Cryptocurrencies, tokens and blockchain technology

We look into digital assets as an asset class and how they may be used as an alternative investment within a strategic asset allocation.

The digitalisation of assets has been on the rise since the turn of the millennium, coinciding with significant advancements in software and information technology over the last three decades. This is one of the key mega-trends that has the potential to shape the global economy in the future. 

Digital assets have recently been driven by the development of blockchain and ‘Distributed Ledger Technology’, which focus on the idea of reducing the role of intermediaries in financial transactions and de-centralising the financial system. 

A key driver in the strength of the system is the level of adoption of the blockchain (the underlying network), which allows a greater level of efficiency in verification as more individuals use it. Digital assets stretch much further than just Bitcoin, which has become the poster-child for cryptocurrencies and what they represent.

What is blockchain technology? 

Blockchain technology is an innovative and disruptive technology with the ability to improve efficiencies in a number of industries. We believe companies incorporating blockchain technologies into their business models may be well positioned to take advantage of the current shift towards innovative working processes. This may in turn add to their profitability and/or returns when included within a basket of equities.

For cryptocurrencies, given the immature nature of these markets and their high level of volatility, we do not believe these assets are suited to most institutional investors. For investors who are early adopters and who have an adequate risk appetite to support an investment in speculative assets, we believe that they should only consider investing in projects supported by sound business models.

Blockchain technology

The diagram below illustrates how blockchain technology provides the framework for digital assets to operate.

What can you invest in?

Digital assets come in many forms, the most popular of which being cryptocurrencies. However, these are often confused with other forms of digital assets which are slightly different, for example tokens. It is important  to note that all of these digital assets must run on an underlying blockchain which allows the movement/transactions of these assets to take place.

Below we have listed the main opportunities within digital assets and blockchain technology.

Digital currencies

• Cryptocurrencies are digital assets which are created along with their own decentralised blockchain technology. The database for the cryptocurrency is not all in one place. Instead, the database is operated by computers, also known as nodes, owned by individuals or groups from all over the world. The benefit of this structure is that the database is not owned by one individual and therefore data within the database cannot be altered. If one individual did try to alter the data, then the other nodes would correct the data. The advantage of having the database in a variety of places is that large data centres are not needed to run the system and, instead, this can be done from people’s homes, work or smaller data centres. Cryptocurrencies can act as a store of value. However, as many will know, they can be very volatile and their value is based on trust in the technology and the demand for the currency. The most commonly known coin is Bitcoin and this was the first decentralised cryptocurrency. ‘Altcoin’, refers to cryptocurrencies that are an ‘alternative’ to Bitcoin and are designed to be different in certain ways. The most important altcoins are Ether, Ada and Binance.
• Central Bank Digital Currency (CBDCs) are centralised cryptocurrencies that are issued by the monetary authority of the country in which they are being used. Around 90% of central banks are considering CBDCs in some form, with China already trialling a digital yuan.

Tokens

Tokens (also known as crypto tokens) are similar to cryptocurrencies, however, the underlying difference is that they do not run on their own blockchain. Instead tokens run on a blockchain that has already been created for a cryptocurrency (as explained above). This underlying blockchain will look over the transactions for the tokens as well as the original cryptocurrency. These tokens are not traded on other blockchains. Therefore, tokens can be thought of as similar to casino chips; they have value in the casino where they were issued, but are of no value to other casinos.

These are not intended to be used as general-purpose currency like the typical cryptocurrencies mentioned above. However, they can have many other uses, some of which are listed below.

• Utility tokens have a function and are not considered an investment by the buyer. In general, a company will issue a utility token to raise money and in exchange they grant the buyer access to use their products/services in the future. They are bought with the intention to be used. 
• Asset-backed tokens are backed by an underlying asset, such as real-world currencies, gold or real estate. As such, they are structured in the same way as exchange traded funds (ETFs) or investment trusts. A ‘stablecoin’ is the name for an asset-backed token that is backed by a ‘stable’ asset (that is, an asset that does not experience large amounts of volatility). For example, the price of the stablecoin Tether is pegged to the price of one US dollar.
• Non-fungible tokens (NFTs) are mainly cryptographic assets (pictures, videos, media, invoices etc.) which exist on the same blockchain technology as cryptocurrencies. However, they cannot be replicated and are all unique. The most common NFTs are digital artwork; these are similar to traditional art where the owner of the art piece owns the original, whereas this does not stop people making replicas. In the digital world, the equivalent is that other people can make copies of the art and continue to view it online, but the token is thought of as proof of ownership of the original piece. There has been a lot of ‘hype’ recently surrounding NFTs as digital artwork and original ‘memes’ have sold for large amounts of money on both digital platforms as well as at established art auction houses. NFTs are most commonly traded on the Ethereum blockchain.

