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Introduction
While we are long-term bulls on blockchain technology and its related cryptoassets, it does feel like the crypto market has gone a bit ahead of itself, having grown 8-fold since the start of 2020 (and that’s after a 40% market cap decline in the past two weeks). The market cap of all cryptocurrencies is now valued at US$1.6 trillion, similar to the market cap of Global High Yield Corporate Bonds!
It’s tough to estimate a fair value for cryptocurrencies, since the market is driven by the pace of blockchain adoption, institutional endorsements and regulatory clarifications, all of which are hard to predict. As such, it’s worth framing crypto valuations in relative terms, against each other (and its value vs other asset classes).
Given the high volatility of cryptos, crypto investors should ideally have longer-term investment horizons with appropriate bite sizing (which in our view would be a low single-digit percentage allocation of one’s investment portfolio).
Some have observed seasonality in Bitcoin’s price, which follows its 4-year halving cycles. There’s a possibility that Bitcoin (and cryptoassets in general) has already hit its current cycle peak. What follows is typically a bear market lasting 1 year, and another 1.5 years of price consolidation. The next Bitcoin halving is expected to be in early 2024, which could be the catalyst for the next bull cycle.
For investors who are keen to invest in crypto but don’t already have a crypto trading account, we include a list of stocks that are highly correlated to the price movements of cryptocurrencies. Please do your own due diligence before investing, and only invest if you can take the price volatility.
In short, despite the 40% dip in the past two weeks, we aren’t keen to enter the crypto market now, preferring to err on the side of caution since past bear markets have typically lasted 1 year.
NOTE!!! For crypto investors, risk management by bite sizing is important to manage the investment risk, and we think that low single-digit percent allocations (i.e. less than 5%) are appropriate.
Article Summary
1) Size of the crypto market and its growth drivers
2) Is there a need to have more than 1 cryptocurrency?
3) Is now a good time to invest in cryptos?
4) List of Blockchain-related ETF / Stocks
Appendix 1: Difference between blockchain and cryptocurrency
Appendix 2: Commonly cited blockchain applications
Appendix 3: Description of the largest cryptocurrencies / tokens
Appendix 4: How to value cryptos
1) Size of the crypto market and its growth drivers
If you are relatively new to this topic, it’s helpful to read Appendix 1 first. We explain what’s the difference between blockchain and cryptocurrencies, using analogies that are suitable for non-techies.
The total market cap of all cryptocurrencies stands at approximately US$1.6 trillion. That’s a really large figure, around the size of the Global High Yield Corporate Bond market!
Growth in the past year has been phenomenal. At the start of 2020, the total crypto market cap was worth “only” US$196 billion, and it has increased close to 8x since (see chart below). As a result, cryptos have reached a scale which can no longer be ignored.
The 7 largest cryptocurrencies together makes up roughly three-quarters of the total crypto market cap (see pie chart below). The remaining one-quarter of value is dispersed across more than 5,100 other cryptocurrencies, as of May 2021.
The crypto market has been supported by two key growth drivers in the past year.
- Increased institutional endorsements
- Supportive regulatory clarifications on cryptos
Increased institutional endorsements
Many view blockchain technology as relatively nascent, hence the value of cryptos may be largely driven by its rate of adoption. In the below table, we highlight some institutional endorsements that have happened more recently, which has helped fueled the crypto rally in recent years.
Mainstream crypto adoption is also happening in Singapore. For example, DBS launched a Digital Exchange in December 2020, and provides investment and custody services for Bitcoin, Ether, Bitcoin Cash and XRP (Ripple) to DBS Private Bank clients (Business Times, 14 May 2021).
The DBS website even features their own “Beginners Guide to Cryptocurrency”!
Supportive regulatory clarifications on cryptos
Regulators have been providing commentary about how they view cryptos (see table below), and that’s also been broadly supportive to the crypto market.
For example, there’s debate on whether cryptos should be classified as “securities”. If they are, stricter regulations and oversight would apply that could severely affect liquidity and the ease of initial coin offerings (ICOs). Regulators have clarified that they do not consider Bitcoin and Ethereum as “securities”, which provides some comfort around the potential classification status of other large-cap cryptos.
Another important announcement was made in 2020, where the Office of the Comptroller of the Currency (OCC) clarified that all federally chartered banks and thrifts may provide crypto custody services to clients, and also provide cash banking services to crypto-related companies.
