Analyst Insight
Introduction
“Crypto peaked a year ago — investors have lost more than $2 trillion since”, was a headline run by CNBC in November 2022. The fall from the blissful peaks seen during the pandemic of cryptocurrency giants has been sharp and drastic. The popular cryptocurrency, Bitcoin, has fallen below $17,000 from its peak of $68,000, representing a loss of 74% in value in just over one year. News headlines have been dominated by distress and fallout at prominent entities in the industry while the two biggest cryptocurrencies, bitcoin and Ethereum have lost value in step with the riskiest stocks listed on American stock exchanges. By all measures, this seems like a spectacular crash for the industry and the death of a space overrun with hype and questionable risk management. But the question still stands, why do the biggest investment banks worldwide have exposure to the industry? What has caused savvy institutional investors to establish a stake and expend resources on research on the industry? The answer is the unique technology that backs these digital assets.
What are Cryptocurrencies?
A typical currency is a medium of exchange that is dependent on centralized authorities to support it, for example, through faith in the backing of a Government and a Central Bank that controls changes in the overall supply of the currency through its actions. A cryptocurrency breaks this mould via two main characteristics:
- Digitalization – Cryptocurrencies are exclusively transacted on computer systems over the internet. Cryptocurrencies have no physical form and exist only in a virtual record.
- Decentralization – Cryptocurrencies are not inherently dependent on a centralized organization determining its supply or managing its creation. Rather, new cryptocurrency can be minted through the solving of complex mathematical problems, verified by the consensus of the digital network.
What is the appeal?
The technology behind these digital networks is revolutionary and has many practical real-world applications. Decentralized cryptocurrencies are almost universally based on a blockchain which serves as a public database for the transaction history of these currencies.
A blockchain is a Distributed Ledger Technology that provides a secure way to access, validate, and trade assets and record each transaction across multiple locations on the network at the same time. The blockchain is virtually tamper-proof due to the cryptographic fingerprint that users leave with each entry on an increasingly vast peer-to-peer network. In other words, blockchain technology is essentially immune to cyber-attacks, as all previous records or nodes on the chain are practically immutable. In order to alter the blockchain, attackers would have to control 51% or more of the nodes on the network, a task that requires inordinate amounts of cost and equipment to carry out on mature networks. These characteristics can reduce the need for intermediaries, reduce counterparty risk and ultimately reduce transaction and operating costs.
Blockchain technology has significantly more practical use cases than just being the backbone of a currency like bitcoin. It has the potential to be disruptive in banking and finance by providing more secure and efficient ways to settle international payments; faster settlement times and more consolidated audit trails for capital market transactions. Additionally, Governments can better regulate the auditing and compliance practices for organizations because of the high barrier to blockchains being altered by fraudulent individuals. In Business, blockchain technology may be superior for managing supply chains, healthcare information, insurance contracts and any type of transaction or record management-based application.
The almost endless applications of blockchain technology behind cryptocurrencies is part of the reason why the industry has attention from institutions and governments worldwide despite being an initially confusing asset class.
What does this mean for consumers and retail investors?
The cryptocurrency and broader digital asset markets are largely unregulated and include participants who trade despite not fully understanding the asset they are trading. These markets expose investors to a high degree of risk, significant volatility and potential fraud. Large investors only expose a small portion of their portfolios to these assets for this reason, while also investing much larger amounts into researching and implementing the underlying blockchain technology.
While cryptocurrency markets may not be the most suitable for material portfolio exposure at the moment, investors must be aware of the technology backing the space. Blockchain and digital ledgers have the potential to act as a catalyst for a paradigm shift in the way businesses and governments operate moving forward and pioneers in the space may see great benefits which may eventually be more reflected in the traditional investment landscape
Michael Pryce
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