Wells Fargo Investment Institute Global Investment Strategy Team
- Improved regulatory clarity and rising interest in digital technologies, especially during the coronavirus pandemic, have accompanied a wider variety of cryptocurrencies and increased market capitalization.
- Risks remain, yet we view improved depth and breadth as components of a gradually maturing marketplace.
What it may mean for investors
- We view digital assets as an alternative investment for qualified investors through a professionally managed fund. Due to the uniqueness, complexity and continued evolution of these assets, we plan to produce a series of reports with a goal of increasing investor education and understanding of cryptocurrencies.
Executive summary – What’s changed and why now?
We believe that cryptocurrencies have evolved into a viable investment asset. There are over 9,000 cryptocurrencies, with $2.4 trillion in capitalization (as of May 7, 2021), and this depth and breadth allow additional analysis of their trends.1 Short-term factors suggest further deepening of the market. We believe long-term supply and demand trends support further industry growth, the potential for further compression in price volatility, and a possible role as portfolio diversifiers.
Several crucial events in 2020 drew increased mainstream usage in transactions and accelerated the maturation of cryptocurrency markets. First, banks received regulatory permission to custody cryptocurrencies, and the investment industry and regulators took additional steps to extend a legal and oversight framework that should help solidify cryptocurrencies as investable assets. The coronavirus pandemic also played a role by fast-tracking the digital economy, as the return to near-zero interest rates sparked inflation fears and interest in alternative payment systems.
Evolving markets for investable assets often introduce unique risks that require deeper due diligence. The main known cryptocurrency risks include the possibility of additional regulation and various operational risks associated with making transactions. Periods of persistently high volatility remain likely as maturation occurs. These potential risks and the need for ongoing due diligence underscore our preference that qualified investors consider a professionally managed option.
We classify any cryptocurrency or digital asset investment as an Alternative Investment. In general, assets in the Alternative Investments category entail some combination of nontraditional sources of return, potential long-term diversification, complexity, potential illiquidity premiums, and higher volatility. Exposure through a professionally managed fund potentially may serve alongside private equity and debt strategies as the primary means of capturing long-term trends from fintech and other secular developments arising from digitization in the economy.2 Additional investment structures may arrive in the not-too-distant future.
Brief background on the evolution of cryptocurrencies and blockchain
Governments create and control nearly all the money used around the globe – from printing to banking rules, short-term interest rates, and global settlement networks. Cryptocurrencies challenge the global system of government-provided, or centralized, money by decentralizing controls. Anyone can connect, exchange, and own a cryptocurrency by participating in a shared database distributed across a global network of computers. Cryptocurrencies differ widely in structure, and often are targeting different end markets. Some have billions of coins, others smaller, fixed supplies. And some allow the supply of coins to increase towards a cap, but at a declining rate of coin supply growth.3
These virtual currencies operate on a system that records and validates every transaction in cryptographically secured ledgers, called a “blockchain”. To understand a blockchain, it is helpful to break the word into two components. A “block” is a collection of grouped transactions. Blocks of transactions connect to others, creating a linked chain of blocks. Altering a transaction has proven to be extremely difficult, as it requires changing the previous blocks also. This is an important security feature of decentralized systems.
Transactions accumulate in a block by a process called mining, which secures and validates all transactions. Miners receive compensation for validating and linking blocks in the blockchain. Cryptography secures the transaction data in the blockchain, and access requires a passcode, which, for security purposes, can be longer than most internet passwords. It can take a significant amount of computing power (and electricity) to create the blockchain, creating a major challenge to developing new blockchains.
Blockchains are part of a suite of technologies and functions that help make cryptocurrencies work. Particularly important is the technique of cryptography, which helps secure individual transactions. More participants make for more oversight, and payment in digital coins can be added incentives for overseeing and securing the network. These functions work together to help cryptocurrencies establish investor trust and gain value.
Cryptocurrencies as an investable asset
Cryptocurrencies, in our view, have now evolved into a valid consideration as a portfolio option for qualified investors.
Cryptocurrencies do not pay interest or dividends, and there are no expected earnings to inform today’s prices. Yet, one sign of stability is that cryptocurrencies appear to be developing fundamental short- and long-term price drivers. Low 5- and 10-year correlations with traditional asset class returns hint that the long-term determinants of cryptocurrency prices differ from those of traditional investment assets. In this way, cryptocurrencies are potential portfolio diversifiers, which we believe adds to the stability and viability of cryptocurrencies.