Of course, regulatory clarifications are a double-edged sword. While US regulators have been relatively supportive on cryptos, China regulators have not. On 18th May 2021, Chinese regulators announced a ban on financial institutions and payment companies from providing services related to cryptocurrency transactions, sparking a steep selloff across the crypto market.
2) Is there a need to have more than 1 cryptocurrency?
The answer is yes. The reason is because a specific blockchain algorithm is designed to achieve a particular goal, and may not work as well for other purposes. As a result, there can be a number of cryptocurrencies in co-existence, to cater to varying investor and user needs.
A good example would be to compare Bitcoin and Ethereum. Bitcoin was built to be a mode of exchange and store of value, where users can send and receive Bitcoins to each other, and set up simple escrow type accounts. On the other hand, Ethereum was built to be more flexible and to be used for multiple applications such as smart contracts.
- Bitcoin’s algorithm is more simplistic and static, which gives it better stability and a low risk of being hacked. This gives investors more confidence to use Bitcoin as a store of value.
- Ethereum’s algorithm is more dynamic and frequently updated, which makes it more likely to have bugs (and to be hacked). As a result, it is not the best vehicle to be used as a store of value but has a wider use case for other applications.
We highlight some of the commonly cited key applications that blockchain technology (and its associated cryptocurrencies) may be used for in Appendix 2.
While the crypto ecosystem should theoretically be able to support multiple cryptos, keep in mind that most cryptocurrencies derive its value from “network effects”. For example, you can copy the Bitcoin algorithm and launch a new cryptocurrency under a different name. However, it will be worthless unless you can convince enough people to use it. Over the longer-run, we would expect further consolidation of investor assets towards the largest few hundred incumbents, while many of the 5000+ cryptocurrencies may lose favour over time.
3) Is now a good time to invest in cryptos?
Your guess is as good as mine. Unlike stocks and bonds, where valuations can be more precisely described via earnings multiples and credit spreads, the same cannot be said for cryptoassets which exhibit features that are between currencies and commodities. As such, it’s worth framing crypto valuations in relative terms against each other (and its value vs other asset classes).
Some have observed seasonality in Bitcoin’s price, which follows a 4-year boom-bust cycle around its halving event dates. As Bitcoin’s correlation with other large-cap cryptos is high, akin to stocks within the same sector, this 4-year seasonal cycle may also have relevance to the broader crypto market.
A Bitcoin halving event is when the reward for mining Bitcoin transactions is cut in half. As a result, there will then be less new supply of Bitcoins coming to market, potentially driving up prices. Recall that Bitcoin has a finite supply, and the maximum total supply will be capped at 21 million Bitcoins (18.7 million Bitcoins have already been mined, as of May 2021).
In the below chart, we plot Bitcoin’s price per USD since 2012, using a log scale. The three Bitcoin halving events are represented by the brown vertical lines. If you look at Bitcoin’s price trajectory after halving events, you will see that the shape is quite similar. It may purely be a coincidence but what we think happens is:
- Bull rally (1 to 1.5 years): Halving event drives investor optimism. Bitcoin rises in value (green highlighted segments in below chart).
- Bear market (1 year): Regulators get concerned with the sharp rise in Bitcoin’s price, decides to put in place more regulations and warns public about investment risk. Bitcoin sells off (red highlighted segments in below chart).
- Consolidation phase (1.5 years): Investors gradually start reentering the market, perhaps in anticipation of the next halving event.
- Repeat.
The recent drop in crypto prices seems to have been precipitated by fears of a regulatory crackdown in China, the United States and other countries.
If you are a believer in Bitcoin’s 4-year price cycle, this could imply that Bitcoin has just past its current cycle peak and we have entered the bear market phase (~1 year long).
Apart from market timing, position sizing and rebalancing are also important
Market timing is important, especially for an asset class that’s as volatile as crypto. For investments into this volatile asset class, investors should also keep in mind two things:
- Position sizing – Many asset managers have suggested a crypto allocation that’s between 1 – 5% of an investment portfolio, depending on the individual’s risk tolerance.
- Rebalance your positions – A rebalancing every 2 – 3 months would be appropriate. This would allow you “buy low, sell high” and also manage overall portfolio risk.
Think about how cryptos can complement your existing portfolio
CFA had published some data on the impact of adding crypto to a traditional 60/40 balanced portfolio. You may access the research paper here. In summary, they found that adding a quarterly rebalanced 2.5% allocation to Bitcoin would have improved the traditional portfolio’s returns by 23.9 percentage points (from Jan 2014 to Sep 2020), with almost no increase in portfolio risk.
