A closer look at some relevant questions on the crypto asset market…
Should you refer to Bitcoin et al as crypto assets or cryptocurrencies?
Economists have quite a strict definition of what can be labelled as “money” or “currency”. To be considered as such, it must combine four attributes – it must be a medium of exchange, it should serve as unit of account, it has to be able to store value and finally it must be legal tender. For the time being, none of these four criteria appear to be met for Bitcoin or any other so-called cryptocurrency. First, none of them have become a significant and broadly accepted means of payment. Second, except crypto exchanges, only a handful (individuals or institutions) refer to value or worth in Bitcoin. Third, Bitcoin price swings make it hard to consider it as a stable store of value (Exhibit 1) and lastly it is not legal tender. For these reasons, we prefer the term crypto assets.
See our related video: Three crypto questions you have been wanting to ask… and more
Bitcoin bumpy ride since inception
Source: Coindesk.com; updated as of 13/04/2018
How big is the crypto asset market?
The total market capitalization of the crypto space currently stands at around US$324bn compared to a mere US$10.5bn at the start of 2014. The bulk of the growth has been over the last year with aggregate market capitalization surging more than 2,500%. Coins account for over 90% of the market size while crypto tokens comprise the rest. The crypto coin universe is heavily concentrated with the largest five making up over 70% of the market (namely Bitcoin, Ethereum, Ripple, Bitcoin Cash and Litecoin – Exhibit 2). The market size is still small relative to traditional assets classes considering the market capitalization of global equities stand at over US$80tn while global bond markets exceed a US$100tn. Even mainstream alternative asset classes are meaningfully larger with estimates of total private equity assets under management close to US$2.5tn.
Still a heavily concentrated market
Source: Coinmarketcap.com and AXA IM Research. Updated as of 13/04/2018
The rapid growth in the size of the crypto world has attracted a lot of attention over recent months and several financial products have been developed around the asset class including investment funds (both exchange traded funds – ETFs – and active funds), derivatives and alternative investment vehicles. We estimate around US$2bn to US$3bn of assets under management at the moment, suggesting the investment management industry focus on crypto assets is still small. The average daily traded value of Bitcoin futures on the CBOE and CME has been around US$150mn since inception in December 2017
Are all crypto assets the same?
Generally assets are classified along three lines: capital assets, consumable assets and stores of value. The same applies for crypto assets and although they may seem alike they are not all the same. Bitcoin (XBT) is typically a payment asset that can be to some extent related to a currency, or to gold – hence it could be thought of as a store of value, however, XBT has been about seven times more volatile than gold over the course of its short existence thus making the comparison a bit far-fetched. Furthermore Bitcoin’s analogy to “digital gold” mostly stems from the perception that like gold, crypto asset values rely on a commonly agreed value among market participants for an asset that has limited consumption or industrial utility; nevertheless an essential caveat is that crypto assets are intangible unlike gold.
Although, it might be tempting to associate XBT and Ethereum (ETH), the latter is a platform asset, meaning that beyond its function of transfer of value, it enables a protocol that can be used for other applications of the distributed ledger technology (DLT).
In that sense, ETH could be considered a store of value but also a capital asset (without cash flows) to the extent its value is somewhat related to the usage volume of the underlying technology (for payment or else). Next come application tokens which are designed for a specific use. For instance, augur (REP) is a token designed to be used in a prediction market of the same name. Think of these tokens as the reward points you get from your airline. However, some of them also give the holder a stream of “dividends” based on revenues generated by the underlying business. As such, application tokens are convertible assets of sorts and some also bare the characteristics of capital assets. Another crypto asset class is that linked to side chains, i.e. they lock their values in a parent chain and are sort of “pegged” to it (Exhibit 3). Counterparty (XCP) is an example of such an asset, as it allows users to create a cryptocurrency within the XBT blockchain.
A Classification for crypto assets
Source: AXA IM Research
How efficient is the pricing of crypto markets across exchanges and locations?
Discrepancies in the price of crypto assets across trading venues suggest the market structure still has significant gaps limiting pricing efficiency and arbitrage possibilities while the asset class remains far less liquid than conventional financial assets with traded volumes, transaction processing time and accessibility remaining considerable hurdles. We looked at the price discrepancy of Bitcoin, by far the largest and most liquid crypto asset, across six major trading platforms located in the US, Europe and Asia to gauge pricing efficiency. Over the last year, the standardized price differential across these exchanges has average 70 basis points, going up to as high as 15% at times.
The average absolute deviation between the Bloomberg composite Bitcoin US dollar cross and the CBOE active futures contract (cash settled in one month) price since inception has been 1.3%. Similarly, tracking errors for ETFs benchmarked to these assets tend to be above 35%. These discrepancies suggest the market structure still has significant gaps limiting pricing efficiency and arbitrage possibilities.
