcoin supply had low inflation built in from day one. To ensure that the issuance of Bitcoin would eventually cease completely, its creator Satoshi Nakamoto encoded a mechanism to halve Bitcoin’s mining reward roughly every four years. This is the mechanism that is key to Bitcoin’s value as it ensures that the Bitcoin supply will never exceed 21 million Bitcoin. Therefore, for new coins to come into circulation, Bitcoin’s new supply is cut in half every four years through a “halving” mechanism, until all 21 million coins are mined.

As a result, it is estimated that only 18 million coins have been mined to date. Of those, it is believed that 5 million are technically lost, 10 million stored in long-term cold storage, and close to 3 million are on exchanges.

The growth in the number of cryptocurrencies is changing all of this, and the faith placed in them by investors is driving confidence in them as an asset class. If investors continue to believe in the value of gold because others believe in it, it will remain an asset. The difference between cryptocurrencies today and gold in the past is therefore minimal.

But what is driving that faith, and what is underpinning the huge increases in the value of cryptocurrencies? Well, maybe it has less to do with the currency itself and more to do with its ability to store value in relation to other asset classes. Widespread social adoption, together with their privacy, security and transferability, makes cryptocurrencies an important asset class to store values.

A look back at recent history may explain this. Since 2008 and the unleashing of quantitative easing, there has been an undoubted period of price inflation, and yet if we look at the balance sheets of many central banks one point stands out—global currencies have depreciated.

Valuing an Intangible and Totally Invisible Asset

Cryptocurrencies do not follow the same rules as fiat currencies, or even secured assets; instead,, matters tend to get complicated. Given that a cryptocurrency does not generate or support cashflow, it needs to be valued against potential and—critically—future prices. That then opens the door to several different valuation methods and guess what—our old friend gold is back. Among the differing valuation models now available—the stock-to-flow method, institutional participation method, and high-net-worth participation method—we find the gold valuation method.

But let’s not forget this is a new asset class, so we would expect investors will consider a range of valuation methodologies to estimate future value. This is, however, not risk free. It is a new asset class, and one that does not exist physically. It is not gold, as we have repeatedly said. Risks do exist and they are well known, and some would argue, substantial. We are therefore firm believers that the financial industry needs to address—and support—government initiatives around regulation.

But this is not the only risk associated with cryptocurrencies. Swings in the wider macroeconomic environment, risk associated with the technology backbone—everything from electricity supply to bad faith actors—and even an ever-more vocal and powerful economic, social, and corporate governance framework (ESG as it is known)—all add to the potential risk for crypto as an asset class in its own right.

El Salvador recently became the first country in the world to adopt Bitcoin as its national currency, allowing people to use a digital wallet to pay for everyday goods. Many countries are considering issuing their own central bank digital currencies. All these developments tell of cryptocurrencies’ future potential in line with an asset class.

Is Crypto the New Gold Rush?

The key questions remain: Should institutional investors dive in, and is this in fact a dedicated new asset class?

The primary reason why some do not regard cryptocurrency as an asset class is because of its unclear regulatory environment and high volatility. However, more and more institutional investors use cryptocurrencies to hedge against inflation and currency debasement, and to diversify their portfolios in the pursuit of higher risk-adjusted returns. Over time, institutional investors have been more inclined to consider cryptocurrency as new asset class

As we have mentioned, Bitcoin is the most famous, most written-about and also the most volatile of the many cryptocurrencies now on the market. Given the number of methodologies available to value not only Bitcoin but all digital assets, if anything, institutional interest is only just beginning.

This is, without doubt, a new asset class and one that will increasingly gain acceptance and the participation of institutional investors as time goes on.

It may not be physical gold, but it could very well be digital gold.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

William Je is CEO of Hamilton Investment Management Ltd.

The author may be contacted at: william.je@hamilton-im.com

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