February 17, 2021

Key takeaways

• The acceptance of cryptocurrencies as a means of exchange is accelerating, but investors should be aware they are not legal tender like a traditional currency
• Volatility, illiquidity and regulatory uncertainty have been stumbling blocks to broader adoption in the past, but there may be significant developments in these areas over coming months
• As a direct investment, it is critical that investors understand how the risk profile of digital currencies differs from traditional assets
• Bitcoin’s underlying technology, known as “blockchain,” offers significant potential applications
• Tokenization facilitated by the technology may be a new avenue to provide greater liquidity in illiquid assets
• The most liquid way at present to gain exposure is through publicly traded companies with a high exposure to blockchain technologies

Interest in Bitcoin continues to grow as the cryptocurrency reaches new highs. The rise in its value over the past few months has been stunning, with its price doubling in value from $20,000 in December 2020 to $40,000 less than a month later. On February 16, 2021, Bitcoin’s price touched $50,000 for the first time.

While the buzz around cryptocurrencies was initially driven by individuals, more recently institutional investors and businesses have become more heavily involved. One example of the latter is Tesla, which recently announced the acceptance of Bitcoin as a form of payment as well as an investment.

In recognition of the increasing adoption, BNY Mellon announced plans on February 11, 2021, to provide an integrated service platform for digital assets later this year, initially to institutional clients. This is an important step in assimilating digital assets within the broader financial ecosystem, and reflects the growing acceptance of cryptocurrencies among asset managers, hedge funds and other institutional investors. BNY Mellon is the first global bank to announce a structure that will support cryptocurrencies and allow them to flow through its financial network.

Although many investors may fear missing out on the stellar advance of Bitcoin in particular, we believe there are several factors that should be considered before making an allocation to digital currencies as a direct investment within a portfolio. In particular, it’s important to understand how digital currencies work, what’s behind the underlying blockchain technology and investment considerations. 

What are cryptocurrencies?

At their core, cryptocurrencies provide an electronic payment system that enables paperless transactions from one party to another through blockchain technology (Exhibit 1). The transactions are secured with cryptography and are entirely anonymous. As cryptocurrencies are digital and direct, they bypass middlemen such as banks or credit card companies, and there is no central monetary authority.

Exhibit 1: How Blockchain Works

Bitcoin is the most well-known cryptocurrency but others, such as Ethereum, Ripple and Tether also have a strong following (Exhibit 2). Though their potential as alternative currencies is what first garnered the public’s attention, it’s the underlying blockchain technology that may have broader applicability as a potential replacement to many existing electronic transfer and settlement systems.

Exhibit 2: Top Cryptocurrencies by Market Cap

What is blockchain?

Blockchain is a digital ledger that logs transactions in real time without the need for a single, centralized authority. In the case of cryptocurrencies, transactions that take place on the network are compiled into “blocks,” which are added to the chain in chronological order. On their local computer, everyone who participates in the network has a copy of the blockchain, which contains a record of every transaction ever made, allowing for a transparent auditable trail. This distributed network of computers is used to validate transactions and to prevent tampering or duplicated entries. By offering a secure and efficient method of exchanging and validating information, blockchain technology could have a tremendous impact on the global economy, with significant implications for the financial services, health care, real estate and consumer sectors. Because of this broad application, blockchain technology has the potential to be more meaningful than the cryptocurrencies it powers.

How bitcoin works

Bitcoin’s 2009 creation is shrouded in mystery. The true identity of its creator, who goes by the pseudonym Satoshi Nakamoto, remains unknown to this day. Bitcoins are produced through a process called “mining,” in which participants in the network are awarded Bitcoins as a reward for solving complex computational problems that help verify transactions and add them to the blockchain. Each Bitcoin has both a private and a public key that enables secure trading, selling and spending.

As of February 16, 2021, Bitcoin’s market cap stands at more than $900 billion, double that of companies such as Walmart and Visa, and far exceeding the value of the world’s largest banks (Exhibit 3). Much of that value was gained recently: Between October and December 2020, Bitcoin’s market cap rose from roughly $196 billion to a high of over $750 billion.¹

Exhibit 3: Market Capitalization

As a means of exchange, Bitcoin offers several advantages, including enhanced privacy, independence from country-specific monetary policies and substantial cost reductions for transactions. It also creates exposure to additional risk presented by Bitcoin’s heightened volatility and illiquidity, which may render it a poor store of value in the near term.

Use as a form of payment has grown in acceptance as large payment processors such as Visa, Mastercard and PayPal have embraced the growth of cryptocurrency. They have been working to extend processing capabilities to the millions of merchants within their networks. While it has yet to become a widely accepted medium of exchange, steps are certainly being taken for its adoption. The recent announcement that Tesla will not only accept Bitcoin as aform of payment but has also invested $1.5 billion in the cryptocurrency has gained significant attention. It is unclear, however, whether Tesla views its Bitcoin holding as a long-term investment.

Not your keys, not your coins

Bitcoin offers no means of financial recourse for its users. There’s no FDIC-style consumer protection for stored Bitcoins. Losing one’s private key means losing access to Bitcoin assets, and there’s no way to recover them. For example, tech writer Campbell Simpson purchased 1,400 Bitcoins for $25 in 2010 and kept them stored offline on a hard drive. He later disposed of the hard drive without backing up its data.² Without the hard drive, those coins — and the value they represent —were lost forever. As of December 31, 2020, those Bitcoins would be worth over $40 million.

It is estimated that up to 20% of Bitcoins mined have been lost forever. While PayPal has recently begun to offer the ability to purchase Bitcoin through its network, it does not provide purchasers with their private key, which is raising concern among the cryptocurrency community.

A volatile asset: hold on for dear life (HODL)

Bitcoin is highly volatile, which is perhaps one of the large obstacles to broad adoption. Originally a typo for “hold,” HODL has become known as “Hold On for Dear Life,” the term used to refer to a Bitcoin holding period of greater than one year. Individuals who hold Bitcoin for more than one year are known as “hodlers.” 

With large fluctuations in price, it is difficult to know precisely what the purchasing power of one’s holdings will be over any period of time. Bitcoin started 2017 below $1,000 and increased to nearly $20,000 by the end of the year. Twelve months later, Bitcoin had dropped back to $3,100. Fast forward to 2020, and Bitcoin was relatively stable for the first three quarters, trading around $10,000 except for the pandemic-driven pullback in March. During the fourth quarter, increased institutional ownership, further expectations of supportive monetary and fiscal policy and renewed interest by retail investors propelled Bitcoin to end the year at nearly $30,000.

Despite what seems like extreme volatility and a meteoric rise in what usually precedes a bubble, so far Bitcoin is unlike any bubble in history. It has survived three peak-to-trough drawdowns of over 80% in a span of 10 years (Exhibit 4). This is different than previous bubbles, which usually experience a drawn out “boom-doom” cycle spanning many years or an outright collapse akin to the death knell of tulip mania in the 17th century.

 Exhibit 4: Bitcoin Drawdowns