The last few days witnessed an unprecedented increase of around 45 per cent in Bitcoin’s value resulting in a 20x price hike in less than a year. While the rally, at least in part, can be attributed to the launch of bitcoin futures on Chicago Board Option Exchange, the crypto-currency has created frictions in the global financial system from the very beginning.
The regulators are concerned about decentralisation, the lack of central issuer, a loosely managed payment system ownership concentration, which can at any time trigger speculative shocks in the monetary system. Given that crypto participants are from all over, any resulting financial infection can be contagious.
Another issue why regulators should closely monitor the popularity of Bitcoin (and other crypto-currencies) is its probable use as an instrument to replace conventional tax havens by facilitating tax evaders. The recent financial reforms all over the world have more or less transformed the financial intermediaries to act as agents for tax authorities.
The increasing pressure on these intermediaries have forced them to declare monetary information to the public exchequer, and even withholding taxes at source on earnings accumulated in the accounts. As transactions in crypto-currencies can be anonymous and without the existence of any intermediary, they have the potential to defeat recent successes of governments in battling offshore tax evasion.
While regulators are being cautious, Bitcoin has the potential to emerge as an alternate asset class along with commodities, hedge funds, real estate, etc. Like any alternate asset class, Bitcoin can be included in portfolios along with conventional investments. The comparative stats between bitcoin and other forms of investments highlight some interesting facts.
While there is no doubt about Bitcoin being highly volatile in the last three years (at an annualised 120.9 per cent) compared to peer investment groups, the returns offered (annualised 354 per cent) make them attractive for risk seeking investors. The extreme negative and positive outcomes are captured by a very high Kurtosis among various alternates.
The most interesting observation is the low and negative correlations between Bitcoin exchanges and other investing possibilities like the euro (-15 per cent), MSCI developed (-5 per cent) and emerging market indices (-12 per cent) and World Real Estate Index (-13 per cent).
The last three years were characterised by sluggish economic growth and these correlations suggest that use of Bitcoins can ease investment returns during such periods. So while yields on other investments were drying out, money started flowing towards Bitcoin. However, investor behaviour is vital for proper utilisation of Bitcoins as a financial asset.
The recent increase in transactional activity may lead investors to treat their holdings as a speculative asset rather than an alternate investment or as means of payments. This raises a fundamental question for the market participants — Is Bitcoin in essence a bubble?
There is no certain answer to this as bubbles are rarely predictable on an ex ante basis. Even the recent bubbles (Nasdaq, housing, fixed-income, etc) were once deemed fundamentally solid investments. Historically, financial bubbles are triggered due to high money supply and easy access to leverage.
Owing to its fixed supply, at least for now, Bitcoin at least offers a potential solution to the debasement of other fiat currencies. If it is properly recognised as a substitute currency, the fair value will be far more than the current market cap. Therefore, it is hard to establish that despite the recent appreciation, Bitcoin is a bubble and, if it is, for now it is a good bubble.
The success of Bitcoin on account of its distinctive characteristics makes it a unique investment vehicle. The introduction of futures contracts will increase the liquidity and marketability. It is obvious that taking a position in Bitcoin may require significant risk tolerance.
However, high returns and negative correlations with other investments can significantly improve risk return characteristics in a well-diversified portfolio, even with a small exposure towards this virtual currency.
The criticism surrounding its existence is contaminated by early stage observations, which were naturally turbulent due to it having no sovereign backing. With increase in market capitalisation and interest among investors, regulators need to work closely to mitigate transactional, operational and governance issues.
Given the ecosystem of crypto currencies, Bitcoin has the potential to completely eliminate credit card systems, be a leading channel for international transfers, and replace short-term bank deposits. It can easily provide an alternate opportunity for investments.
The writer is Associate Professor of Finance at S P Jain School of Global Management, Dubai Campus.
