SUMMARY

● An increase in demand for decentralised network and transparent transactions are the key factors driving the rapid growth of blockchain technology, especially in cryptocurrencies. This technology is seen as a transition to a new digital economy.

● Bitcoin (BTC), the first real example of the blockchain technology, operates under a deflationary model, with a fixed supply of 21.0m units. It uses a Proof of Work (PoW) consensus mechanism to validate transactions and add a new block to a blockchain.

● As the underlying technology matures, with clarity on the related regulations, less volatility in prices and further mass integration of the cryptocurrencies, we view that the BTC would dominate over other cryptocurrencies and continue to strengthen over the long term.

● Altcoins, or alternative digital currencies (e.g. Ethereum, Ripple, Litecoin), have launched in abundance following the success of BTC. These cryptocurrencies attempt to improve upon perceived limitations of BTC or provide a considerably different types of services.

● Stablecoin, whereby its value is backed by a stable asset such as USD and gold, is gaining popularity given its relative stability while leveraging on cryptocurrency's benefits.

● Cryptocurrencies’ exponential growth has captured international attention and brought an interesting topic about its future as a payment mode, an investable asset class and possibly as a reserve currency.

● An increasing number of institutional and retail investors are adding the digital asset in their portfolios due to its massive return and its uncertainty-cum-inflation hedging property.

● Despite the big investment potential that BTC and cryptocurrencies might offer, there are still risks and pitfalls that investors should be aware of: its tentative status as a store of value, risky one-way bet against inflation, risk of losing everything and security issues.

Overview

● It seems timely that the first blockchain-based digital currency or Bitcoin (BTC) was born amid the Global Financial Crisis in late 2008 to revolutionise the monetary system. Described as the worst financial crisis since the Great Depression, the birth of BTC was initially an alternative to what appears to be the failure of the centralised financial system. Early adopters were mainly those with the libertarian mindset who advocate a more transparent and a decentralised monetary system, Unfortunately, in the early days it received bad press as it was portrayed as a payment method used by criminals and bad elements for illicit activities to evade detection by the authority.

● Fast forward to the present, however, BTC is no longer in the periphery of the monetary system. In fact, it has received wider recognition and adoption by big banks, corporations and investors alike. Even countries and their respective central banks are looking into adopting an alternative blockchain-based digital currency to challenge BTC and other cryptocurrencies.

● From an investment perspective, BTC has charted a phenomenal return of almost 200% on its 10-year compounded annual growth rate (CAGR). According to CaseBitcoin, an on-chain cryptocurrency resource in its tweet, that kind of return is “unmatched in financial history…In raw ROI, that works out to 5.2m% return over the decade.” Its closest rival, Tesla, only managed to achieve 62.8% on its 10-year CAGR. Meanwhile, based on our calculation on the latest data available, local champion Top Glove trails behind at 29.1%, slightly below Amazon’s 33.1%.

Understanding Blockchain

● Blockchain is a type of distributed ledger technology (DLT) that enables data to be securely stored by using cryptographic algorithms. A blockchain protocol runs on a peer-to-peer network, a distributed architecture that allows users to participate in a file sharing network (e.g. cryptocurrency transactions). Of note, blockchain is the first fully functional DLT. Other types of DLT are Hashgraph, Directed Acyclic Graph (DAG), Holochain and Tempo.

- The blockchain technology has been receiving increasing attention due to its decentralised network, faster processing time, secure transactions, transparency and trusty chain. Due to its decentralised property, the system works without any intermediary and therefore reducing any sort of hacking risk significantly. In addition, blockchain offers a relatively fast payments transfers as the transactions of the blockchain can be verified and processed independently.

- In turn, the main disadvantages of using this technology are the high energy consumption and cost of implementation. Due to the Proof of Work (PoW) system that major cryptocurrencies use to validate transactions, bitcoin for example, consumed approximately 121.36 TWh of electricity annually, which is more than the whole of Argentina (source: Cambridge Centre for Alternative Finance). Due to the vast amount of energy usage, the cost of mining cryptocurrencies that use the PoW system is very expensive.

First Application of Blockchain Technology: Bitcoin (BTC)

● Launched in Jan 2009 and invented by a programmer under the alias Satoshi Nakamoto, BTC is the first real example of the blockchain technology. Amongst all cryptocurrencies, BTC holds the largest market cap (USD946.8b), with its price surpassing the USD50,000- level again on Mar 7 that is a 1,041% increase from its previous trough of USD4,455 on Mar 16, 2020. It registered an all-time high of USD58,640.77 on Feb 21 and briefly touched a market capitalisation of USD1.0t, before it corrected all the way back down to around USD43,000-level on Mar 1.

