The worrying rise of the bitcoin investor…
Is everyone buying bitcoin? Should I? Why aren’t we?
You may be forgiven for thinking that everyone you come across is investing or thinking about investing in cryptocurrency. When an ‘asset’ increases in value significantly, as the most well-known of the cryptocurrencies, Bitcoin has done in 2020, it often becomes the talk of the dinner table and at social events. In the absence of these traditional ‘gossip’ venues, the chat has moved to social media and online forums. A research note published by the FCA in June 2020 suggested that awareness of cryptocurrency had increased significantly from 42% to 73% but that less than 5% of the UK population had invested or thought about investing in it. Of those who did invest, most owned less than £1,000, so although awareness has increased, investment is still small scale.
Ultimately this is what we would expect from a very new, speculative asset. Carbon’s investment team regularly reviews alternative assets classes such as gold, commodities, timber and now cryptocurrency. We ask ourselves some fundamental questions to determine whether an asset class is something we would be comfortable investing in. Given the recent publicity surrounding cryptocurrency, we thought sharing these questions might be insightful. For more information on each of these answers, you can click to reveal a more in-depth explanation:
A: No, it is a very complex asset with multiple elements to it. There are numerous currencies, with new versions entering the market daily. The blockchain technology supporting them is very new and untested too.
- Although we understand that cryptocurrency is a digital or ‘virtual’ currency, secured by cryptography, based on blockchain technology, we are far from comfortable with the definition.
- Bitcoin is mined by cracking a computer algorithm which gets more complex with every bitcoin that is created. This means that super computers are being used to mine the last remaining bitcoins and the balance between the energy/cost to mine it and the value once mined is regularly analysed.
- The secrecy of the blockchain technology is also a cause for concern in trying to define the asset class.
A: No, you are relying on demand or sentiment driving up the price of each ‘coin’ to more than you paid for it. You are not owed a return for the risk of holding it in the same way as traditional assets such as bonds, property or equities, which pay interest, rent or dividends as a reward for your investment.
- With cryptocurrency, or any currency for that matter, you are not owed a return for holding it. It is purely speculative in nature and does not meet our definition of an investment.
- Bitcoin is often likened to gold. Although one is a physical asset and the other is ‘virtual’, they share the feature that neither owes you a return for holding it.
A: Not really. There are still only limited uses as global regulators continue to be extremely cautious about mass adoption of cryptocurrencies. We know they can be used to purchase goods and services, as initial start up fundraising through ‘Initial Coin Offerings’ and to send money to others. The blockchain technology also has some degree of utility as a low cost, instant transaction platform and for online voting. But the technology is still heavily linked to financial crime and many of the legitimate uses are in the embryonic stages of development.
- The links to financial crime are because the transactions are all but anonymous and are not facilitated by a 3rd
party such as a bank or credit company.
- The only information held is very basic, recorded by the blockchain that the transaction was done on.
- It seems that using crypto as cash and buying normal goods and services is a very small part of what it does.
- The blockchain system itself may provide a low-cost alternative to transaction platforms in the future and have uses in crowdfunding and online voting. You may have seen Ashton Kutcher send $4m dollars to Ellen Degeneres’ charity whilst also converting into Rwandan Francs, instantly and at no cost.
- Another use that has been seen is in small company start up funding called ‘Initial Coin Offerings’ or ICOs (an alternative to IPOs). Whilst some of the uses look promising, it is far too early to be comfortable with the role that the currencies and the secure ledger (blockchain) should play in our economic system.
- It would be very difficult to put a value of any significance on these until they have been embedded for a long period of time.
A: Yes, but it doesn’t make us comfortable! News and the resulting market sentiment seem to have a huge impact on price due to the small market size and illiquidity. Changes to regulation and the uses are also likely to significantly affect the price in the future.
- Although there are many uses for cryptocurrencies, much of the price fluctuation seems to be caused by market sentiment following news stories. The relatively small market size and low levels of liquidity add to the lack of regulation in making us nervous. Let’s take these in turn:
- Sentiment: If news and views about bitcoin, which is a small market and has low liquidity, change, this dramatically affects the price. We have seen this both positively and negatively in the past few years. When the price is rising, many people want to try to participate in this upside. Equally, when it is falling, they want out as soon as they can. This suggests a lack of fundamental valuation metrics for cryptocurrencies.
- Market size: Bitcoin market size is c. $350bn but compare this to the world stock market, at $95 trillion, you can see why sentiment and news could be affecting the price so dramatically. If we know that the price is the combined view of all market participants then we would assume that the price could move more dramatically if there are less market participants. Also, these participants are a combination of experienced investors who hold significant chunks of bitcoin along with a high number of new, small investors.
