Since their introduction in 2009, cryptocurrencies have evolved into a global phenomenon, becoming a topic of intrigue for individual and institutional investors alike. PIMCO has been applying its time-tested investment research process to examining cryptocurrencies, an approach that has included analyzing current trends, polling the firm’s employees for views, and actively seeking out opinions of both passionate believers and ardent skeptics. Here, we address some key questions.
Q: Is cryptocurrency a currency, an asset class, or something else entirely?
A: Cryptocurrencies are a form of digital asset that use encryption to verify transactions in a decentralized manner, meaning transactions are recorded and stored across a global network of computers rather than with one central authority. Cryptocurrencies exist independent of central banks and have no physical form. They can be traded on exchanges, and there are futures and derivatives markets as well.
Unlike traditional currencies, cryptocurrencies derive their value in part from the trust placed in the security of the network that does not rely on a central counterparty. Their function as a medium of exchange for goods and services is limited but growing. High volatility has tended to limit their use as a unit of account, while relatively high transaction costs require additional layer 2 solutions (independent technologies that provide scaling) on top of blockchains such as Bitcoin or Ethereum.
Cryptocurrencies don’t have the hallmarks of traditional investment assets, such as the ownership stake and dividend income of equities, the coupon payments and principal of bonds, or the utility of commodities. However, they now power a rapidly evolving ecosystem in centralized and decentralized digital finance including yield-focused strategies based on lending, staking, or liquidity provision for exchanges. Proponents argue that with increasing institutional engagement, cryptocurrencies have the potential to disrupt elements of the existing financial industry, and bring about the emergence of a new suite of purely digital and decentralized assets.
Q: What are the key considerations when assessing Bitcoin or other cryptocurrencies as a potential investment?
A: As with any investment, it is crucial to assess their potential role within a portfolio – such as diversification benefits and return enhancement – versus the risks, which include volatility, liquidity, and regulation, among others.
Using Bitcoin, the predominant cryptocurrency, as an example highlights some key issues investors should consider.
Bitcoin’s returns initially came from strong retail demand for an asset engineered for scarcity, but the future price path depends on the participation of traditional institutional investors, which may have different needs and risk appetites. In order for Bitcoin to experience continued high returns, it would need broader adoption, in our view – especially among venture capital investors, hedge funds, and high-net-worth individuals.
Meanwhile, Bitcoin’s price swings have been dramatic, as it’s an emerging technology with rapid adoption and no consensus valuation anchor, which creates uncertainty in the price-discovery process. Another contributor to volatility is the participation of highly levered investors, whose rapid liquidation may increase drawdowns in tail events.
Liquidity on the spot market remains rather low. Based on the timestamps of transactions, we know that a majority of outstanding bitcoins are “buy-and-hold” (i.e., no recent trading activity), which tends to limit liquidity and suggests many investors see Bitcoin more as a volatile store of value than a medium of exchange or short-term speculative instrument.
Regulation of Bitcoin and cryptocurrencies is an important source of uncertainty, and greater regulatory clarity could present a risk or an opportunity for broader adoption. Similarly, the environmental footprint of Bitcoin’s proof-of-work protocol can cause concern for ESG (environmental, social, governance) investors, and improved transparency about renewables use is needed.
Q: How can cryptocurrencies be valued?
A: Several models have been proposed to assess cryptocurrencies’ underlying value, resulting in a wide range of valuations, and underscoring the challenge investors face when valuing Bitcoin and other cryptocurrencies:
- The store-of-value or “safe haven” model considers that investors see cryptocurrencies, especially Bitcoin, as a store of wealth and a hedge against potential debasement of a fiat currency. They may thus choose to substitute Bitcoin for gold, which has a similar role in traditional portfolios. Depending on the amount substituted, it implies a different valuation for Bitcoin.
- The model known as Metcalfe’s law views cryptocurrencies through a similar lens as telecommunications technology, whereby a technology derives its value from the size of the network. Valuation thus depends on current and future user count.
- The stock-to-flow model is based in commodity valuations, which assess the potential for future scarcity by estimating current stock against the expected flow of new production. For Bitcoin, future supply is known due to the programmatic supply schedule, while the current stock needs to be adjusted by coins lost or unlikely to be recovered.
- Another model suggests the price of a cryptocurrency should reflect its marginal cost of production. For Bitcoin, this includes the cost of electricity to provide the hash power that secures the network and mines new bitcoins.
