The Case for Cryptocurrency

Executive Summary
Periodically, technology/product innovation—in tandem with
policy and regulatory evolution—converges with the
demands of the macroeconomic backdrop to pave a path for
the emergence of a new investable asset class. This was the
case with gold nearly 45 years ago, and is currently the case
with cryptocurrency, which has crossed the critical thresholds
of market liquidity, regulatory scrutiny and institutional
acceptance at a time when managing cash and achieving
portfolio diversification has become ever more challenging
and meaningful.
On the one hand, our recognition of cryptocurrency as a likely
permanent investment category is an acknowledgement of its
potential to power decentralized, tamper-resistant,
anonymous transactions on blockchains leveraged for myriad
applications. That is undeniably exciting. On the other hand,
cryptocurrency represents a radical new invention lacking a
known sponsor, a centralized standards-setting body or an
actual physical incarnation that continues to search for the
“killer app” or best applications and could ultimately prove
challenging to sovereign governments, climate advocates and
market regulators. Thus, in acknowledging cryptocurrency as
a viable asset class, we nonetheless are suggesting that
qualified* investors approach it as speculative. As with any
asset class still in its speculative phase, there are a multitude
of risks—some predictable, some identified and some yet to
be uncovered. Such risk characteristics limit prudent advice to
having exposures in small positions in a highly diversified
form, akin to how one might approach venture capital
investing. Our initial modeling, replicated in spirit by a
recently published CFA Institute study, suggests
diversification benefits from the low correlation of
cryptocurrency to other assets and that Sharpe ratio
improvements can be achieved with positions no greater than
2.5%. It is important to keep in mind that we are only in the
top of the first inning.
Our approach to cryptocurrency as an asset class should not
be misconstrued for endorsement of any particular coin
ownership. To the contrary, we see direct coin ownership,
whether through private closed brokerages or cash app
services, as still being in its infancy, with many questions yet
to be answered about the achievability of low-cost best
execution, central clearing, accurate and timely market data,
and transparent and integrated custodial services.

Understanding the Controversy
For most of its existence, cryptocurrency—and Bitcoin,
specifically—has proven a challenge for investors, regulators
and asset allocators. Unlike other nontraditional arenas that
have initially attracted faddish financial speculation,
cryptocurrency (“crypto”) has proven particularly vexing as it
lacks a known sponsor, a centralized standards setting-body
or even a physical embodiment.
In many ways, it is the ultimate incarnation of an increasingly
globally interconnected, communal and virtual world; an
invention of distributed computer coding. Beyond the
impediments surrounding its intangibility, there has been the
controversy around defining the use case for this digital
creation. Is it simply a technology component that embodies
the value creation of computer coding that enables
anonymous, decentralized and tamper-resistant transactions
to be recorded on a blockchain ledger? Is it a transaction
medium or cash currency with reliable exchangeability for
goods and services? Is it a commodity, essentially delivering a
long-run store of real (net after inflation) value, like digital
bullion? Is it a new means of payments processing? Or is it
simply an investable asset? Equally daunting for regulators
and central banks to ponder have been issues of governance
and investor protection, especially given the potential for
borderless and anonymous transactions—a factor that
sometimes associates cryptocurrencies with illegal and illicit
activities.**
Another demanding factor for investors has been the unique
risks around ownership rights and the transferability of the
“coins” themselves. Coin ownership is anonymous, connoted
by a complex, long and computer-generated password. If the
“private key” (password) is lost or stolen, the coin can be
stolen, with no recourse to recovery. Custodians must ensure
that no one person has the entire password and that
passwords are protected from hackers. In a world highly
sensitized to cybersecurity risks, the claim that something is
“unhackable” has proven a tall order, begging credulity. While
insurance is available, it is not yet standardized and can be
quite expensive. Finally, the largest exchanges in crypto are
typically vertically integrated, closed systems: They are not
interconnected through regulated centralized clearing
mechanisms and do not necessarily follow the best practices
of traditional securities-based finance that breaks exchanges
into independent brokers, market makers and custodians,
which help to guarantee best execution. While crypto
exchanges are evolving rapidly, they remain in their infancy

Acknowledging the Opportunity
Despite such challenges, crypto’s unique attributes are
unassailable and its value proposition must be acknowledged.
(See "Update: Bitcoin, Crypto and Digital Currencies," Morgan
Stanley & Co., Feb. 10, 2021 and "Cryptoassets: The Guide to
Bitcoin, Blockchain and Cryptocurrency for Investment
Professionals" by Matt Hogan and David Lawant and
published by the CFA Institute Research Foundation*). Most
simply, cryptocurrencies are the “award metric” or economic
incentive for work done to process and validate transactions
on a distributed ledger network (or blockchain). Because
every transaction is independently and publicly validated by
each network node, error and fraud are reduced and
processing costs are low because the need for
disintermediation is eliminated. Furthermore, cryptocurrencies
can accrue value because of their scarcity, as the concept of a
fixed/limited supply of coins ensures that processing
continues, even as the blockchain network grows in
complexity. Finally, because cryptocurrency is coded, it
enables property rights information and value to be
embedded on the same token, features that facilitate
optimized peer-to-peer transactions. Given these provocative
and innovative properties and myriad potential applications,
investor interest is understandable.
On a Path Toward Financial
Market Maturation
The head-spinning price appreciation, together with greatly
increased trading volume, forced a material acceleration in
crypto’s path toward financial market maturation (see Exhibit
1). Currently, all cryptocurrencies carry a market capitalization
nearly the size of the entire high yield bond market and half
the size of the small-cap universe.

The Financial Crimes Enforcement Network (FinCEN) was the
first regulator on the crypto scene in 2013. The Internal
Revenue Service followed quickly, and for tax purposes
defined cryptocurrency as a “property asset,” not a foreign
currency. It wasn’t until late 2017, when Bitcoin peaked at
nearly $20,000, that there was a transformational structural
change in regulatory frameworks.
Since then, as illustrated in Exhibit 2, we have seen critical
action by the Commodity Futures Trading Commission (CFTC)
establishing rules for futures contracts trading and approval
of derivatives for hedging; the Securities and Exchange
Commission (SEC) declaraing that Bitcoin is not a security;
and the mid-2020 decision by the Office of the Comptroller
of the Currency (OCC), a bank regulator, authorizing national
banks to act as custodians for digital assets.

The Case for Cryptocurrency