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Cryptocurrencies as an Emerging Asset Class

How Bitcoin and Co are changing the world of banking (part 5/7)

Axel Wieandt - July 6, 2021

Tips for practitioners

Cryptocurrencies’ market cap of over USD 1.7 trillion at the end of March 2021 make the category too big to ignore. While the category is small compared to, say, the global market value of real estate, bonds, stocks, or even gold, the market cap of Bitcoin is approximately USD 1 trillion, accounting for 60 percent of all cryptocurrencies. Although Bitcoins market cap value is greater than the total value of all outstanding JPY and over 900 percent of outstanding GBP, its liquidity is comparatively very low. The average number of bitcoins exchanged daily is equivalent to less than 0.05 percent of outstanding JPY and 0.06 percent of outstanding GBP. The other major cryptocurrencies, such as Ethereum (ETH), Cardano (ADA) and Polkadot (DOT), are even smaller and less liquid.

Considering their significant market cap and low liquidity levels, is it justifiable to consider cryptocurrencies a new and permanent assetclass? Greer defines an asset class as “a set of assets that bear some fundamental similarities to each other, and that have characteristics that make them distinct from other assets that are not part of the class.” There are three broad asset classes: capital assets, consumable/transformable assets, and store of value assets. Capital assets such as equities, bonds, and real estate typically generate an income stream for the owner. Consumable/transformable assets such as physical commodities and precious metals provide economic value to the owner when they are consumed or transformed into other assets. Store of value assets such as precious metals, currencies, and fine art store value for the owner over a longer period of time.

Currencies function as a medium of exchange, a unit of account, and a store of value asset. Despite their similar sounding name, there are several reasons why cryptocurrencies such as Bitcoin do not qualify as a currency. For one, they are not a viable medium of exchange because they are not a legal tender and are only accepted as payment by a small, albeit growing, number of merchants. Moreover, their historically high price volatility makes them ill-suited as a unit of account.

A store of value or an entirely new asset class?

Since most cryptocurrency owners hold on to their holdings for a longer period, it could be argued that cryptocurrencies belong to the store of value asset class. However, some scholars argue that cryptocurrencies constitute a new asset class. Although they are similar to other asset classes, some scholars argue that cryptocurrencies have their own unique set of characteristics and features. There are four characteristics that distinguish cryptocurrencies from traditional asset classes: investability, politico-economic profile, correlation of returns, and risk-return trade-off profile.

  • Investability: while cryptocurrencies have historically low liquidity, their liquidity has improved over the past few years, and they remain accessible independent of regulation and capital controls.
  • Politico-economic profile: cryptocurrencies differ from traditional asset classes due to their innovative technology of public, permissionless, distributed ledgers / blockchains, their incentive design, and the ensuing novel forms of decentralized governance.
  • Correlation of returns: As is the case with gold, there is a historically weak correlation between the price development of cryptocurrencies and the price development of other assets such as equities and bonds. However, recent COVID-related market episodes have strengthened this correlation, which suggests that investors may consider cryptocurrencies a short-term risk-on asset.
  • Risk-return trade-off profile: Recent empirical studies show that adding cryptocurrencies to traditional investment portfolios including equities, bonds, and real estate, improves their risk return profile. Since cryptocurrencies introduce new technological, reputational, regulatory and political risks, they require due diligence and influence risk budgets. The lack of an established, harmonized taxonomy and legal framework such as that in place for other better-established assets make such due diligence of this new, experimental, and rapidly evolving asset (class) challenging.

How to determine the value of a cryptocurrency

Recall for a moment Keynes’ allegory in “The General Theory of Employment, Interest, and Money.” In Keynes’ beauty contest, judges are rewarded for selecting the faces most popular among all judges, rather than faces they personally like most. Keynes explains that winning this contest “is not a case of choosing those faces that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached a third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” Keynes postulates that in the stock market, fundamental value matters less than what everybody else predicts the average assessment of value to be. In terms of cryptocurrency valuation, in the absence of a common valuation model, cryptocurrencies prices will follow expectations about how news will be interpreted by key stakeholders.

Most cryptocurrency valuation models rely on market cap and the long-term token supply schedule. Market cap is calculated by multiplying the unit price of a token by the supply of tokens in circulation. The market cap of Bitcoin on March 28, 2021, for example, is USD 56,000 multiplied with18.7 million Bitcoins in circulating supply, which equals USD 1 trillion market cap. The long-term token supply schedule tracks how many tokens will be created in what timeframe and how many are circulating in the secondary market. For example, the current circulating token supply of Bitcoin is approximately 15.2 million bitcoins (18.7 million minus 3.5 million due to lost keys), and its supply is capped at 21 million bitcoins. Some tokens like Ethereum (ETH) follow an inflationary model and do not cap total supply. Cryptocurrency supply can be reduced permanently through coin burns (sending coins to a known private key) or temporarily through lock-ups (such as through a smart contract) or buy-backs (repurchase of tokens by network). Cryptocurrency supply increases through “mining” or “minting” new coins.

