The meteoric rise of cryptocurrency is grabbing headlines but also dividing opinions among financial pundits. Some hail it as the future ‘currency of the internet’ and ultimate store of wealth, while others call it worthless and dangerously speculative.

Either way, cryptocurrency is undeniably volatile in 2021, supported by a surge of interest from institutional investors, payment networks, and digital assets companies. Along the way, cryptocurrency is changing the rules, presenting threats to incumbents and posing many questions about the future of financial systems.

Has the market matured enough for crypto assets to be considered mainstream?

Should investors have exposure to cryptocurrencies despite their high volatility? Can cryptocurrency survive regulator scrutiny? What is the future of money and central bank-backed digital currency?

Crypto is an increasingly dominant topic of conversation among investors, but is it a genuine asset class or the latest in a long list of financial manias?

The current enthusiasm for cryptocurrencies and related technology companies appears tame. Yet it bears many of the hallmarks of historical manias:

• The advent of a new technology
• A low interest rate environment
• A rapid increase in supply (according to CoinMarketCap, the total value of cryptocurrency reached a recent peak of more than $2.2 trillion, up from $243 billion a year ago)
• A disregard for traditional asset valuation principle; and
• A separation of society into those who “get it” (recall the “laser-eyes” social media profiles) and those that don’t.

Given these similarities, historic manias can therefore provide several important lessons for investors in the current environment that are equally relevant to those on the “inside” or “outside”.

First, manias can persist and grow for longer than seems reasonable as they are fuelled by stories of those that have made huge sums of money. Such stories tend to draw more people in until the mania collapses under its own weight, resulting in a redistribution of wealth between those that sold early and those that bought late.

Second, the apparent availability of wealth acts as a strong incentive to poor moral behaviour and so we should be more than usually vigilant to the potential for fraud which is typically only discovered after the event.

Third, the existence of a mania does not preclude the possibility of significant financial gains for some long-term investors and benefits to society as a whole. While the railway mania of the 18th century ruined many investors, for example, the resulting infrastructure development fuelled long term economic growth in the UK.

Fourth, there may be hidden transmission mechanisms between the epicentre of the mania and the broader financial system exposing previously unknown vulnerabilities in the latter. A good example of this is the impact on savers, especially the retired, following the bursting of the US property boom of the last decade.

Finally, beware of escalating commitment. This phenomenon was identified by Professor Barry Staw and describes a situation where enthusiasts become increasingly committed to a belief following setbacks, resulting in increasing investment (of either monetary of emotional capital) and subsequently greater loss as the eventual outcome becomes inescapable. This escalation is characteristic of a deterministic view of the future.

We remain cautious, perhaps the most notable observation is the changing motive of cryptocurrency traders. What started as a pool of “early adopters” has morphed into a growing group of “quick profit traders”. Knowing who is on the other side of a trade is a key consideration we would emphasise. For every buyer, there is a seller (unless you’re in the business of mining coins), so you really need to think about what your edge might be over that person or entity.

In reality, the future is uncertain and therefore as investors, we should be careful about adhering to a single opinion too strongly, including our own. Always think back to your edge as an investor. If you don’t have one, you should tread very carefully. That’s not to say an edge isn’t attainable in the exhilarating world of cryptocurrencies – and some investors will be able to capitalise on their edge.

To close, the one thing we do know about manias is that we must be focused on the robustness of the portfolios we manage. This is holistic by necessity, looking for potential knock-on effects to other assets or inherent vulnerabilities in the financial system. Ultimately, cryptocurrencies are complex and extremely difficult to value, but such deep work is exactly what is required to make a sound investment. We would argue that now is a great time to focus on portfolio robustness as part of this analysis, which is really two sides of the same (Bit)coin.

Source – Dan Kemp, Chief Investment Officer,
Morningstar Investment Management