The toughest cryptocurrency challenges await us

More than a third of millennials and half of Gen Z would be happy to receive 50% of their salary in cryptocurrency, a study has found.

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With over $ 1 trillion in cryptocurrency value obliterated since its peak in 2021, many investors may be tempted to enter the cryptocurrency circuit at a potentially attractive, lower price.

After all, past dramatic declines in the valuation of cryptocurrencies have been followed by explosive growth – and all that volatility could be justified by the expected uneven price discovery process for a whole new class of cryptocurrencies, significant assets.

However, the deepest risks of investing in cryptocurrencies may lie ahead rather than in hindsight. Investors considering a long-term allocation to cryptocurrencies should remain cautious for five main reasons.

1. Bitcoin’s risk-adjusted return has been ‘imperceptible’

After a meteoric first decade, bitcoin has become a bit of a troubled teenager. In its intoxicating early days, bitcoin had almost zero correlation to equities and broader commodities, allowing for real portfolio diversification.

But as investing in cryptocurrencies has become more mainstream, and especially since 2020, bitcoin’s correlation with US equities and bonds has risen sharply and has been constantly positive.

It could be fine if bitcoin offered spectacular risk-adjusted returns as compensation. Unfortunately, recent empirical evidence shows the opposite: Since 2018, bitcoin’s risk-adjusted returns have been pretty imperceptible compared to stocks and bonds.

Cryptographic “safe haven” properties have yet to be proven

Despite all the hype surrounding digital gold, cryptocurrencies have not been able to demonstrate “safe haven” or anti-inflationary characteristics in the light of actual market volatility or the first real onslaught of inflation, severe inflation in developed markets.

Between 2010 and 2022, bitcoin had 27 episodes with withdrawals of 25% or more. In comparison, shares and commodities registered only one each. Even during the pandemic-related market sale in March 2020, bitcoin suffered far greater losses than conventional asset classes such as stocks or bonds.

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Similarly, while bitcoin’s fixed supply – hard-coded in its blockchain – could offer resistance to currency depreciation, bitcoin has provided limited inflation protection in recent episodes of high global inflation. Prices fall even as inflation rises in the US, UK and Europe.

3. Cryptocurrencies are in conflict with ESG targets

Cryptocurrencies remain deeply problematic from an environmental, social and governance or ESG perspective. This is true even though the transition from proof-of-work to proof-of-stake, led by the ethereum blockchain-based software platform, reduces the massive energy consumption that supports mining and cryptography validation.

Environmentally, bitcoin – which accounts for more than 40% of the current market value of cryptocurrency – will continue to use a validation process where a single transaction requires enough energy to run the average US household for two months.

Socially, the promise of financial inclusiveness of cryptocurrencies also seems exaggerated, with cryptocurrency wealth as unevenly distributed as conventional wealth and with simple telephone payment services such as M-Pesa in Kenya or money transfer pilots. international funds from Grameen Bank in Bangladesh already provide a digital platform for underbanked households – without the need for a new currency or payment infrastructure.

4. Stablecoins “may be made redundant”

Even disregarding the recent implosion of stablecoin Terra, the surviving universe of stablecoins faces a potentially existential risk: they may well be made redundant when central banks’ digital currencies, also known as CBDCs, become commonplace. In fact, a digital dollar, euro or pound would provide all the functionality of stack coins, but with almost no liquidity or credit risk.

In other words, even if stablecoins changed from their current status as unregulated money market funds (with limited transparency or audit of reserves) to regulated digital tokens, they would not provide any advantage over CBDCs. It is important that the digital currencies of these central banks may not be a distant prospect. China has already launched an electronic currency known as digital yuan or e-CNY.

The Fed published a long-awaited study of a digital dollar in early 2022, and the ECB will share its findings on the viability of a digital euro in 2023.

5. Uneven regulation creates uncertainty

Finally, the lack of clear and uniform rules for cryptocurrencies – both within countries and between countries – creates enormous uncertainty for long-term investors. It is still unclear in the US, for example, when a cryptocurrency falls within the legal framework of a security subject to the rules of the Securities and Exchange Commission and when it is considered an asset or commodity such as bitcoin and ether, who has claimed it.

In fact, cryptocurrencies face a direct ban in some countries. China’s abrupt ban on all trade in cryptocurrencies and mining in 2021 is a sharp example, but by no means the only one. Regulators have also raised concerns about remarkable and repeated outages of infrastructure that support mining and cryptocurrency trading – another area where regulatory uncertainty remains.

Of course, momentum, retail speculation and “fear of missing out” may continue to drive up the short-term price of bitcoin, ether and other cryptocurrencies. But there are enough dark clouds on the cryptocurrency horizon that long-term investors may want to look carefully behind the scenes to better understand facts versus fiction and true value versus hype on social media before deciding how, where and if they want to invest in the crypto ecosystem.

– By Taimur Hyat, COO of PGIM.

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