Cryptocurrencies are relatively new to global financial markets, and longer-term value may differ greatly from the day-to-day fluctuations in prices. As we have seen narratives changing throughout the history of Bitcoin, from a collectible to a volatile store of value, we urge caution in subscribing to any one of the views and related valuation models without acknowledging the potential for a structural break in their current narrative.
Q: How is the cryptocurrency market developing relative to other investable markets?
A: Unlike traditional assets, cryptocurrencies are designed for self-custody via virtual wallets. Institutional investors often rely on custodial wallets, where a third-party financial institution holds bitcoins or other crypto assets in trust.
As cryptocurrency markets grow, there has also been increasing financialization. U.S. dollar-settled Bitcoin futures launched on the CME in 2017. Several other nontraditional financial institutions also offer Bitcoin futures and options with margin transactions also occurring in bitcoins. The first exchange-traded fund based on bitcoin futures launched in October.
Derivatives markets for cryptocurrency are still in their infancy compared with other financial assets, and liquidity on the spot market remains a significant consideration. Data on the actual liquidity is difficult to obtain as most exchanges remain self-reporting. In addition, the ownership structure appears to be highly concentrated, which is partly due to network entities that combine a larger amount of underlying individuals under one roof.
Although this illiquidity poses risks to short-term investors, a still-emerging market structure can also offer opportunities for investors who can provide liquidity to take advantage of dislocations in the market without material beta exposure to cryptocurrencies. For example, spot Bitcoin versus futures, or purchasing investment vehicles backed by Bitcoin at a discount to net asset value (NAV), have sometimes provided larger arbitrage opportunities than typically seen in more traditional asset classes.
Q: How does PIMCO think about digital assets’ role in broad portfolio asset allocation?
A: Given high volatility, lack of liquidity, and significant operational and financial risks, cryptocurrencies are at this point ill-suited for investors saving for retirement or with short- to medium-term time horizons, in our view. Investors with a very high risk tolerance and ability to weather significant volatility may be more appropriate to consider a modest allocation to digital assets.
Within an asset allocation framework, it’s also important to consider the diversification benefits (or lack thereof) of adding exposure to digital assets to a portfolio. Although limited history makes assessing the role of cryptocurrency in a portfolio over multiple business cycles challenging, there is some evidence for diversification: Cryptocurrency prices generally have not moved in tandem with those of gold or other inflation hedges, or of other risk assets such as equities, given significantly higher volatility. However, in tail events, cryptocurrencies have been more correlated with other risk assets, diminishing some of the diversification benefits.
Q: What opportunities does PIMCO see in digital assets?
A: Looking at the evolving environment in cryptocurrencies and other digital assets, we observe three high-level classes of opportunities:
- Market structure. Investors can seek to take advantage of structural inefficiencies in the market for an emerging asset class, even without meaningful beta exposure to cryptocurrencies.
- Financial system innovation. The digital asset landscape is evolving quickly, and disruption to existing financial system infrastructure can create opportunities for investors.
- High risk, high return. Some digital assets may fit within strategies targeting a high-return strategy that can weather significant volatility and risk.
Q: What are the biggest risks you see?
A: We’re monitoring a range of investment risks associated with digital assets:
- ESG concerns. Mining Bitcoin and other cryptocurrencies based on the proof-of-work consensus mechanism requires enormous amounts of electricity, posing significant challenges for ESG-sensitive investors from an environmental perspective. Although the Bitcoin mining industry has started to increase transparency and has acknowledged the need to shift to more sustainable energy sources, this area remains a major concerns among investors.
- Regulation. The regulatory and tax treatment of Bitcoin varies significantly between countries, and even between regulators in the same country. The regulatory environment can change rapidly and often drives price volatility.
- Volatility. The Bitcoin market appears subject to liquidity risk and heightened market frictions. Extremely high volatility and limited liquidity make digital assets inappropriate for many types of investors.
- Operational risk. Crypto investments are at risk of hackers targeting exchanges or lost keys in case of self-custody. This calls for secure custody and some combination of digital and physical security plus insurance against theft or loss. Despite its idea of decentralization, Bitcoin is systemically levered to existing large exchanges, concentrated ownership, and several large mining operations.
PIMCO’s Digital Asset Working Group is focused on researching issues related to cryptocurrency and financial technology.
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