From a portfolio management perspective, cryptos act as a good portfolio diversifier given its high historical returns and very low correlations to stocks and bonds. We should expect more institutional investors to allocate funds into this space, should custody services for cryptos become readily available and if the overall volatility of the asset class starts to come down.
4) List of Blockchain-related Stocks
Opening up a crypto trading account can be complex. Hence, an alternative way to express a positive view on blockchain (and cryptocurrencies) would be to use your existing stock brokerage account and invest into blockchain-linked companies instead.
Goldman Sachs had recently published a stock screen of 19 US-listed stocks with high exposure to blockchain technology. We have further narrowed this list down to just 9 stocks, which exhibits the highest correlations against the two largest cryptocurrencies Bitcoin and Ether (see chart below).
The below table shows some fundamental info of the 9 shortlisted stocks. Of note would be the stocks “beta” to Bitcoin and Ether (orange cells in below table).
“Beta” refers the sensitivity of the stock price, relative to a change in the price of Bitcoin or Ether. For example, Riot Blockchain’s “Beta” to Bitcoin is 1.8. This means that if Bitcoin’s price increases by 1%, Riot Blockchain’s share price is expected to increase by 1.8%.
If you think that the crypto sell-off is subsiding (disclaimer: that’s not our view), and want to buy stocks that are the most sensitive to price movements of Bitcoin and Ether, Riot Blockchain (RIOT US) and Marathon Digital Holdings (MARA US) would be worth exploring.
The InvestQuest View:
While we are long-term bulls on blockchain technology and its related cryptoassets, it does feel like the crypto market has gone a bit ahead of itself. There’s also a possibility that Bitcoin (and cryptoassets in general) has already hit its cycle peak, based on the seasonality effect observed in prior Bitcoin halving cycles.
Despite the 40% dip in the past two weeks, we aren’t keen to enter the crypto market now, preferring to err on the side of caution since past bear markets have typically lasted 1 year.
NOTE!!! For crypto investors, risk management by bite sizing is important to manage the investment risk, and we think that low single-digit percent allocations (i.e. less than 5%) are appropriate.
Appendix 1: Difference between blockchain and cryptocurrency
To describe blockchain technology, perhaps it’s easiest to use an analogy. Let’s think of blockchain as a “Google Doc” that anyone in the world can access. Users may propose additions into this “Google Doc”, and the proposed addition will only be made permanent when enough other users approve it.
To incentivize users to approve/reject proposed additions to this “Google Doc”, a reward is given for participation, which takes the form of a cryptocurrency.
Hopefully, this analogy is more explanatory than “blockchain is a decentralized ledger of all transactions across a peer-to-peer network”.
Blockchains can exist without a cryptocurrency
Note that a blockchain can exist without a cryptocurrency. However, without the incentive of earning the cryptocurrency, no user would make the effort to approve/reject proposed additions into this “Google Doc”. Hence, such blockchains are typically private blockchains that are maintained by a company or organization, and access is granted to specific users.
Private vs Public blockchains
An analogy to describe a private blockchain could be a company’s Intranet where content is maintained by a specific team and access is restricted to relevant employees. In contrast, an analogy to describe a public blockchain could be the Internet, which is decentralized (not owned by anyone) and anybody can interact with it and even create a website.
Are all blockchains decentralized?
There’s some misconception that all public blockchains are decentralized. First, it’s important to make the distinction between a “distributed ledger” and “decentralization”.
A “distributed ledger” is simply a record of consensus, which is the foundation of blockchain technology. It’s like a Google Doc that’s accessible by everyone and everyone sees more or less the same content (some might have a slower Internet speed or got disconnected, and may be seeing an older version of that Google Doc).
This “distributed ledger” can be decentralized (where everyone is granted similar rights), or centralized (where some users get special rights, akin to how some Google Doc users are granted the ability to edit the document, while others only have an ability to view the document).
Although many demonize centralized blockchains, there are cases where a centralized blockchain may work more effectively.
Appendix 2: Commonly cited blockchain applications
Commonly cited blockchain applications would include:
- Low-cost fund transfers, available 24/7
- Store of value
- Digital contracts (programmable money)
- Digital property rights
1) Low-cost fund transfers, available 24/7
Given the decentralized nature of most cryptocurrencies, fund transfers can be made anytime and at low cost.
