Home Opinion pieces Cryptocurrencies still a speculative play

Cryptocurrencies still a speculative play

An opinion piece by Dr Mohamed Damak, Senior Director and Global Head of Islamic Finance, S&P Global Ratings

Dr Mohamed Damak, Senior Director and Global Head of Islamic Finance, S&P Global Ratings

Cryptocurrencies continue to be speculative instruments, which investors mostly use as a store of value rather than a means for commerce, despite some moves toward broader adoption. We believe that the regulations and much greater public confidence are the keys to the more widespread use of cryptocurrencies.

Financial markets are getting excited again about cryptocurrencies—especially bitcoin after prices rallied to record highs in February. However, in the long run, we see a greater chance of large-scale adoption of central bank digital currencies (CBDCs) as a means of payment than private digital currencies. In our view, ultralow interest rates, substantial liquidity, growing inflation expectations, and high valuations for other securities may have contributed to the renewed interest by investors in bitcoin. Some investors see bitcoin as a competitor to gold and other commodities as a store of value and hedge against inflation.

Acceptability of these instruments has increased somewhat over the past couple of years, though more as an investment rather than a payment tool. We have seen the first exchange-traded fund (ETF) launched in Canada and a few others lining up. We also observe traditional asset managers becoming more open to the idea of investing in cryptocurrencies or in taking positions.

Blackrock, for example, announced that bitcoin derivatives registered on commodity exchanges will become eligible investments for a couple of its funds. Moreover, new players have started to accept or offer products connected to cryptocurrencies, with large payment providers such as Visa and Mastercard as well as PayPal and Tesla being the most noteworthy examples, but volume remain marginal.

Despite rising interest, the overall bitcoin market is still concentrated, with about one million active addresses among the 30 million with non-zero balances and only 788,000 addresses with more than one bitcoin. The number drops to 16,000 if we increase the minimum holding to 100 bitcoins, as of 22 February, according to blockchain data and intelligence provider Glassnode.

We are of the opinion that such concentration makes the instrument prone to market manipulation. We continue to believe that bitcoin and other cryptocurrencies will have to overcome their technical and nontechnical weaknesses, including lack of regulatory support, to thrive.

In our analysis of risks, we note that the environmental footprint of these instruments, mainly bitcoin, is reportedly high. For example, last year bitcoin reportedly consumed a broadly comparable amount of electricity as the Netherlands or the United Arab Emirates. Cryptocurrencies could also leverage clean energy solutions as they become more prevalent. However, this is a partial solution because their networks need a constant energy supply. Another angle to the environmental footprint is the reportedly short lifespan of the mining machines. While initially cryptocurrencies and particularly bitcoin, were supposed to use the spare capacity of computers, miners discovered that graphic cards and then Application Specific Integrated Circuits (ASICs) can do a better job. However, once becoming obsolete, these machines cannot be recycled easily elsewhere, and they become a source of electronic waste.

That said, we view cryptocurrencies’ price volatility as a limited risk for the financial institutions we rate. We believe a collapse in the value of cryptocurrencies would be just a ripple across the financial services industry, still too small to destabilize the system or weaken the creditworthiness of banks we rate.

Nevertheless, some banks—for instance those active in marketing cryptocurrency ETFs (exchange-traded funds)—might be exposed to product mis-selling or reputational risks if prices collapse. It could be argued that buyers do not really understand the risks of investing in digital currencies.

What would lead to increased risks for rated banks would be a wider adoption most likely of CBDCs. Indeed, they may face changes to and perhaps even disruption of their business models.

Another game changer for financial markets could be cryptocurrencies’ distributed ledger technology, which many traditional financial institutions are working to use for various purposes.