We have seen a big uptick in the hype surrounding bitcoin, driven largely by the massive return numbers reported. Recent Bloomberg research contrasted the rise in bitcoin with market bubbles, like the tech market crash in the late nineties. But there is almost no comparison. Tech stocks rose just over 1 000% over the entire course of their bubble, and bitcoin is already up by almost 17 000%. Returns have been strong, but does it have a role to play in wealth management?
There are some immediate challenges with this cryptocurrency that one needs to consider. Firstly, Bitcoin is not approved by the Financial Sector Conduct Authority (FSCA) as a financial product. Since bitcoin operates without a central authority (i.e. a central bank), there is no clear recourse if things go wrong.
The FSCA recently issued two ‘health warnings’ to investors, as cryptocurrencies are increasingly being used in scams. For example, Mirror Trading International (MTI) has been named as the biggest crypto scam of 2020, where R8.6 billion of investors’ bitcoin was stolen.
Should bitcoin play a role in your financial plan?
Your financial plan links your goals to the investments and investment returns that you require to achieve those goals. Your financial plan also ensures that you understand the risks inherent in any investments and that you are comfortable with the possibility of not achieving your goals, should those risk materialise.
Currencies are usually considered as investment vehicles and not investments. An accurate assessment of an investment’s intrinsic value requires a linked cash flow stream. This cash flow stream then needs to be discounted and valued to determine whether the asset is trading at a value under, or above, its intrinsic value. Without this assessment, we would contend that any allocation is highly speculative.
Bitcoins have been subject to sharp and rapid changes in value, rendering their value highly unpredictable at any given time. There are no specific licensing requirements for wealth managers and credible research is thin, which means risks are largely unknown and not actively monitored. With unpredictable risk, comes real uncertainty about an investor’s ability to ultimately meet their financial planning goals.
Fraud, theft, and liquidity risks
Bitcoin holds appeal to those engaged in illegal activities because of its anonymity. This, combined with a rise in digital crime, introduces the risk of fraud and theft. This is exactly what happened in February 2014 when Mt. Gox filed for bankruptcy protection. Mt. Gox, the world’s cryptocurrency exchange, which at one point controlled 70% of bitcoin transactions, was plagued with hacks and other problems. It finally closed down in 2014.
The currency is managed by peer-to-peer technology that is responsible for all functions, including issuance, transaction processing and verification. As a peer-to-peer vehicle, it bypasses financial institutions as intermediaries. It may be cheaper to use, but this removes the safety net provided by financial institutions and the regulations that govern their oversight functions.
Cryptocurrency issuance is very tightly held, with 99% of all supply being held anonymously by fewer than 1% of the owners. This may pose liquidity problems during a currency crisis or when a financial plan must deliver on emergency funding for unforeseen needs. Its commitment to a limited production (of 21 million bitcoins) is fundamental to its objective of retaining value. Although it must be noted that this commitment is not contractual, and there is no clear recourse indicated should the currency be devalued (or more bitcoins mined).
Will bitcoin ever be appropriate in the wealth management space?
The FSCA warns investors who would like to invest in unregulated risky assets, such as cryptocurrency, that “if it is too good to be true, then it usually is”. This summarises our current position on bitcoin.
We will reconsider this view when credible research and regulatory oversight is commonplace, and when wealth managers can be appropriately licensed and accredited. We would also like to see a central authority taking responsibility for ongoing oversight, and illegal activity via bitcoin being traced back to specific accountable parties.
These measures would help investors to understand the risks well enough to assess whether the risks are acceptable in the context of a goal-based financial plan.