Broadly speaking, there are six approaches to valuing cryptocurrencies, illustrated here using Bitcoin as an example:

1. The “store of value” framework assumes that Bitcoin will eventually replace other assets as a store of value. If Bitcoin were to replace all mined gold, with an estimated value of USD 10.6 trillion, each of the 21 million bitcoins would be worth over USD 500,000. Deducting the estimated 3.5 million lost Bitcoins would increase the value of each Bitcoin to over USD 605,000. If Bitcoin were to replace 20 percent of gold’s share as a store of value asset, the value of each Bitcoin would be approximately USD 100,000. Discounting could be introduced to reflect the uncertainty of reaching a 20 percent market share at a future date.

2. The “token velocity thesis” considers token transaction velocity a key driver of long-term token value. Transaction velocity is calculated based on the monetary equation of exchange M x V = P x Q, where M is the size of the asset base, V is the velocity of the asset, P is the price of the digital currency and Q is the (current) supply of the digital currency. The lower the velocity, i.e., the more people are holding a currency as a store of value, the higher the value of the currency. Staking features such as “proof-of-stake consensus mechanisms” reduce token velocity and support higher prices. The velocity of a currency is calculated by dividing a nation’s gross domestic product (GDP) by the total money supply. Since Bitcoin is not a currency, the rate of its exchange on the remittances market is a possible market substitute. Before the pandemic, remittances from high-income to low- and middle-income countries were valued at approximately USD 500 billion. If 20 percent of this market were to migrate from traditional cross-border payment channels such as Western Union or MoneyGram to the Bitcoin protocol, and assuming a Bitcoin circulation velocity of 5.48, in line with the velocity of the USD prior to the pandemic, each circulating bitcoin would have a value of approximately USD 1,000.

3. The “INET & crypto J-curve thesis” framework was developed to calculate the value of a fictitious coin INET. The framework has four parts:

  1. the number of tokens in circulation,
  2. the current utility value using the monetary equation of exchange,
  3. the forecasted adoption of the crypto asset within its target market following a J-curve, and
  4. the forecasted utility values discounted back to the present.

This model is best suited for the valuation of so-called utility coins with real utility value, such as Filecoin (FIL), that give token holders the right to use a decentralized storage network.

4. The “network value to transaction (NVT) ratio” compares the relative use of the cryptocurrency network over time. NVT for a given time is calculated by dividing the network value, i.e., the market cap by the transaction volume, i.e., the daily monetary volume transmitted through the protocol. A higher NVT ratio suggests the network is overvalued, while a lower NVT ratio suggests it is undervalued. To improve this metric, the denominator is smoothed with the 30-, 60-, or 90-day moving average function. A limitation of the NVT ratio is the assumption that the value of the cryptocurrency is only derived from its function as a medium of exchange. A higher NVT ratio can also reflect a high number of people holding the cryptocurrency as a store of value. Bitcoin’s current NVT ratio ranges from 70 to 80, below the levels it had reached before the bursting of prior bubbles.

5. “Daily active addresses – DAA” is a metric for the number of users that employ the crypto network in transactions on a daily basis. Similar to the concept of daily active users (DAU) for platforms and applications, DAA can provide information about the activity level on the network as an approximation for network utility. It is often used as a complement to NVT and on-chain transaction volume. In the wake of Bitcoin’s price increase at the beginning of 2021, the number of DAA increased to over 1.3 million active wallet addresses. In January 2021, more than 22.3 million unique wallet addresses actively sent and/or received Bitcoins in the network.

6. “Stock-to-Flow ratio – SF-ratio” goes back to Nick Szabo´s insight, that “precious metals and collectibles have an unforgeable scarcity due to the costliness of their creation.” Bitcoin, for example, has “unforgeable costliness” because mining Bitcoins is very energy intensive. Gold has the highest SF-ratio of 62 as the supply grows on average 1.6 percent each year, and it would therefore take 62 years of production to get to the current stock of gold. With a current reward of 6.25 Bitcoins per block mined and a stock of 18.7 million coins, the Bitcoin SF-ratio is 57, very close to the level of gold and ahead of silver that has a SF-ratio of only 22. Statistical analysis indicates a strong relationship between SF-ratio and market value, suggesting further increases in the value of Bitcoin with future “halvings” of the mining rewards occurring every 210,000 blocks, i.e., every four years.