Table 1. Insignificant long-term cryptocurrency correlations with select traditional investment assets
|Period||MSCI All Country World Index||Bloomberg Barclays U.S. Aggregate Bond Index||Bloomberg Commodity Index||Gold spot price|
|From 1/31/2011 to 4/30/2021||0.15||0.01||0.05||-0.07|
|From 1/31/2015 to 4/30/2021||0.21||-0.02||0.14||-0.12|
|From 1/31/2020 to 4/30/2021||0.56||-0.01||0.45||0.17|
Sources: Bloomberg and Wells Fargo Investment Institute, monthly data, January 31, 2011 to April 30, 2021 as of May 6, 2021. The price of gold is the Intercontinental Exchange (ICE) U.S. dollar price per troy ounce. Cryptocurrency prices are represented by a composite (December 2010 = 1) of our construction that consistently has captured roughly 90% of market capitalization (calculated as circulating supply times price) and the growing diversity of the market over time. The composite constituents are the price of Bitcoin from December 2010 to August 2015; a market-cap weighted combination of the Bitcoin and Ethereum prices (market weights and Ethereum price from coincodex.com) from September 2015 to July 2017; and the Bloomberg Galaxy Crypto Index from its inception in August 2017 through April 2021. As can be seen in Chart 2, first Bitcoin, and later Bitcoin and Ethereum together, represented roughly 90% of market capitalization until mid-2017. The Bloomberg Galaxy Crypto Index includes Bitcoin and Ethereum but adds other cryptocurrencies for diversity, and represented approximately 90% of market capitalization as of April 2021. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
Research indicates that macroeconomic and financial conditions are significant for cryptocurrencies, but likely are transitory price drivers over short-term horizons, such as the past 16 months.4 For example, the correlation between a cryptocurrency price composite and the MSCI All Country World Index, a benchmark index for global equity prices, increased sharply during the January 2020 – April 2021 period (Table 1). The composite’s correlation with a commodity benchmark index was also notable.
The point is not that cryptocurrencies are evolving into equity and commodity substitutes, but that all three can share common factors or trends for a short time. In the case of commodities, the recovery from the global pandemic created a large but likely temporary increase in demand for manufactured goods and their commodity raw materials. Commodity price gains are likely to moderate as households shift to spending on services, but we do not expect household spending preferences to impact cryptocurrency prices. Meanwhile, the cryptocurrency composite’s low short- and long-term correlations with gold (Table 1) suggest no intrinsic relationship between cryptocurrencies and commodities as commodity currencies. We foresee no developing trend that would change the low long-term correlation already observed between cryptocurrencies and commodities.
The pandemic also appears to be playing a temporary role in stronger correlations between cryptocurrencies and equities. Here, a common policy factor may be at work. Growth in the U.S. money supply surged in 2020, as monetary policy changed during the pandemic (Chart 1). Money growth since 2020 was the fastest since 1981 and came with dramatically lower interest rates, which increased the demand for equities as an alternative to low fixed-income yields. That surge in money growth led or preceded the jump in cryptocurrency prices during 2020. Historically extreme money growth since 2020 also raised inflation fears and worries about eventual dollar debasement. In fact, some research finds a sharp rise since last year in media reports that mention both cryptocurrencies and consumer price inflation.5 Our expectations for above-average money supply growth in the short term should attract more investors to cryptocurrencies and increase the depth of that market.
However, as with commodities, the high correlation is unlikely to persist. Long-term interest rates already are rising as the pandemic fades. Money growth eventually should slow from its rapid pace, and fears of rising inflation should fade with it. Chart 1 shows no perceptibly consistent positive or negative co-movement between cryptocurrency prices and money supply growth before 2020. Most research that studies the relationship between cryptocurrencies and traditional financial markets (i.e., equities, fixed income, currencies) finds only a short-term correlation between cryptocurrencies and traditional financial markets.6 We expect the cryptocurrency-equity correlation to remain a temporary phenomenon.
In sum, environmental (e.g., the pandemic) or policy factors may elevate short-term correlations between cryptocurrencies and traditional investment assets. Nevertheless, their persistently low correlations over 5- and 10-year horizons suggest that the diverse factors specific or idiosyncratic to cryptocurrency returns differentiate these assets from traditional assets. Looking ahead, we expect that the market for cryptocurrencies will continue to develop from separate and unique factors, as we discuss below.