To quote an example cited from the CFA Crypto Whitepaper, “On 12 April 2020, someone transferred 161,500 bitcoin – worth more than $1.1 billion at the time – in a single transaction. The transaction settled in 10 minutes, and the fee for processing the transaction was $0.68”.
This is in contrast to a traditional bank, where you can only make international wire transfer during bank opening hours, with fees that range 1% to 8%, and takes a few days to settle.
2) Store of value
For example, Bitcoin can function as a store of value is because like gold, there’s limited mining supply that’s inbuilt into its algorithm.
In contrast, owners of fiat currencies will run the risk of a Central Bank deciding to print more money, thereby devaluing the currency. Recall Economics 101 – higher supply of a good (or in this case currency) would lead to lower prices (or a currency devaluation).
3) Digital contracts (programmable money)
Consider the scenario where you are selling an item to a buyer that lives overseas. If you send out the item first, you run the risk of not receiving payment. If the buyer pays first, he/she runs the risk of not receiving the item.
One solution to the above is to use an independent third party (such as a bank). The third party holds the payment in escrow, and releases the payment to the seller only when the item is received by the buyer. A fee is then paid to the third party. Trade financing is a classic example.
Blockchain technology can function in place of the independent third party, executing an outcome when certain conditions are met, in a way that is cheaper, faster, more transparent and available 24/7.
Ethereum is commonly cited as the platform of choice to facilitate smart contracts.
4) Digital property rights
Let’s say you have a brokerage account. When you buy a stock, the broker has an internal database that records your ownership of that stock. This information is centralized.
In contrast, blockchain technology can offer a decentralized system of such records. This means that if you purchased something, all users would know that you are the owner. As a result, this creates the opportunity to create property rights on digital assets (i.e. NBA clips, memes, digital art etc.), which has given rise to nonfungible token (NFTs).
Appendix 3: Description of the largest cryptocurrencies / tokens
Appendix 4: How to value cryptos
Ashworth Damodaran, a famous Finance Professor at New York University, did a fabulous job in describing the value of cryptocurrencies (see source).
“Not everything can be valued, but almost everything can be priced,”
“cash generating assets can be both valued and priced, commodities can be priced much more easily than valued, and currencies and collectibles can only be priced.”
And according to a CFA crypto whitepaper, cryptos fit somewhere between the second (commodities) and third buckets (currencies and collectibles).
There are a number of ways to value cryptocurrencies, many of which have been borrowed from methods used to value venture capital, commodities, currencies etc. I will highlight one way that’s commonly cited and easy to understand.
Valuing cryptocurrencies via their “total addressable market”
Using Bitcoin as an example, its purpose is to be a store of value. Many have referred to Bitcoin as “digital gold”, given its similarity with gold in terms of its limited supply.
If you deem Bitcoin to be a good substitute for gold, you could estimate how much of the gold market would eventually be taken over by Bitcoin, and divide that by the number of Bitcoins in circulation. Let’s look at the actual steps:
- Compute the market cap of gold, which is estimated to be US$13 trillion.
- Estimate the proportion of the gold market that would be taken over by Bitcoin in future. Let’s call it 30%, implying that Bitcoin’s future estimated market cap would be US$3.9 trillion (US$13 trillion x 30%)
- Divide Bitcoin’s future estimated market cap by the number of Bitcoins in circulation. Dividing US$3.9 trillion by the maximum limit of Bitcoins of 21 million would yield a valuation of roughly US$186k.
- [Bonus step] Discount the valuation of Bitcoin, by a factor of Bitcoin’s price volatility over gold’s price volatility. The higher the volatility, the higher the implied risk. Hence, a more volatile asset should be priced cheaper to reflect the higher risk. At present, Bitcoin is roughly 5x more volatile than gold. So a risk-adjusted valuation for Bitcoin could be US$37k (US$186k divided by 5).
One weakness of such a valuation method is that many assumptions have to be made, and a slight tweak in a single assumption could lead to a big difference on the valuation of Bitcoin.
Other questions that an investor might also want to ask include:
- Is Bitcoin’s total addressable market just gold? Or should it include other stores of value such as negative yielding govt bonds, art etc.
- Will the price volatility of Bitcoin in future be similar to how it is now? If its volatility is expected to come down, perhaps you could use a smaller discount factor in step 4 earlier.
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