Cryptocurrency due diligence

  • “Whitepaper”: Cryptocurrency due diligence should always begin with a “whitepaper”. The Bitcoin whitepaper is Satoshi Nakamoto’s 2009 paper “Bitcoin: A Peer-to-Peer Electronic Cash System”. Cryptocurrency whitepapers typically combine elements of peer-reviewed academic research papers and business plans, including the following basic elements:
  1. the problem statement,
  2. an exclusive solution,
  3. competitors and alternative solutions,
  4. the need for blockchain technology,
  5. token issuance, distribution methods and technical usage aspects, and
  6. the team and its experience.

Other important aspects of cryptocurrency due diligence include the quality of the code across all layers, the size and level of activity of the developer community, consensus-mechanisms and governance, and incentive design.

  • Quality of code: Since all blockchain technologies rely intrinsically on code, the code must be screened, and its quality scored. Most cryptocurrencies have open-source protocols, and their codebase is easily accessible on GitHub repository.
  • Developer community: The quality and size of developer support influence code quality. In October 2020, 9,000 monthly active developers contributed to the development of cryptocurrencies, and the number of new crypto-developers grew in 2020 for the first time since 2017. Over time, higher-quality ecosystems grow, while lower-quality ecosystems shrink. Developer activity is particularly strong in the Bitcoin, Ethereum, and Decentralized Finance networks. The Bitcoin ecosystem had 361 monthly active developers in October 2020, 70 percent more than in October 2019. In comparison, the Ethereum ecosystem had over 2,300 monthly active developers in October 2020.
  • Governance: A successful cryptocurrency needs a strong system for managing and implementing changes. Most cryptocurrencies follow the governance model of collaboration of open-source software. In the case of Bitcoin, developers propose changes and updates to the code as Bitcoin improvement proposals (BIPs). Each BIP must pass several stages of peer and security review before it can be implemented and activated through a soft (backward-compatible change to the protocol) or hard (not compatible) fork in the blockchain. Soft-fork BIP activation requires a clear miner majority that upgrades their software to include the BIP. Hard-fork BIP activation, in contrast, requires the adoption from the entire Bitcoin community, including Bitcoin holders and those providing services with Bitcoin.
  • Incentive design: Built-in incentive design is critical for the success of a cryptocurrency. To survive and thrive, a cryptocurrency ecosystem must properly incentivize adoption, contribution, and participation among relevant stakeholders.

Crypto-custody and wallets

Before buying and trading cryptocurrencies, investors must consider crypto custody. The fundamental principle of token ownership is “I know, and I own” rather than the “I am, and I own” principle governing bank and security accounts. Tokens are stored in e-wallets and exchanged by sending them from one wallet to another. Wallets are protected using public-private key encryption. In order to dispose of a token/coin the investor needs to know the private key of his or her wallet. If he or she loses the key or sends the token to the wrong address, the cryptocurrency is lost.

There are three types of storage technologies for private keys, depending on whether the wallets are connected to the internet. In cold storage, the private key is stored off-line as a hard copy or on an external electronic data storage device. Famously, the Winkelvoss Bitcoin billionaire twins distributed snippets of a printout of their private keys across multiple safe deposit boxes in the USA. Retrieving a key from cold storage takes time and can therefore slow trading, and the owner can lose the private key. In hot storage, the crypto wallet is run through a system connected to the Internet, such as in the cloud, on a mobile device or on a stand-alone computer. Most retail crypto exchanges hold a share of their cryptocurrencies in hot wallets. Warm storage is attractive to institutional investors for whom the lack of secure custody solutions for private key storage has been a barrier to investment. Military-grade “warm-storage” technological solutions, which rely on certified hardware security modules and allow withdrawal of tokens within seconds, have recently made crypto-custody more appealing to institutional investors. Together with regulated crypto-custody services and the increased availability of insurance for crypto-custody, “warm-storage” custody is paving the way for increased institutional cryptocurrency activity.

Trading on crypto exchanges

Some cryptoexchanges are centralized exchanges, such as Coinbase in the US, or Kraken and Bistamp in Europe, and decentralized exchanges, such as dYdX. Coinbase is regulated in the US and has a New York money transmitter license. It offers a smaller number of cryptocurrency coins than, for example, Binance, in order to avoid US securities laws infringement. Binance, as one of the largest exchanges worldwide, attempts to appear decentralized but in fact is a network of several legal entities in different jurisdictions each with their own regulatory regime. Binance offers its native token, the Binance Coin (BNB), which initially offered discounts on trading fees but has since developed into an entire ecosystem. Initially, Binance did not offer fiat on- and off-ramps, whereas Coinbase has developed extensive fiat payment options. In 2019, Binance launched Binance US, which supports deposits and purchasing via bank transfer, debit card, or wire transfer and withdrawals via bank transfer. dYdX is a new form of decentralized exchange. It is a permissionless platform powered by smart contracts that run on Ethereum supporting lending, borrowing, and most importantly, margin trading.