We view long-term supply and demand as the main factors in building stability. Many cryptocurrencies have fixed supply caps, and some can only grow at restricted and often declining rates. (As an example, see footnote 3.) Potential demand growth for cryptocurrencies and blockchain is just as important as the supply constraints. The disruptive potential of decentralized systems could be large across the economy. An entire system of such applications is developing to provide financial services – from trading to lending to custody. Even new decentralized stock and coin exchanges are emerging.7 These new digital applications do not have to pass through payer and payee banks, which increases accessibility and reduces processing costs. As well, transactions validated by multiple participants adds transparency. A growing group offers “smart contracts”, which are essentially legal contracts that execute automatically when specific conditions are met. Digital applications such as these could extend soon into healthcare, insurance, and supply chain management, to name only a few.
The pandemic has accelerated these trends toward digitization, and artificial intelligence increasingly is a part of that digital approach to doing business. Artificial intelligence refers to developing computers to perform tasks that normally require human intelligence. The Information Technology and Communication Services sectors have led in adopting artificial intelligence, especially in using natural language systems to take customer calls.8 The same research shows automotive and other assembly industries close behind, with robots on assembly lines, while the Utilities, Financials and Health Care sectors are advancing, but from the rear.
Cryptocurrencies complement the rise of artificial intelligence by connecting payment systems to the broader automation trend. For example, a computer may monitor the status of machines and soap dispensers at a laundromat, but adding a cryptocurrency-based payment system would allow the computer to order and pay for soap deliveries as well. In sum, we believe the trends point toward more automation, and digital payment systems should further increase the prospect for lowering business operating costs.
Growing interest during the past 11 years has brought more cryptocurrencies, larger market capitalization, and gradually improving consistency in cryptocurrency prices. Chart 2 indicates a broader diversity in cryptocurrencies, and Chart 3 shows the corresponding increase in market capitalization.
Investments in a greater variety of cryptocurrencies should imply a decreasing percentage of investors who buy or sell on any given news, which, in turn, should reduce price volatility. It has already. The annualized volatility in a cryptocurrency index was 160% between July 2010 and August 2015, but halved to 80% between August 2017 and March 2021.9 We also calculated correlations between cryptocurrencies based on monthly price returns. The same data and two periods also showed increasing correlations between pairs of cryptocurrencies, particularly among those with the largest market capitalizations, indicating that the rising number of cryptocurrencies may reduce the idiosyncratic risks of holding any small subset.10
Sources of volatility exist but appear to balance better with potential return than in the past
We believe there is an investment thesis behind digital assets but want to be clear about the risks. The main risks include the following:
- Additional regulation
- Technology failures
- Operational risks, such as handling and storing cryptocurrencies
- The cost of heavy energy consumption to produce
- Price volatility: Even though cryptocurrency price volatility has halved over the past decade, volatility levels still exceed those found on the S&P 500 Index.
- Consumer protections: There are few cryptocurrencies that can reverse mistakes, including difficulty in recovering funds sent to the wrong person or place, and losing access to one’s private key or access code (which could lose the cryptocurrencies for good).
- The exchanges where cryptocurrencies trade can suffer data breaches and stolen cryptocurrencies.11
- With over 9,000 cryptocurrencies available today, many could see their buyers go to other competitors. This consolidation risk reinforces our preference for a diversified fund that is managed professionally.
More broadly, investors may need more education on the unique technological features that affect cryptocurrency values. As an example, each cryptocurrency has its own hardcoded rules that are difficult to break, but not impossible. Someone(s) could acquire a controlling interest in computing power and change the protocols for use, which could impact the value of the cryptocurrency. Reducing these risks is most likely a question of time, education and increased usage – and possibly additional government regulation.
Parameters for investing in digital assets
Cryptocurrencies have gained stability and viability as assets, but the risks lead us to favor investment exposure only for qualified investors, and even then through professionally managed funds. Such a private placement could serve alongside private equity and debt strategies as the primary means of capturing long-term trends from the emergence of next-era digital technologies and infrastructure. Currently, we offer only private placements, because the Securities and Exchange Commission (SEC) has not yet approved an exchange-traded fund (ETF), although increasing numbers of U.S. financial firms are seeking approval. If, or when, more liquid professionally managed vehicles become available, we will consider them at that time.
We expect more availability as the industry and investors come to understand better the trends toward digitization in economic activity and the demand for cryptocurrencies and blockchain technologies.