- Low liquidity: Any asset that has liquidity issues may cause investors issues getting their money back due to infrequent valuations and issues finding the cash to pay investors back!
- Regulation: As this is a new asset, it is a hot topic for countries around the world to regulate. China took a very strict stance on crypto assets and other countries are taking their own view. Whenever new regulations are put in place, it limits the freedom and flexibility of the asset, therefore affecting the price. Reducing red tape tends to create liquidity and makes prices more efficient.
A: Some, but not all of them and again, it doesn’t make us comfortable! Potential theft/loss and fraud through online attacks are a significant risk. There is no consumer protection and not having an intermediary means that failed transactions or errors pose significant risks. New regulations limiting use and the possibility of newer technology overtaking existing cryptocurrencies also increase the risk.
- Fraud – Online fraud is increasing and new assets such as cryptocurrency are popular subjects of scams. Due to the opaque nature of the asset, it is easy to offer unrealistic returns and safety to unassuming investors.
- Regulation – Whilst there isn’t a coherent worldwide system for regulating cryptocurrencies, it remains a risk that regulation will shut down one or more of the uses, affecting the price dramatically.
- Theft/loss - An attacker could steal the entire contents if they gained access to their digital wallet (by accessing their private secret key).
- Consumer protection – Basically, there is no consumer protection whatsoever in cryptocurrency transactions. If a transaction fails, or has an error, there is no form of recourse. You would be relying on the recipient returning the transaction to you. Having no intermediary to facilitate the transaction means this risk increases considerably.
- Experimental phase risk – Whilst cryptocurrencies have many potential uses, the experimental nature of the technology carries risk. For example, ICOs will either be proven to be a good way to raise capital for start up businesses or IPOs will remain the best way and ICOs will fall away.
- Technology risks – New and innovative participants to the market will have a dramatic affect on this area of finance. As there are so many new technologies and competitors entering the market each day, investors will not know when their investment is trumped by the next iteration.
A: Most will not, or certainly not with most of their money. Our research shows that the most important parts of a successful long-term plan are understanding where you need to get to (thinking about future spending, bucket list goals), where you are now (digging deeper under the surface to understand your current situation and values) and creating an efficient plan to get you there (considering costs, tax and risk). Within this, a well-diversified investment portfolio based on academic research, taking account of our 7 investment principles will help you get there.
- When thinking about your future, it is important to set out your goals and aspirations for the future and create a roadmap to get there. We do this by helping you create your financial masterplan, helping to show you what you need to do to achieve what you want.
- One of Carbon’s founding principles is to take the minimum amount of risk in order to achieve your goals.
- We often help clients reduce the risk that they are taking in their investments by showing them tax efficient and cost-effective ways to save for the future.
- Our risk scale typically runs from 1 to 6, where 6 is our highest risk investment solution. This has 100% exposure to growth assets, mostly equities, but is widely diversified across the globe and has over 10,000 different securities in the portfolio. This diversification reduces the impact that any one security has on your portfolio.
- Most of our clients do not need to take the risk associated with our highest risk portfolio, never mind something like bitcoin which would be into double figures on our risk scale.
- We understand that our clients have businesses or single shares that they hold for sentimental value and we facilitate this by having that as their ‘personal investment pot’ or ‘fun money’, but you have much more chance of long-term success by placing the assets you will rely on in retirement into the structure of our financial masterplan and only taking necessary risks.
- Some of our clients will also put a bet on at the horse racing or rugby and we would liken a bitcoin investment more to this type of gambling than an investment.
- Bitcoin and other crypto assets go against almost all 7 of our investment principles, which means it doesn’t satisfy our investment criteria.
We can never say that bitcoin won’t end up in our investment portfolios of the future, in the same way that we don’t rule out gold, timber and the other alternative assets that we regularly review. If it ever does, it is likely to be because it, or companies associated with it, form part of the global market that we invest in rather than as a cryptocurrency asset class. We would want much more evidence, driven by long term data and clear facts to show that it provides significant, systematic reward for the risks taken by our clients. Investing in something that does not owe you a return such as currency does not fit into our investment philosophy due to its speculative nature.
Our job is to coach our clients throughout their relationship with Carbon so that they make smart decisions with their money. Investing in Bitcoin doesn’t feel like the smartest thing to do right now, even if it means you are not part of the ‘cool’ gang once we get back to being able to have dinner parties and events.
Is everyone buying into bitcoin? No
Should I? Not unless you like a gamble
Why aren’t we? It doesn’t pass any of our investment tests
For more information contact Darren Lees
The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.