● BTC operates under a deflationary model, whereby its supply is fixed at a maximum of 21.0m units. The BTC protocol is structured such that one block of transactions is mined at an average of 10 minutes and that the BTC rewards (i.e. block reward) given to the miners for each block mined is halved at every 210,000 blocks or at an average of every four years (current reward: 6.25 BTC). At this rate, the 21 millionth BTC is expected to be mined in the year 2140.

- Total BTC mined as of Mar 7: 18,647,350 BTC (88.8%).

- With less BTC rewarded to the miners after each halving, the rate of mining softens, creating a scarcity of new coins and hence tending to lead to an extended bullish price movement post-halving. Based on historical data, the duration of the cycle (trough→halving day→peak) for each halving shortens as we move on, while the duration from halving day to peak gets longer. Assuming that the rate of decrease in the cycle duration is unchanged, the next peak is forecasted to be in Dec 2021, with the price expected to hit at least around USD80,000, acording to some estimates.

● BTC is based on a PoW consensus mechanism, whereby in order to validate transactions, add a new block to a blockchain and subsequently earn the block reward, miners consume massive computing power as they need to concurrently compete via a brute-force basis to be the first to solve the SHA-256 cryptographic hash function (i.e. finding the nonce to calculate the hash that meets the difficulty level restrictions).

- An alternative consensus mechanism, the Proof of Stake (PoS), has been developed in 2012 in an effort to create a less energy-intensive option. Under PoS, only one miner will be selected to validate a block of transactions. The probability for a miner to be selected is proportionate to the amount of cryptocurrency staked by each miner.

● The current BTC rally is somewhat different than the previous ones. While it is still influenced by speculative flows, the rally is also a manifestation of advancement in the adoption of cryptocurrencies by major global corporations (e.g. Tesla, MicroStrategy, PayPal, BNY Mellon, Mastercard).

- That being said, there could possibly be a crash in BTC price in the short-term, similar to what happened during the onset of the new internet technology (i.e. dot-com bubble). However, as the underlying technology matures, with clarity on the related regulations, less volatility in prices and further mass integration of the cryptocurrencies, we view that the BTC could possibly chart a steady long term gain.

Altcoins: Alternative Digital Currencies to BTC

● Ethereum: likely the most popular altcoin, it is a decentralised, open-source software platform created in 2015, that allows “smart contracts” to be run and blockchain applications to be built inside its system. Ether (ETH) is the digital coin of the platform, used by developers to pay for transactions and run applications on the Ethereum.

- ETH and BTC are both digital currencies that make use of the DLT known as blockchain, however the primary purpose of ETH is to facilitate the operation of the Ethereum platform, rather than to establish itself as an alternative monetary system.

- ETH has become very popular among investors, and with a market cap of USD189.12b it is the secondlargest cryptocurrency behind BTC. Notably, ETH reached an all-time peak price of USD1958.47 on Feb 19, rising 699.3% from USD280.65 the year before. However, in line with the high volatility of cryptocurrencies, ETH has since depreciated considerably amid a market-wide crypto correction.

- Nevertheless, ETH still holds a positive outlook with investors, as it is considered an improved variant of the blockchain technology. Furthermore, Ethereum has recently begun implementing a series of upgrades, called Ethereum 2.0, designed to improve its scalability and security.

● XRP: a cryptocurrency controlled by the company Ripple Labs and serves to facilitate transactions on its payment protocol platform. The Ripple platform is a payment settlement, asset exchange and remittance system that aims to be an alternative to traditional services for international money and security transfers, such as SWIFT, used by banks and financial intermediaries.

- The Ripple platform uses a unique distributed consensus mechanism, different from the blockchain mining concept of BTC, which allows for faster transaction processing and lower operating costs. Also, unlike BTC, XRP coins are premined and distributed by Ripple itself.

- XRP is among the largest cryptocurrencies with a market cap of USD21.05b. It reached a record high price of USD3.29 in Jan 2018, but has since fallen in value, hovering between USD0.1 – USD0.6 through 2020. With that said, the Ripple Labs protocol has been adopted by a number of financial institutions.

- Setting back XRP and the Ripple platform, in Dec 2020 the U.S. Securities and Exchange Commission sued Ripple Labs for USD1.3b on the basis that XRP should have been categorised as a security rather than a currency, due to its distribution via Ripple rather than a decentralised network. Should the lawsuit prevails and XRP is established as a security instead of a currency, the outlook of the coin would likely turn negative.

