Cryptocurrencies are experiencing an extraordinary run. Bitcoin, the largest virtual currency by market value, is up over 1,000 per cent year-to-date, and its crypto-cousin Ethereum is up a breathtaking 5,920 per cent at the time of writing. For all its record-setting year, the S&P 500 in contrast is up just 17 per cent.
Even negative headlines like government clampdowns on initial coin offerings have not stopped their blistering ascent. Still, they are also among the most volatile of publicly investable assets - for example, bitcoin plunged 31 per cent at one point in September and again 10 per cent last month, only to regain all losses and more in just a couple of days.
But without an end to the rally in sight, the question on everyone's mind is: "Are cryptocurrencies for real or a bubble?" They certainly display bubble-like characteristics: They are born of a new paradigm - in this case, an innovative new technology - their real-world uses are extremely limited, and their prices have soared by double-digit multiples in just two years. That said, while bitcoin may not become a mainstream currency, its underlying blockchain technology could change the world by driving innovations across key economic sectors in the years to come.
CRYPTOCURRENCIES AND THEIR SHORTCOMINGS
Cryptocurrencies are essentially digitally coded scripts that attempt to replicate modern-day currencies. Bitcoin was first launched in 2009, and more than a thousand digital currencies are in existence today with an aggregate value north of US$300 billion (S$404 billion). The backbone of a cryptocurrency network is made up of "miners": individuals or syndicates who use highly efficient networks of computers to solve complex mathematical sequences in exchange for transaction fees and, in some cases, newly minted cryptocurrency.
Cryptocurrency supporters typically point to their decentralised nature as the foremost virtue; supply and demand forces determine their value instead of a central bank, rendering them immune to government manipulation. Also, transactions are designed to be low-cost, secure and, in many cases, anonymous, thanks to the use of a publicly viewable digital ledger, called a blockchain, to track payments. Unfortunately, this also makes digital currencies the perfect tool for criminal activities such as money laundering and tax evasion.
While they are gaining interest globally as an asset, cryptocurrencies may never achieve mainstream acceptance as a medium of exchange. A critical barrier to widespread adoption is that cryptos will unlikely be accepted for the world's most important activity - the payment of government taxes, which remains the greatest advantage of government-backed currencies.
Bitcoin could be used, but doing so would incur a loss on the exchange rate. Companies will, therefore, continue to use legal tender to pay staff salaries and expenses, which account for an average 70 per cent of costs in developed economies. Naturally, too, governments prefer to issue liabilities in the same currency that they can control. Furthermore, without central banks managing supply to meet demand, cryptos can hardly function as a store of wealth. The currency's price will be subjected to wild swings as its supply would be uncertain and its natural demand limited. This makes judging a currency's intrinsic value a difficult endeavour.
BEWARE THE CRYPTOCURRENCY BUBBLE
Bubbles grow and pop because of several key factors. They almost always occur on the back of a new paradigm in the economy. The dot.com bubble in the early 2000s, for example, promised untold future wealth, but the underlying story of the ubiquity of the Internet was still far from materialising. This delay between expectations and real-world returns is a key characteristic of bubbles.
Cryptocurrencies are essentially digitally coded scripts that attempt to replicate modern-day currencies. Bitcoin was first launched in 2009, and more than a thousand digital currencies are in existence today with an aggregate value north of US$300 billion.
The mix of buyers is another one. In the later stages of a bubble, there are long-term investors who believe in the actual value of the asset and speculators who seek immediate returns. The influx of the latter is what inflates a bubble, and their exodus is what causes it to pop.
The sharp rise of cryptocurrency prices in recent months displays many characteristics of an asset bubble, most notably the lack of mainstream applications and the speculator-heavy mix of buyers. Investors should, therefore, proceed with extreme caution, as the promise of huge returns will come with great volatility and risks.
INVESTING IN THE BLOCKCHAIN WAVE
Nonetheless, we believe exciting opportunities are there in the underlying blockchain technology, which could revolutionise industries. The amount of economic value created could be as high as US$ 300 to US$400 billion globally by 2027, according to UBS estimates.
Blockchain is essentially a distributed database that is shared and continuously reconciled. Unlike traditional databases, where a trusted party alone holds complete authority, every user in the blockchain system has a copy of the database and is required to approve the transactions. This structure reduces costs (individual users need not rely on a central party or intermediary to transact) and improves security and reliability (there is no central party at risk of cyber attack or malfunction).
Just as the Internet has transformed our lives with e-mail, e-commerce and smartphone apps, blockchain could do the same for infrastructure technology through distributive ledgers, smart contracts, tokens and identity management. Emerging markets could be key beneficiaries, as blockchain helps build "trust" and allows countries to leapfrog stages of digital development.
Countries like Singapore are already diving into blockchain and exploring its potential application in various ways. For example, the Monetary Authority of Singapore's Project Ubin aims to evaluate the implications of having a tokenised form of the Singapore dollar and its potential benefits to Singapore's financial ecosystem. The central banks of Hong Kong and Singapore have also teamed up to link trade finance platforms they are developing with blockchain technology to reduce fraud and accounting errors.
In short, the cryptocurrency boom is likely a speculative bubble and, at some point, it will pop; but blockchain is another matter altogether. As blockchain technology matures, it will attract increasingly sizeable investments from large corporations and governments. Investors should look to capitalise on this trend by positioning into technology enablers and early and successful adopters globally.
•The writer is the Asia-Pacific regional head at the chief investment office of UBS Wealth Management.
We have been experiencing some problems with subscriber log-ins and apologise for the inconvenience caused. Until we resolve the issues, subscribers need not log in to access ST Digital articles. But a log-in is still required for our PDFs.