The large number of exchanges and the diversity of regulatory regimes for cryptocurrency trading are conducive to fraudulent trading activities such as “wash-trades” and “pump-and-dump” schemes. In addition, over the past few years, there have been several serious hacks of cryptocurrency exchange wallets, diverting significant amounts of cryptocurrencies, mostly Bitcoin and Ethereum, into hackers’ wallets. While public blockchain protocols make it easy to trace transfers into wallets, it is very difficult to link wallets with computer terminals or individuals across jurisdictions. In 2019, for example, hackers stole USD 40 million worth of bitcoins from Binance. In response, Binance suspended withdrawals and deposits for one week and drew on a secure asset fund based on allocations of ten percent of all client trading fees since 2014 to reimburse affected investors for their losses. Only if crypto-trading moves away from centralized exchanges that hold investors´ private keys and tokens in so called “hosted” wallets to fully decentralized, permissionless peer-to-peer exchanges can the concentration of digital wealth that has attracted hackers and bad actors be avoided.

Other methods for investing in cryptocurrencies

For investors wishing to skirt the hazards of trading on crypto-exchanges, investment vehicles such as brokers, contracts for difference derivatives (CFDs), trusts, exchange traded notes and exchange traded funds offer viable alternatives:

  • Brokers: Examples of crypto brokers are Austrian-based Bitpanda and Swiss-based Crypto Finance, both of which serve experienced, professional, and institutional investors. 
  • CFDs: Contracts for difference (CFDs) are highly complex, speculative, over-the-counter derivatives. Leading derivatives dealers are CMC and Plus500, both UK-based financial derivatives dealers.
  • Futures: Several exchanges offer Bitcoin futures, such as the Chicago Mercantile Exchange (CME) and the US company Bakkt. The large crypto-exchanges like Binance or BitMEX offer a novel form of perpetual futures that drive leverage in the the crypto-universe.
  • ETNs: Bitcoin exposure can also be purchased through exchange-traded notes (ETNs), which carry counterparty risk. An established crypto-ETN provider is XBT, whose notes are traded on the Swedish stock exchange.
  • ETFs: Hashdex, a Brazilian-based fund manager, and American stock exchange Nasdaq have recently launched a cryptocurrency exchange-traded fund (ETF), which will be listed on the Bermuda stock exchange. The largest Bitcoin ETF with more than one billion US Dollars in assets is the Purpose Bitcoin ETF, managed by Purpose Investment Inc. of Canada. The US Securities and Exchange Commission (SEC) has repeatedly rejected applications by US ETFs due to the lack of a national cryptocurrency exchange that meets the requirement to be designed to prevent fraudulent and manipulative acts and trading practices.
  • Trusts: Trusts are more traditional investment vehicles whose shares can be publicly listed and traded. The Gayscale Bitcoin Trust, launched in 2013, is now the largest cryptocurrency trust with over 35 billion Dollars in assets under management (AUM) in March 2021. Its shares have been trading at a significant premium to net asset value for a long time. In February, however, the premium turned negative with investors exiting the trust in favor of other investment options.

Tips for practitioners

  • Recognize that cryptocurrencies are a new, emerging asset class
  • Consider differences between the return profile of cryptocurrencies and other asset classes, as well as the idiosyncratic risks of cryptocurrencies, in particular technological and political/regulatory risks
  • Rely on the five heuristic frameworks to value a cryptocurrency as a store of value asset or a cross-border payment network
  • Perform careful due diligence before investing in a cryptocurrency
  • Avoid the risk of hot online cryptocurrency wallets and consider engaging professional crypto-custodial support
  • Compare the risks and benefits of various instruments to gain exposure to cryptocurrencies, such as exchange-traded notes, trusts, and futures

Literature references


Professor Axel Wieandt

Axel Wieandt, a former CEO/CFO at a DAX-30-listed bank, Global Head of Corporate Development, FIG banker and McKinsey consultant, is a senior financial services professional with a focus on banking, fintech, and finance. Axel is currently advising American and European private equity/venture capital funds and real estate companies on their investments and value creation plans. He also serves on the advisory and supervisory boards of German fintech and real estate investment companies. Axel is an early fintech investor himself and has teaching assignments with top-ranked international business schools, including WHU – Otto Beisheim School of Management. Over the years, he has published over 70 research papers, op-eds, and interviews. He is a frequent speaker/panelist at conferences. Axel is the author of “Unfinished Business: Putting European Banks (and Europe) Back on Track” (2017).

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