The uncertain promise of cryptocurrencies

Horizon 2022

0 min read

It is still too early to tell whether cryptocurrencies will ever be investable, but blockchain technology has plenty of potential.

“Despite regular news items on self-made ‘crypto millionaires’, we remain sceptical that cryptocurrencies can substitute fiat currencies.”

New investable assets have regularly appeared in recent decades. In the 1970s, it was gold, then emerging markets came to the fore in the 1990s, followed by alternatives (hedge funds, private equity, venture capital) during the 2000s. Each shared a number of characteristics in their early days – they’ve been difficult to access; they’ve had low correlations with existing assets; they’ve had insufficient liquidity; and they have provided the chance of significant extra returns for taking on risk.

Cryptocurrencies could well fit into that mould—but it is far too early to tell. Despite regular news items on self-made ‘crypto millionaires’, we remain sceptical that cryptocurrencies can substitute fiat currencies as they do not adequately fulfil the three main functions of money (means of payment, unit of account and store of value) in part because of their high volatility.

Indeed, a key drawback to the adoption of cryptocurrencies as an alternative to legal tender has been their volatility – the US dollar price of cryptocurrencies has tended to fluctuate wildly. This has led to the creation of collateralised cryptocurrencies, or tradable payment tokens called stablecoins, whose stability is meant to be assured by their peg to traditional currencies like the US dollar or to gold.

“Cryptocurrencies’ prospects may be uncertain, but the technology that underpins them – the distributed ledger – has the possibility of disrupting finance and investment.”

However, stablecoins have no formal depositor protection and no access to interbank clearing. The rise of stablecoins therefore poses questions about consumer protection and wider risks to the financial system, with doubts about whether stablecoins really are fully backed at all times by the kind of reserves they say they are. In practice, while they tout their peg to fiat currencies, the stablecoins in circulation are often backed by a mix of commercial paper, short-date securities and cash. Some compare them to US money-market funds—supposedly highly liquid assets that nevertheless came under substantial stress during the financial crisis in 2008 and again in March 2020. This has left the regulatory authorities scrambling to build a robust regulatory framework to ensure proper transparency and liquidity.

Central banks have woken up to the demand for crypto. Their response has been to look at creating their own digital currencies, called central bank digital currencies (CBDCs). These are unlikely to have all the features (especially anonymity) that make cryptocurrencies so attractive to some. But the official seal of approval, safety and widespread recognition will likely give CBDCs an impregnable advantage over cryptocurrencies as a way of payment. CBDCs could indeed allow faster, safer and cheaper payments, as well as offer the possibility for central banks to instantly transmit policy decisions (to ease policy, central banks could simply decide to place money in people’s digital wallets, for example). Although fiat currencies could morph into CBDC over the years, the drivers impacting the value of both are likely to remain the same.

Cryptocurrencies’ prospects may be uncertain, but the technology that underpins them – the distributed ledger – has the possibility of disrupting finance and investment. Through smart contracts, blockchains could give rise to a whole new spectrum of assets that can be easily traded as asset tokens – non-fungible tokens (NFTs, a type of digital collectible), tokenised physical assets, or even tokenised financial assets – in a trusted way on the blockchain (i.e., outside the traditional finance infrastructure).

“Blockchain technology could also be used to widen access to the financial system and combat inequality.”

Such developments could open up enticing new investment opportunities. Distributed ledger technology belongs to the category of innovation that is a major investment theme for Pictet Wealth Management, with the huge investments being poured into blockchain technology bearing many similarities to the huge spending on telecoms infrastructure in the late 1990s. One recalls that many of the companies back then went bust in the subsequent dotcom bust. But the technological breakthroughs provided the foundations for the digital revolution that has transformed the world economy over the past quarter of a century. There is no reason to think that distributed ledger technology will not produce similar results.

As we move through what looks like a long-term shift in the way that money works, an argument can be made for allowing properly regulated digital currencies using blockchain technology to experiment ways to facilitate cross-border payments. The technology could allow for the self-execution of smart contracts that could lower banking costs for small businesses, substituting lawyers and public notaries. Blockchain technology could also be used to widen access to the financial system and combat inequality.

While there are still many open questions to answer before this vision becomes reality, we will continue to closely follow blockchain developments to ensure our clients are optimally positioned.

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Footnote

The uncertain promise of cryptocurrencies