Bitcoin – beloved, loathed and (in)dispensable(?)

Is Bitcoin a Ponzi scheme in which the proverbial hot potato keeps getting passed around until the house of cards finally collapses? Or are cryptocurrencies a new asset class that belongs in every portfolio? Despite the ups and downs of Bitcoin and the like, cryptocurrencies are conspicuously being increasingly adopted in financial products. We examine here whether private investors should pounce on cryptocurrencies.


The Weeble of the financial markets

Those declared dead live longer – this old German saying certainly applies to Bitcoin, which seemingly has died a dozen deaths over the last decade but is nonetheless still vibrantly alive today and remains the king of all cryptocurrencies. In retrospect, every swan song about Bitcoin was premature, and every purportedly burst bubble was followed by new all-time price highs. In fact, the digital currency has experienced seven boom-bust cycles with price drawdowns of more than 50% since 2011. To Bitcoin devotees, this volatility is normal everyday business on the road to a rosy future of mass adoption of the cryptocurrency as a revolutionary medium of exchange or at least as a new asset class. To foes of Bitcoin and its cohorts, in contrast, their volatility is just one of the many “problems” they pose. We take a neutral stance in the debate about the pros and cons of cryptocurrencies. We are not blind to the promising future potential of blockchain technology, but we also cannot close our eyes to undeniable shortcomings such as Bitcoin’s sustainability deficit. In our role as a private wealth management bank, what interests us most is the question of whether Bitcoin belongs in investment portfolios and provides an added value there. Before we address this question, let’s first draw up a list of some of the most prominent pro and con arguments regarding Bitcoin and its relatives. The aim of this list, which is not exhaustive, is to provide a little insight into the debate surrounding cryptocurrencies, about which everyone should form his or her own opinion.


How often can a bubble burst?
Bitcoin crashes remain a routine occurrence

Historic Bitcoin corrections exceeding 50%

Sources: Bloomberg, Kaiser Partner Privatbank


Pros: To the moon

  • Cryptos are eating gold’s lunch: Investors hold the precious metal gold not first and foremost in view of its function as jewelry or for its electrical conductivity, but primarily as a hedge against the devaluation of paper currency. For many cryptocurrencies as well (and especially Bitcoin), their function as a medium of exchange does not stand in the foreground. They are viewed instead as an alternative to gold and as being immune to potentially inflationary central-bank monetary policies. The market value of all of the world’s gold mined to date amounts to almost USD 10 trillion. If cryptocurrencies were to reach only half the “market capitalization” of gold, from their present level (USD 1.7 trillion) they would have the potential to triple in price.
  • The future belongs to proof-of-stake: The slowness of Bitcoin transactions is by design and owes to Bitcoin’s proof-of-work architecture, by which the Bitcoin algorithm solves complex mathematical puzzles to verify transactions and thus guarantee the security of the network. This process undeniably is extremely energy-intensive, which is a problem that can easily be solved by switching to a proof-of-stake verification mechanism. That’s precisely what Ethereum, the world’s second-largest cryptocurrency by market value, intends to do soon. It is generally assumed that this will lower Ethereum’s energy consumption by 99% and that Ethereum transactions will become 5,000 times faster.
  • Bitcoins are social: Although Bitcoin does not score particularly high on the “E” aspect of “ESG”, it veritably shines with regard to the “S” aspect. As a completely decentralized open-access system, the Bitcoin network comes as close as possible to being a direct democracy. It provides a high level of data protection and privacy and does not discriminate against users on the basis of gender or provenance. Anyone with access to the internet can participate in the crypto revolution, even without a bank account.


Comeback kid
High volatility: A normal circumstance on the road to mass adoption?

Bull and bear markets in Bitcoin

Bitcoin – beloved, loathed and (in)dispensable(?)Bitcoin – beloved, loathed and (in)dispensable(?)

Sources: Bloomberg, Kaiser Partner Privatbank


Cons: Back to earth

  • The costs of cryptos: Who pays for cryptocurrencies? Not just those who speculate with them – some negative externalities (especially with Bitcoin) are undeniable. A single Bitcoin transaction consumes 14 times as much energy as 100,000 Visa card transactions. The annual electricity consumption of Bitcoin exceeds the yearly power consumption of Pakistan and its 217 million inhabitants. Mining for new digital coins makes energy more expensive than necessary in some countries. Even if all Bitcoin mines were operated with “green” electricity in the future, they would still divert a lot of resources away from other places where they are more urgently needed. Crime is another negative externality and remains a big problem in the crypto industry to this day. Chainalysis reports that digital wallet addresses linked to illicit activity received USD 14 billion worth of cryptocurrency payments in 2021, a year that saw crypto fraud increase by 82% year-on-year and crypto theft surge by 516%.
  • What is Bitcoin good for? The number of retailers that accept Bitcoin as a means of payment has hardly increased in recent years. Speculative capital flows – not e-commerce – continue to account for the majority of cryptocurrency transactions. The Bitcoin network is capable of processing just five transactions per second (in contrast to the 20,000 per second that the Visa network is able to settle). Bitcoin transaction fees can vary significantly and are usually much higher than credit card transaction fees. Although there are technological possibilities to make Bitcoin more efficient, the Bitcoin fanbase hasn’t shown any inclination to date to deviate from the current protocol.
  • Hyperinflation of cryptocurrencies: One of the selling points put forth by Bitcoin enthusiasts is that the supply of the cryptocurrency is capped at 21 million coins. Other cryptocurrencies also cap their maximum supply of coins. The limited money supply aims to prevent the kind of inflation that looms with paper money issued by central banks and to ensure continually rising currency prices over the long run. However, there is absolutely no limit to the number of cryptocurrencies that can come into existence. Anyone can mint his or her own Dogecoin. The obvious hyperinflation of digital coins exposes the fragility of the inflation protection argument.
  • How much is Bitcoin worth? The value of a share of stock is based on the fundamentals and future cash flows of the company that issued it. Cryptocurrencies, in contrast, do not have an intrinsic value. Their value is determined solely by what other people are willing to pay for them.
  • Regulation will come: Cryptocurrencies have largely been unregulated thus far in most countries, but governments are already changing their laissez-faire stance. The environmental problem posed by cryptocurrencies is just one aspect here – protecting consumers, businesses and banks from the high volatility of cryptocurrencies is also increasingly moving into the foreground. In addition, governments will strive to ensure that they don’t lose control over the monetary system. The ability to create and control legal tender mediums of exchange is a crucial component of states’ economic sovereignty. If cryptocurrencies proliferate uncontrollably, central banks and policymakers lose their ability to effectively manipulate the money supply and general price levels and to stimulate economic activity if necessary.