How do crypto assets prices behave?
Despite the growing interest in crypto assets, there are only a few studies on their properties. Are they correlated with traditional financials assets? Most of the existing research focuses on Bitcoin (XBT) since it is the oldest crypto with the largest capitalization. Dyrhberg (2015a, 2015b) highlighted that XBT lies somewhere in between gold and the US dollar in terms of its statistical properties in a portfolio and also that it showed anti-correlation to UK equities. More recently, Bouri et al. (2017) argued that Bitcoin can be considered as a diversifier with low or anti correlation against some assets (mostly Asian equity markets; Shanghai A-share, Nikkei 225).
Replicating their methodology and extending the dataset until early 2018, we find similar results notably observing that XBT, on back testing, exhibits low or anti correlation against MSCI Emerging Markets, the Hang Seng Index, Shanghai A-share, Nikkei 225 and the Nifty 50.
However, a word of caution is needed on these results (we do not suggest using XBT as a hedge on any of these markets) given that since the creation of XBT in 2009, equity markets have been on a bull run and the sample on which the analysis is conducted does not contain a period of market turmoil. Also, investors should be wary of the liquidity of XBT (and other crypto assets). Crypto investments are far less liquid than conventional financial assets with traded volumes, transaction processing time and accessibility remaining considerable hurdles for now. Within the space, with the exception of Ripple (XRP) which does not exhibit strong correlation with XBT, the results suggest that crypto assets are quite correlated with each other (i.e. market participants do not differentiate much between them – Exhibit 4).
Correlations in the crypto space (2015-March 2018)
Source: Coinmarketcap.com and AXA IM Research
What other applications does blockchain technology have?
To add value, all applications of the distributed ledger technology (DLT) must share the same principle: decentralization. Think of a decentralized notary or decentralized data clouds. The scope of DLT applications is also very wide, ranging from legal to insurance, from data storage to healthcare, and from government to education and supply chains.
Supply chain management is a great example. The food-safety manager at a large retailer in the US asked his team to identify the origin of a package of sliced mango. It took the team of experts over six days to trace the complete supply chain. Then, the manager performed the same query with the aid of blockchain technology. The supply-chain information was readily and safely available within about two seconds. This anecdote illustrates the value added one could hope for, for example by being able to respond with very low latency to the outbreak of an epidemic, thus preventing the disease from spreading to other regions.
In any case, the list of future, disruptive applications is long and to complicate things there is also great uncertainty about the time to adoption. It can take a very long time before the current status-quo does change and the entrant technology becomes part of the value chain.
What are the regulatory issues surrounding these assets?
Recently, Benoît Coeuré, Member of the European Central Bank (ECB) Board and Chair of the Bank for International Settlements (BIS) Committee on Payments and Market Infrastructures (CPMI), wrote, that “cryptocurrencies are poor imitations of money […] Policymakers are rightly worried about consumer and investor abuses, as well as illicit use”. Central banks, governments and international organizations are increasingly looking into privately issued crypto assets and reflect on the regulatory environment necessary to prevent money laundering, terrorism financing, contraband trafficking and insure investor protection in the marketplace. Besides, the topic of privately issued crypto assets,
The regulatory debate around crypto assets
Some central bankers have also been considering the possibility of issuing their own cryptocurrencies, which are now referred to by the acronym CBDC for central bank digital currencies. Although, it is not yet clear whether CBDCs are necessary or desirable and the debate is ongoing. Exhibit 5 summarizes the views of key institutions both on privately issued crypto assets such as XBT or ETH but also on CBDCs. A recent study from the Centre on Sanctions & Illicit Finance, a think tank focused on financial and economic measures related to US national security, found that the amount of observed Bitcoin laundering was rather small (less than 1% of all transactions entering conversion services), but more importantly most of the laundering schemes occur through a handful exchanges and gambling services. Earlier this year, the U.S. Securities and Exchange Commission (SEC) raised a number of concerns regarding cryptocurrency related holdings like valuation issues, liquidity constraints, custody matters, and potential market manipulation amongst other risks. We would expect regulators to continue to analyse the consequences of crypto assets.
What is the environmental impact of crypto asset mining?
Various studies have criticized the negative externalities of crypto asset mining and questioned the sustainability of such practices. Globally, electricity consumption for bitcoin mining alone is estimated to be around 60.5 TWh annually or 989 KWh per transaction, which corresponds to more than the annual energy consumption of Portugal or of more than five million US households (Exhibit 6).
Furthermore, the dependence of the networks’ consumption on coal fired power plants rather than more sustainable energy sources results in a considerably higher carbon footprint. On the contrary, proponents like the majority of large miners have stated that this is a required cost for maintaining a secure distributed computer system and it is a minor issue compared to the environmental cost of extracting fossil fuels and precious metals.
Rapidly growing XBT energy consumption