The toughest challenges for cryptocurrency lies ahead

More than a third of millennials and half of Generation Z would be happy to receive 50% of their salary in cryptocurrencies, revealed a study.

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With more than $1 trillion in cryptocurrency value wiped out since the 2021 high-water mark, many investors may be tempted to enter the cryptocurrency orbit at a potentially attractive, lower price point.

After all, previous dramatic drawdowns in cryptocurrency valuations have been followed by explosive growth — and all this volatility could be justified as the expectedly bumpy price discovery process of an important brand-new asset class.

However, the most profound risks to cryptocurrency investing may lie ahead, rather than in the rear-view mirror. Investors contemplating a long-term allocation to cryptocurrencies should remain wary for five primary reasons.

1. Bitcoin’s risk-adjusted return has been ‘unremarkable’

After a dazzling first decade, bitcoin has become a somewhat troubled teenager. In its heady early days, bitcoin had near-zero correlation with broad equities and commodities, providing the potential for true portfolio diversification.

However, as cryptocurrency investing has become more mainstream, and especially since 2020, bitcoin’s correlation with US equities and bonds has spiked sharply and remained consistently positive.

That might be fine if bitcoin offered spectacular risk-adjusted returns as compensation. Unfortunately, recent empirical evidence shows otherwise: since 2018, bitcoin’s risk-adjusted return has been quite unremarkable compared to equities and bonds.

2. Crypto ‘safe haven’ properties remain unproven

3. Cryptocurrencies conflict with ESG goals

Cryptocurrencies remain deeply problematic from an environmental, social and governance, or ESG, perspective. That’s true even if the transition from proof-of-work to proof-of-stake that blockchain-based software platform ethereum is spearheading reduces the massive energy consumption underpinning crypto mining and validation.

Environmentally, bitcoin — which represents more than 40% of current cryptocurrency market cap — will continue to use a validation process where a single transaction requires enough energy to power the average American home for two months.

Socially, cryptocurrencies’ promise of financial inclusiveness also appears overblown, with crypto wealth as unequally distributed as conventional wealth, and with simple phone-based payment services such as M-Pesa in Kenya or Grameen Bank’s international remittance pilots in Bangladesh already providing a digital platform for underbanked households — without the need for a new currency or payment infrastructure.

Most disturbingly for investors with ESG goalshowever, are the governance issues with cryptocurrencies whose decentralized frameworks and anonymity make them especially attractive for illicit activity, money laundering and sanction evasion.

The increased trading between ruble and cryptocurrencies following sanctions on Russia after the Ukraine war suggests that the evasion of financial sanctions is not just a theoretical concern. Market manipulation is another area of ​​governance concern, especially with celebrity crypto influencers who can send market prices soaring or tumbling with impunity.

4. Stablecoins ‘could well be made redundant’

Even putting aside the recent implosion of the Terra stablecoin, the surviving universe of stablecoins face a potentially existential risk: They could well be made redundant once central bank digital currencies, also called CBDCs, become commonplace. This is because a digital dollar, euro or sterling would provide all the functionality of stablecoins — but with almost no liquidity or credit risk.

In other words, even if stablecoins transformed from their current status as unregulated money market funds (with limited transparency into or auditing of reserves) into regulated digital tokens, they would afford no benefit over CBDCs. Importantly, these central bank digital currencies may not be a distant prospect. China has already launched an electronic currency known as the digital yuan, or e-CNY.

The Fed released a long-awaited study on a digital dollar at the start of 2022, and the ECB will share its findings on the viability of a digital euro in 2023.

5. Patchwork regulation creates uncertainty

Finally, a lack of clear and uniform cryptocurrency regulation — both within and across countries — creates tremendous uncertainty for long-term investors. It is still unclear in the US, for example, when a cryptocurrency falls under the regulatory framework of a security subject to Securities and Exchange Commission regulations and when it is deemed to be an asset or commodity like bitcoin and ether have claimed.

Indeed, in some countries, cryptocurrencies are facing outright prohibition. China’s abrupt banning of all cryptocurrency trading and mining in 2021 is a prominent example, but by no means the only one. Regulators have also been concerned with the notable and repeated breakdowns in the infrastructure supporting cryptocurrency mining and trading — another area where there remains significant regulatory uncertainty.

Of course, momentum, retail speculation, and the “fear of missing out” may continue to drive up the short-term price of bitcoin, ether and other cryptocurrencies. But there are enough dark clouds on the cryptocurrency horizon that long-term investors may want to observe carefully from the sidelines to better understand fact vs. fiction and true value versus social media hype before deciding how, where and if to invest in the crypto ecosystem.

— By Taimur Hyat, chief operating officer of PGIM.


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