Limited supply?
The crypto money supply is theoretically unlimited

Number of cryptocurrencies

Sources: Coinmarketcap, Kaiser Partner Privatbank


Added value for portfolios? More than questionable

Regardless of where you stand on cryptocurrencies, the question or whether they provide an added value for an investment portfolio can be answered independently of your stance. For the past (and taking Bitcoin as an example), the answer is a resounding yes. Although one had to stomach an average volatility of around 80% and weather drawdowns of up to 83% during the observation period from 2014 onward (it wasn’t so easy to invest in Bitcoin prior to 2014), the prodigious annualized performance of around +68% made this rollercoaster ride worth the gut-wrenching thrills. With a resulting Sharpe ratio of 0.85 (better than that of the S&P 500 index over the same period), an investment in Bitcoin was also acceptable from a risk-adjusted perspective. In addition, Bitcoin’s correlation with other assets classes was relatively low. Viewed in hindsight, this means that the digital currency would have generated an added value within a broad-based portfolio from both a return standpoint and a diversification perspective. But does this also apply to the future?

As the evolution of Bitcoin’s price since the start of November 2021 (with its 50% plunge in the span of just ten weeks) illustrates, Bitcoin hasn’t lost any of its volatility despite the increasing involvement of institutional investors in the cryptocurrency. But whoever takes on that much risk would like to continue to be compensated in the future with a reasonably attractive risk-adjusted return. If we set the threshold at a Sharpe ratio of 0.5, Bitcoin (factoring in its long-term annualized volatility of 80%) would have to deliver a performance of +40% per annum to be attractive. This means that one Bitcoin would have to be worth more than a million US dollars in 2030 to represent a worthwhile investment. Every investor must decide for him or herself whether such a price target is realistic. But whoever considers a Bitcoin trading at seven figures by the end of this decade an exaggeration should tend to refrain from investing in the cryptocurrency because if Bitcoin doesn’t deliver the requisite performance, the risks taken will not be adequately compensated. At any rate, it is not worth investing in cryptocurrencies solely for their diversification attributes. Although the correlation between Bitcoin and stocks stood at just 0.1 for the aggregate period of the last ten years, whenever things got dicey on the equity markets and a low correlation would have been needed, the correlation between stock and cryptocurrency prices spiked significantly. During equity market corrections of more than 5%, Bitcoin’s performance averaged out to –13% and was negative 86% of the time. It is hardly to be expected that this behavior will change along with the increasing institutionalization of cryptocurrencies. Quite the contrary, their correlation with stocks has generally risen considerably over the last two years. Large- and small-scale investors alike appear to view digital currencies as being the riskiest part of their portfolios (for good reason) and the first assets to be dumped in the event of rising risk aversion. In this sense, cryptocurrencies have recently been behaving like a leveraged variant of (unprofitable) growth stocks. Like such growth stocks, Bitcoin and its cohorts are also particularly vulnerable to the upcoming return of (US) monetary policy to normal. This is another reason why cryptocurrency price volatility is unlikely to decrease much anytime soon.


No more than a proxy for highly speculative stocks (any longer)?
Cryptocurrency prices increasingly correlate with stock prices

Correlation between Bitcoin and S&P 500 index (2-year rolling)


Sources: Bloomberg, Kaiser Partner Privatbank


If you do invest in cryptocurrencies, do it in a diversified way

Developments in the crypto universe unfold at a very fast pace. That’s why we will regularly review our appraisal of cryptocurrencies. As things stand today, we do not consider cryptocurrencies a compulsory component of our asset allocation particularly in view of the price behavior described above and the problematic sustainability aspects. An optimist, though, who believes that the price of Bitcoin really will soar to the moon should construct a potential investment in cryptocurrencies in the most diversified way possible. Alongside Bitcoin as the still-leading digital coin, competitors like Cardano, Solana and Polkadot that employ more promising and sustainable proof-of-stake technology should also be part of any crypto basket. But even the biggest optimist should invest no more than 5% of his or her liquid assets in cryptocurrencies. Even such a small admixture of cryptocurrencies would already account for 20% of a diversified portfolio’s volatility. A larger allocation to cryptocurrencies would overconcentrate risk and would raise expected drawdowns for the overall portfolio during weak market phases to unreasonably high levels. Another aspect of elevated volatility also mustn’t be forgotten: adding in cryptocurrencies makes it necessary to regularly rebalance a portfolio, which entails elevated trading expenses.


Not a safe haven
Only for investors with strong nerves?

Volatility (6-month rolling)

Sources: Bloomberg, Kaiser Partner Privatbank


Oliver Hackel, CFA Senior Investment Strategist

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