● Litecoin (LTC): a peer-to-peer cryptocurrency and opensource software project that started in 2011. Similar to BTC, LTC uses blockchain technology, is a proof-of-work ecosystem, has a fixed supply with a cap of 84.0m coins, as well as stores and transacts comparably. Indeed, the developers of LTC likened LTC as the “silver” to BTC’s “gold”, highlighting LTC’s position as a spinoff of BTC.

- LTC does have some technical differences, namely that LTC’s average transaction confirmation time is quicker at 2.5 minutes compared to BTC’s 10 minutes. Furthermore, there is a difference in cryptographic algorithms that makes it slightly less taxing for computers to mine LTC, thereby making mining more accessible to the public.

- With a market cap of USD12.38b, LTC is a very popular cryptocurrency but is significantly smaller than BTC and ETH. Its price reached a peak in Dec 2017 at USD321.0 but saw its value plummet to USD24.0 by Dec 2018 due to a market-wide crash. Towards the end of 2020, LTC prices picked up to over USD100.0 and has benefitted from the recent cryptocurrency bull-run.

- Due to its similar infrastructure to BTC, LTC is highly sensitive to changes in BTC’s price. Nevertheless, its status as a leaner, more efficient version of BTC, and the fact that it is still in the process of being adopted by traders and exchanges, may mean that it has considerable growth potential.

Tokens and Stablecoins

● Tokens are created on existing blockchains and are made to be used with a decentralised application (dApps). Tokens usually serve to facilitate the transactions on the blockchains or represent a physical item. There are several different types of tokens, namely security or asset tokens, payment tokens, equity tokens and utility tokens. Creating a token would utilise less time and resources, while maintain the cryptocurrency features and security of the native blockchain.

● Another type of cryptocurrency that gained tremendous traction in recent months is stablecoin. It is designed to mimic traditional fiat currencies, by having a fixed value with reduced volatility, as it is pegged to an external asset, such as the USD or gold. For instance, every token created is backed by one USD, hence it is redeemable on a 1:1 basis. With the additional features of stability against the crypto volatility and trust of regular fiat currencies, the stablecoins are more suitable for everyday use, acting as a medium of monetary exchange and storing monetary value.

● There are over 200 stablecoins, given that more institutions, including financial institutions, are adopting it as a cheaper and faster means of settlement. Among the well-known stablecoins are USD Coins (USDC) and Tether (USDT).

- Tether (USDT): built on BTC’s blockchain and later updated to work on multiple blockchains such as Ethereum, Tron, Algorand, OMG and EOS blockchains. It was launched in Jul 2014 as Realcoin by Brock Pierce, Reeve Collins and Craig Sellars before later renamed to USDT. USDT was designed as a blockchain-enabled platform to facilitate fiat currencies digitally. Its current market cap is about USD36.5b.

- USD Coins (USDC): runs on the Ethereum blockchain technology and pegged to the USD. It was launched in Sep 2018 and managed by Centre, a consortium company that include Circle (peer-to-peer payment services company) and Coinbase (cryptocurrency exchange). USDC adopts an open standard and public smart contract and is issued by regulated financial institutions. USDC is also audited by the accounting firm Grant Thornton LLP every month, unlike USDT. Its current market cap is about USD9.1b.

Cryptocurrencies and Gold

● As of Mar 5, 2021, one BTC is equivalent to approximately 28 ounces of gold and one ETH is worth 0.9 ounce of the 5000-year-old asset. The digital asset has become increasingly popular due to its so-called inflation-hedging property. However, due to its volatile nature, it is arguable that it can serve as a hedge against inflation.

● Most cryptocurrencies are hitting their all-time high due to its decorrelation aspect as investors are looking to invest in assets that do not move with the market, especially in the current low-rate environment. Despite cryptocurrencies massive returns, investors should also hold to some gold as the historically stable asset could act as a buffer against the volatile digital asset.

Impact on the Financial Market

● Since BTC network was set in motion in Jan 2009, there are now more than 4000 digital currencies in existence with total market capitalization of more than USD1.5t. The rise of cryptocurrencies’ value on the market has prompted many investors to include cryptocurrencies, especially BTC in their portfolio.

● Eventhough cryptocurrencies are a relatively new financial instruments, their usage has increased significantly due to its decentralised nature. In 2020, cryptocurrencies have been the best performing asset as evidenced by the Bloomberg Galaxy Crypto Index, a gauge of cryptocurrencies, which is up by 276.7%, outpacing gold, stocks, bonds and commodities.

