While cryptocurrencies have drawn investors’ interest with outsized returns and the chance to own an early stake in a potentially transformational innovation, they have also exhibited significant price volatility and dramatic drawdowns. The daily flow of digital currency news is accompanied by ongoing debate over its validity and uses, including as a legitimate asset class.
Below we weigh in on this debate by reviewing cryptocurrencies’ qualifications for playing a role in a diversified portfolio — and ultimately, funding investors’ goals.
What Are Cryptocurrencies?
Cryptocurrencies are based on the novel blockchain technology, which uses the encryption from cryptography to validate transactions and securely transfer and store assets. Blockchain technology can be used as a public ledger to record any transaction, but its first and best-known use was with cryptocurrency.
Cryptocurrencies are a type of money that differ from traditional currencies as they are digital in form and not issued by a government or backed by a scarce asset. They use the blockchain coding system to safely store, transfer and validate transactions. At the end of 2020, there were over 8,000 cryptocurrencies accounting for a market value of $772 billion. Bitcoin is the dominant cryptocurrency accounting for 70% of market value. It was launched in 2009 and was the first blockchain ever implemented.
The Commodity Futures Trading Commission regulates the trading of bitcoin futures, which are financially settled so they are not a way to buy and sell physical bitcoins. Investors may hold long or short positions in futures contracts as a way to hedge bitcoin exposure elsewhere, or more typically to speculate on the price of the cryptocurrency.
At Northern Trust, portfolios are constructed from risk-control and risk-asset building blocks to ensure robust diversification. Risk-control assets are driven by maturity-related interest rate risk (term risk) and are intended to control total portfolio risk with uncorrelated and more stable returns. They fund high-priority and near-term goals. Risk assets are largely driven by compensated market risk and are intended to maximize diversified return. They fund long-term and aspirational goals. Does cryptocurrency have a role as a risk control or risk asset in a diversified portfolio?