Turning Cryptocurrency Into an Asset Class

We’re living in a fiat world. Money has value because the government says so. Even if they keep the printing presses running in an effort to stimulate the economy, the greenback is still backed by the full faith and credit of the United States.

But as economic conditions have gone from the sublime to the ridiculous — think negative interest rates — one must question the theories surrounding the value of money. And as the central bankers of the world simultaneously increase interest rate accommodation in an attempt to fight against deflation, alternatives to centralized currency start to become interesting.

That may have laid the groundwork for the recent resurgence in gold, which is up nearly 25% in the first six months of the year. It also explains the recent interest in bitcoin, a decentralized digital currency (“cryptocurrency” or simply “crypto”) that allows goods and services to be exchanged very efficiently. Its recent appreciation and accessibility via exchange-traded funds raises an interesting question for advisors, one you may mistakenly dismiss at first hearing, but shouldn’t. Does crypto have a place in a diversified portfolio?

Blockchain 101

Understanding the concept of bitcoin starts with nothing more than a simple transaction. Suppose an artist transfers a digital photo to a client’s phone. The value of the work would be affected if the artist sold it to other collectors, a scenario known as the double-spending problem.

Bitcoin addresses this problem by using a ledger to keep track of all transactions. This ledger isn’t just controlled by one person; it’s an open source record of all transactions that live on the computers of so-called bitcoin “miners.” The result is a record (known as the “blockchain”) of verified transactions developed over time. Due to the extensive computational power needed to parse through the blockchain, it is extremely tough to falsify record-keeping. The blockchain is viewable by anyone in the bitcoin network, which makes it even harder to alter transaction information.

Bitcoin miners are compensated for their work by receiving bitcoins for their services. There are so-called bitcoin “farms” that are formed to compute the blockchain using numerous servers, but the computational power used to maintain the chain is sufficiently complex to make this a low-margin enterprise. Exchanges can be used to purchase bitcoin for the purpose of buying goods and services. A recent innovation is the creation of the Bitcoin ETF (GBTC), which allows investors to buy and hold bitcoin for investment purposes.

Surprisingly, the world’s central banks are big proponents of cryptocurrency. In an age where zero is no longer a hard boundary for interest rates, decentralized virtual currency takes on a new level of importance. As rates continue to head lower, individuals and corporations are incentivized to hoard paper cash (and not, as was intended, to spend more money). Transactions with paper money are hard to track. Currently, almost 80% of the value of American currency is in $100 bills, according to the Federal Reserve. While some of these bills are used as stores of value — akin to a mini-Treasury bill that doesn’t pay interest — a good portion is used for illicit purposes like purchasing drugs and weapons. The thought of abolishing paper money in return for a system that records every transaction, everywhere, is not lost on the world’s tax collectors (or law enforcement agencies).

Abolishing paper money and forcing people to use electronic accounts could free central banks to lower interest rates as much as they feel necessary while crimping the underground economy, according to Citigroup Global Chief Economist Willem Buiter and a colleague, economist Ebrahim Rahbari. While a radical concept, former Treasury secretary Larry Summers recently wrote an op-ed piece in The Washington Post promoting the elimination of large denominations like the €500 note and the $100 bill from circulation.

Another benefit of bitcoin is the efficiency of transfer. Credit card transactions cost 1.5% to 3%. PayPal, the online payment system, typically charges merchants a fee between 2.2% and 2.9%, as well as a per-transaction fee of 30 cents. Conversely, the average-sized bitcoin transaction (roughly $23) costs about 0.39%, which scales down quickly as transaction size increases. Further, bitcoin transactions are nearly simultaneous, which eliminates the delay with traditional payment systems. Highlighting the potential savings for banks, Santander U.K. (the first British bank to use blockchain for overseas payments) issued a report in 2015 estimating that blockchain could reduce banks’ infrastructure costs attributable to payments, securities trading and regulatory compliance by $15 billion to $20 billion per year by 2022.

Bitcoin as an Investment

As a cryptocurrency with numerous advantages, bitcoin has the potential to be the next big financial innovation. Its relevance to the investment advisory community is another facet to this new asset class.

Bitcoin is readily investable. Sponsored and managed by New York-based Grayscale Investments, the Bitcoin Investment Trust ETF (GBTC) has been around since 2013 and currently has about $163 million in assets. It is the first publicly available investment trust that allows investors to gain exposure to bitcoin within a traditional investment portfolio.

Investors are allocating a portion of their portfolio to bitcoin for a number of reasons, according to Michael Sonnenshein, director of sales and business development for Genesis Global Trading, the distributor for the Bitcoin Investment Trust. “There is certainly a lot of overlap with gold, in thinking of both assets as decentralized and global stores of value. But bitcoin is more portable and practical, and can be used to transact with firms like Expedia and Dell, just to name a few. Since you can’t buy a hotel room or a laptop with physical gold, investors think of bitcoin as a sort of Gold 2.0,” he said.

One of the most valuable ways to view bitcoin is as a safe haven investment. As the world’s central banks continue to print money with abandon, the once safe havens U.S. dollar and U.S. Treasuries might not always be the first place investors flee. If this turns out to be true, bitcoin could be thought of as another sleeve in a client’s alternative investment portfolio.

GBTC owns more than 1% of the $9.2 billion in bitcoins outstanding. To eliminate the risk of theft, an issue that has plagued several bitcoin companies and exchanges, the trust uses a third-party custodian. Xapo is likened to be the best institutional-grade custodian for bitcoin. “The company is well-capitalized, having raised $40 million from Benchmark and other well-known venture capital firms,” said Sonnenshein. Xapo stores the private keys to bitcoin vaults on offline, encrypted servers — a process known as deep cold storage (see sidebar, “But Is It Safe?”).

Structured as a trust (similar to the SPDR Gold Shares, GLD), the Bitcoin Investment Trust passively holds bitcoins. Accredited investors (those with a net worth of over $1 million or with a minimum annual income of $200,000) can purchase restricted shares of the trust at its daily net asset value via an ongoing private placement. These shares must then go through a 12-month holding period (as do all SEC Rule 144 restricted securities) before they can be freely resold on the open market as symbol GBTC.