Companies using blockchain technology

Blockchain technology is not only used for the likes of cryptocurrencies, many other industries are using the technology as an advancement from data centres to run their businesses more efficiently. This is as widespread as brand-verification in high-end fashion to ensuring there is no slave-labour in the supply chain of chocolate manufacturers.

Whether the use of blockchain is a marketing ploy or whether it provides genuine efficiencies in business operations is up for debate. As this is a new technology, many companies are still in the early stages of implementing it into their business models.

Characteristics of the digital asset market

The digital asset market is relatively immature. Most digital assets, with the exception of some cryptocurrencies, have only recently been established meaning there is limited historical performance data. However, over recent years, mainstream digital assets, such as Bitcoin, have seen tremendous growth, as have investments that focus on blockchain.

The chart below illustrates the cumulative returns on a range of digital assets, alongside the return on global equities, over the period since 2018.

Source: Yahoo Finance

Blockchain technology and cryptocurrencies are new sectors within financial markets and have gained a lot of attention over the past decade. We expect to see continued growth in these markets over the coming years. Given their low correlation to equity markets, exposure to these sectors may be beneficial for strategic allocations in terms of excess returns and diversification. For investors wanting to gain exposure to digital assets, investing directly in those assets offers the greatest return potential, which has been evident for cryptocurrencies such as Bitcoin and Ether. However, investing directly also exposes investors to potentially very high levels of volatility. 

Not all cryptocurrency returns are driven by the same factors. We give two examples below.

• Bitcoin - some cryptocurrencies like Bitcoin are seen as a potential currency which will be used in the future and therefore people invest as they see the currency being of value.
• Ether - other cryptocurrencies such as Ether are seen more as a technology play as these investment opportunities represent conviction in the underlying platforms/networks on which these cryptocurrencies operate.

A good example of the value of a cryptocurrency being in the underlying network links together two of the previously discussed digital assets; Ether and NFTs. Over the second quarter of 2021, there has been a sharp increase in NFT trading volumes, which has in turn led to a rise in the price of Ether due to the fact that NFTs are traded on the Ethereum blockchain. While investing in cryptocurrencies can offer tremendous returns, the level of risk and extreme levels of volatility in the price of cryptocurrencies should be taken into account. 

Investing in the digitalisation theme, rather than directly in digital assets, will reduce the risk of higher volatility due to diversification within digital assets. 

There are mutual funds and ETFs that focus on blockchain specifically, as well as wider technological disruption. These strategies have shown their worth over the last year, outperforming global equities, as digitalisation has accelerated throughout the coronavirus pandemic. However, investors must be aware that these strategies will be much more correlated to global equities compared with direct digital asset ownership, reducing the wider diversification benefit of the asset class against the more traditional asset classes.

ESG considerations of cryptocurrencies

One of the biggest concerns with blockchain technology and cryptocurrencies for investors are Environmental, Social and Governance (ESG) considerations. These issues have added to the volatility experienced within the cryptocurrency market and have impacted many investors. 

Arguably, the most important ESG issues are:

Environmental considerations

• Large amounts of computing power - The main environmental concern regarding blockchain is the amount of computer power and therefore electricity needed to run the blockchain and verify the transactions. However, it has been argued that renewable energy sources could be used instead or excess capacity that would otherwise be lost (e.g. mining companies inCanada which use trapped underground energy that would otherwise be released into the atmosphere to mine Bitcoin). Mining cryptocurrencies is a unique way of using energy as it is fully mobile and can be performed as long as there is computing power and an internet connection available. The transition from proof-of-work to proof-of-stake (see glossary below for definitions) for miners who are remunerated for transactions should also have a considerable positive impact on this concern in certain cryptocurrencies due to the fact that proof of stake mining is more energy-efficient. 