Improved regulatory clarity and rising interest in digital technologies, especially during the coronavirus pandemic, have accompanied a wider variety of cryptocurrencies and increased market capitalization. With these developments, we believe cryptocurrencies should show more viability and durability over time as investable assets. Bouts of rising volatility could persist, but, in our view, the evidence of their greater stability and long-term diversification potential together point to a viable investment asset for exposure in portfolios in a controlled way. These and related topics will be the subjects of our coming series of reports to educate investors on cryptocurrencies
1 Source: CoinMarketCap, May 7, 2021.
2 The term “fintech” refers to computerized or digital tools that support or enable banking and financial services.
3 As an illustration, Bitcoin’s hard-coded protocol fixes the supply cap at 21 million but with a diminishing supply growth over time. About every four years, the Bitcoin reward that a miner gets for validating transactions and creating the next block in the chain gets cut in half. At Bitcoin’s beginning in 2009, miners were rewarded 50 Bitcoin with the right to produce the next block. In 2012, that reward dropped to 25 Bitcoin reward per block. The rate halved again in 2016 to 12.5, and in May 2020 to 6.25. (Source: "Total Circulating Bitcoin", https://www.blockchain.com/charts/total-bitcoins. See also "Bitcoin Halving Countdown" at https://coinmarketcap.com/halving/bitcoin/). Through April 23, 2021, about 18.7 million of the 21 million have been mined. Thus, the total is fixed but supply grows asymptotically slower over time. Source: https://coinmarketcap.com/all/views/all/.
4 Wijk, D. V. What can be expected from the Bitcoin? Erasmus Universiteit Rotterdam, 2013. Also see Aiman Harudin, Azhar Mohamad, Imtiaz Sifat, and Yusniliyana Yusof, “Cryptocurrencies: A Survey on Acceptance, Governance and Market Dynamics”, International Journal of Finance & Economics, December 14, 2020.
5 See, for example, Ronnie Sadka, Travis Whitmore, Gideon Ozik, Rajeev Bargava and Zach Crowell, “Thematic Indicators: New Bitcoin Indicator Offering”, State Street Associates Global Markets, April 12, 2021. Also see Asplund, J., & Ivarsson, F. What drives the price development of cryptocurrencies?, University of Gothenburg, 2018.
6 See Ciaian, P., Rajcaniova, M., & Kancs, d’Artis. “The economics of BitCoin price formation.” Applied Economics, 2015, 48(19), 1799–1815. Ana Pavkovic, Mihovil Andelinovic, and Ivan Pavkovic, “Achieving Portfolio Diversification through Cryptocurrencies in European Markets”, Business Systems Research, vol. 10, no. 2, 2019 finds that cryptocurrencies correlate with the U.S. dollar, but only over short-term horizons.
7 The term “DeFi”, or decentralized finance, refers to the use of contracts on blockchains to replace traditional financial intermediaries such as brokerages, exchanges, or banks.
8 For more on artificial intelligence (AI) and its growing impact on the economy, please see as an example, “Global AI Survey: AI proves its worth, but few scale impact”, McKinsey, November 2019; and “The state of AI in 2020”, McKinsey & Company, November 18, 2020.
9 We proxy annualized volatility by the standard deviation, which is essentially the average deviation in monthly returns from the average return over the particular sample period. The calculations are based on the spliced cryptocurrency composite described in the note to Table 1.
10 We calculated correlations between various cryptocurrency monthly price returns over periods. The results are broadly corroborated by recent research showing a high correlation among cryptocurrencies. See Aiman Harudin, Azhar Mohamad, Imtiaz Sifat, and Yusniliyana Yusof, “Cryptocurrencies: A Survey on Acceptance, Governance and Market Dynamics”, International Journal of Finance & Economics, December 14, 2020.
11 See, for example, “These are the largest cyber thefts of the past decade – and 80% of them involve Bitcoin”, Fortune, April 6, 2021. Alternatively, see “Cloud Security Alliance Releases Guidance for Crypto-Asset Exchange Security”, businesswire, April 13, 2021.
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Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Bloomberg Commodity Index is comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.
Bloomberg Galaxy Crypto Index is a daily, market-capitalization weighted index (May 3, 2018 = 1000), consisting of no more than 12 cryptocurrencies that trade in U.S. dollars, have at least two pricing sources and free-floating pricing. The smallest constituent must not have less than 1% but not more than 40% of the total cryptocurrency market capitalization. Bloomberg rebalances the index monthly and calculates market capitalization as a product of circulating supply and price.
MSCI All Country World Index (MSCI ACWI) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed and 23 emerging markets.
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