● The crypto index has almost doubled in the first two months of 2021 as BTC’s price stabilised around the USD48.0- 50.0k level, leaving other asset classes in the dust. Moving ahead, as cryptocurrencies grow as a global asset class, we see huge potential for integration with other technologies. Therefore, sooner or later, regulators and central banks will have to adopt the DLT and embrace cryptocurrencies as a financial asset.

● In an attempt to control the growing clout of cryptocurrencies, a growing number of central banks are currently working towards creating their own digital currencies. Dubbed central bank digital currency (CBDC), it would create digital tokens and blockchain technology to represent a country’s official fiat currency and regulated by its respective monetary authority. So far, no country has officially issued any CDBC yet.

The Future of Cryptocurrencies

● The emergence of cryptocurrencies and the recent rally have captured international attention, with discussion about its future centered around the following topics:

- Mode of payment: the innovation and technology of cryptocurrency provide a cheaper and more efficient payment solution for merchants and consumers. Cryptocurrency payment typically charges lower or zero fees than the regular and standard credit card payment or bank fees. Cryptocurrency payment services also allow a borderless payment network from anywhere around the world, any amount of transaction and through any devices, making it an attractive alternative to the traditional banking system.

- Company assets: since the US Fed and major central banks have embarked on a massive expansion of their quantitative easing program, investors and institutions are increasingly concerned about the long-term value of fiat currency. This has fueled the search for alternative assets, such as cryptocurrencies, to hedge against inflation. Leading the market is MicroStrategy, a company that develops mobile software and provides cloud-based services. The company has adopted BTC as its primary reserve asset and already accumulated 91,064 BTC (USD4.6b) as of Mar 7.

- International reserve: a global reserve currency is the one that eases cross-border trade, including investments and debt obligations. Global central banks usually hold reserve currencies to stabilise foreign exchange rates and conduct monetary policy. According to the IMF research paper, four factors drive demand for a reserve currency: the economic size, credibility of issuers, transactional demand between parties and inertia. The USD scored in all four aspects and has been the main reserve currency since the Bretton Woods agreement in 1944. In recent years, cryptocurrency has been increasingly used for international transactions with a huge potential to expand in the future.

The Case Against BTC and Cryptocurrencies

● Unstable store of value: although the main aim of the creation of BTC is to be an alternative decentralised currency, it seems that the focus of interest has been about buying it as a financial investment, instead of using it as money to buy goods and services. As demand for BTC has grown as people speculate on its future value and the supply of BTC is set to grow at an inflexible, predetermined rate, its demand fluctuates, generating unpredictable price swings. This price volatility has undermined BTC’s ability to serve as a store of value. Due to its unstable nature, BTC has yet to be universally accepted as an effective medium of exchange. In short, BTC and cryptocurrencies are still far from fully replacing fiat money as a store of value, medium of exchange and a unit of account.

● Risky one-way bet against inflation: unlike investing in stocks, bonds or properties, investing in BTC or cryptocurrencies does not generate cash. Instead, investors can only hope their investments in BTC and cryptos rise in value with the price of inflation or grow above it. The low interest rate environment and the ensuing currency debasement has created a conducive environment for assets like BTC, cryptocurrencies and other alternative investment like gold, forex, commodities or fine arts to thrive in view of the expectation that fiat currency is likely to devalue. On the flipside, such investment in these assets are at a big disadvantage in generating an investment return and they have the added challenge of never even being able to keep up with inflation.

● Risk of failure: buying cryptocurrency is very much early stage investing which means investors who buy into the hype can potentially suffer brutal losses when these projects eventually fail. Hence, investors should expect venture-capital-like results in which the vast majority of crypto projects fail and become worthless. Only a small number of the thousands of blockchain projects will ultimately succeed. Meanwhile, there is a possibility that regulators could also crack down on the entire crypto industry as authorities view cryptocurrencies as a threat rather than just an innovative technology.

● Security holes: the nature that it has yet to be fully regulated has made certain risks present in the crypto market that are not as predominant in traditional financial markets, such as those for stocks and bonds. Cryptocurrency exchanges have been prone to hacks and other criminal activity which led to sizable losses for investors who have had their digital currencies stolen and often times irrecoverable. Instead of the usual investment risk of seing their principal decreasing in value, with cryptocurrencies, investors may lose their crypto assets entirely. In addition to price volatility, investors in crypto assets have lost money because of: outright theft, software flaw and even misplacing login information or private keys for those who opt for the offline "cold storage" or hardware wallets options.

Source: Kenanga Research - 8 Mar 2021