Social considerations

• Cryptocurrencies being used for crime - As cryptocurrencies are not regulated, many investors are hesitant to invest as these assets are sometimes used for illegal activity and are an easy way to make transactions with no middle party totally anonymously. However, although some cryptocurrencies will inevitably be used for crime (as with all currencies), the absolute numbers are a lot lower than for traditional currencies.

Governance considerations

• Unregulated markets - As cryptocurrencies are new and innovative assets, the regulatory environment in which they operate is changing quickly. The influence of regulation on cryptocurrencies is conflicting. Whilst additional regulation would be beneficial in representing the growing maturity of the sector, at the same time regulation may present conflicts to the true decentralisation of the systems in which cryptocurrencies operate. Overall, regulation alongside an adoptive approach by governments will be beneficial for cryptocurrencies in the long-term.

Considerations when investing in digital assets

Taking into account the themes related to investing in digital assets and also the level of conviction in them and the underlying technologies, we have summarised a number of ways to invest in digital assets below. The following factors should be taken into account before reading into our comparative analysis:

• The scale used here (high to low) is for each investment play mentioned in this blog relative to each other. This should not be interpreted against other assets on the risk/return spectrum.
• The ratings provided below are based on a combination of qualitative and quantitative evidence. It is not to suggest that they will hold true for all types of  investment play of each type. 
• We have provided a variety of investment plays for institutional investors with varying levels of conviction in digital assets who do, ultimately, want to gain some exposure to digital assets.
   

Taking the above into consideration, we believe the following takeaways are the most useful:

1. Direct investment in cryptocurrencies and investing through private markets have the highest return potential, but also require a higher level of conviction in digital assets and a risk appetite in line with the very high volatility of such assets. 

2. Investing in public equity is a relatively lower-risk approach to gaining exposure to digital assets through investing in the underlying technology.

3. Though direct investment in cryptocurrencies and NFTs are the highest risk plays, this may be appropriate for investors with an adequate risk appetite.

In conclusion

Digital assets are still new in financial markets and many investors are trying to assess how they work and how they can be included in their portfolios. Additionally, there is a lot of concern surrounding ESG risks, rules and regulations with digital assets. For these reasons digital assets experience very volatile and unexpected returns. 

Although more investors are including cryptocurrencies in their portfolios along with other alternative assets, we do not believe investing is attractive for the majority of investors whilst there is so much uncertainty surrounding them. We do, however, believe that for investors with an adequate risk appetite and capacity to allocate to speculative assets, investing in digital assets which are backed by sound business models should be the investment play chosen. Such an allocation can combine the benefit of low correlation to traditional asset classes with high expected returns. Investors should therefore assess the type of cryptocurrency or coin they invest in carefully, as some are just speculative (such as Dogecoin), others are purely based on trust and demand (such as Bitcoin) and others will benefit from the wider use of their platforms (such as Ether).

Whereas investing directly in cryptocurrencies may be more of a speculative play, we believe that the disruption being caused by blockchain technologies will influence a number of industries and that businesses adopting such technologies will be well placed to advantage from the rapidly changing technological business environment. Our outlook for companies adopting such technology is positive, though it should be mentioned that some companies use blockchain as a marketing ploy. Only companies that operate in industries which are positioned to benefit from the widespread adoption of blockchain (for example, big data/analytics, FinTech and MedTech) will benefit in the long-run. An additional consideration here should be the investor’s investment horizon. As these technologies are relatively new, only investors with long-term horizons should look into potential investment plays, allowing adequate time for the development of these technologies and their efficacy to play out in the long-run. Therefore, we believe that it is advantageous to add exposure to blockchain technology in a portfolio, whilst being aware of the rapidly changing environment and high degree of risk linked to such an allocation.

Be aware

This blog aims to provide a high level introduction to digital assets as an asset class and how they may be used as an alternative investment within a strategic asset allocation. Throughout this blog, we explain what digital assets are, why you may wish to invest in them and how you could implement such an allocation. This piece is aimed at large institutional investors that are looking to take on alternative investments to diversify their portfolio. We do not believe these assets to be suitable for everyone and the risk profile of such investments needs to be assessed alongside investors’ risk appetite and investment beliefs.