Digital assets, such as cryptocurrencies, traveled the long road to investability in a short time. In our view, they now present a compelling case for allocation in certain portfolios as their adoption curve continues to rise. Ease of access, rising liquidity levels with increased utility, and a deeper understanding of their value not only increase the case for including digital assets in a portfolio but also expands their credibility in the investment community.
In this report, we outline some of the investable buckets digital assets fall into and explain how cryptocurrencies can be integrated into a portfolio. More than just a currency play, the space now comprises rich ecosystems of decentralized applications (dapps) that offer utility powered by smart contract platforms. Additionally, we believe that cryptocurrencies can provide diversification benefits, which for some investors, represents a compelling opportunity within the current macroeconomic environment.
Digital assets are in the early stages of the adoption curve, but they are gaining momentum. Factors that could propel user adoption further up the curve include updates and innovation within these platforms, retail and institutional interest as the technology evolves, and economic acceptance by governments.
Many leading platforms continue to drive innovation and build utility in areas such as decentralized finance (DeFi), governance voting, the creator economy, asset management of sectors such as real estate, GameFi, and the overall enhancement of settlement channels. These innovations can create network effects for users and developers, and thus increase the value of these platforms.
Rising institutional participation highlights the growing conviction in the digital asset landscape. Historically a space led by early believers and retail investors, the market now garners significant interest and inflows from institutional funds and large corporations, due in part to customer demand. The chart below shows that the volume of capital flow from institutions into centralized exchanges (CEX), such as Coinbase, has continued to grow.
In addition, governments show sincere interest in integrating cryptocurrencies into their economies. Cryptocurrencies offer a unique ability to democratize the financial infrastructure by leveling the playing field and providing access to underbanked and unbanked populations, particularly in emerging markets. For example, El Salvador is a pioneer in the crypto space, becoming the first country to recognize bitcoin (BTC) as legal tender in September 2021. Elsewhere, other countries, are exploring the feasibility and regulatory framework of integrating cryptocurrencies into their economic infrastructure. At the local level, in the United States, the city of Miami is pushing to become a leader in crypto innovation and Fort Worth’s city government is mining BTC. Lastly, Brazil’s Rio De Janeiro allocated 1% of its Treasury reserves to BTC.1,2,3
Cryptocurrencies continue to prove their value as an accessible global financial infrastructure. Ukraine has raised over $60 million worth of various cryptocurrency donations to support its fight against Russia.4 With banks closed and ATMs out of money, Ukrainians with access to cryptocurrencies can still transact and distribute funds worldwide, offering a glimpse into the multi-faceted uses of digital assets.5
Catalysts Show Digital Asset’s Growth Potential, Regulatory Talk Shows Its Maturation
The 2021 Chainalysis Global Crypto Adoption Index studied cryptocurrency adoption among ordinary people within countries and across global regions. Factors triggering consumer adoption include peer-to-peer transactions within emerging markets, remittances, and the rise of DeFi usage in the developed world. The global market overall showed an increase in adoption year-over-year.6 Cryptocurrency as a form of peer-to-peer payment continues to gain traction. Recently, Stripe partnered with Polygon to facilitate payments using the USD Coin (USDC) stablecoin.7 Also, projects like the Flexa network are increasingly integrating with leading retailers in order to power cryptocurrency transactions with low fees.
The Bitcoin Lightning Network continues to see an increase in BTC amounts under user payment channels, this highlights greater traction in peer-to-peer global transactions. From a supply perspective, BTC’s next halving event, which is expected sometime in 2024, will reduce mining rewards from 6.25 to roughly 3.125 per mined block.8 Considering the reduction in block reward, miners may be further incentivized to seek green, otherwise discarded, and alternative sources of energy in order to reduce their largest cost driver while adapting to today’s sustainability standards. The reduction in supply, the growing interest from governments and traditional institutions to acquire BTC as a monetary reserve, the Lightning Network’s increasing popularity, and BTC’s overall ethos around powering a scarce asset able to serve as a global financial channel could be important catalysts for BTC.
As for smart contract platforms, we outlined in Ethereum: The Basics how the Ethereum network should improve significantly with upcoming upgrades. Ethereum’s transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS) and its introduction of shard chains are two of the most anticipated upgrades in digital asset history.
PoS is expected to increase network security, lower energy use by roughly 2,000-fold, and draw new users to the network due to the benefits it provides.9 Among the benefits, staking participants receive a yield on their assets in exchange for securing the network, increasing the incentive to hold Ether (ETH), Ethereum’s native cryptocurrency, long-term.10 Securing the network will not require expensive hardware, and it will be open to all users. Also, ETH’s issuance rate is expected to drop from 4–5% to 0.4–0.5%, reducing the newly created supply. Assuming network demand stays high, this reduction could lead to ETH becoming a deflationary asset because of the burning mechanism discussed in our Ethereum piece.11 Lastly, sharding, which will come at a later stage, and layer 2 scaling solutions will increase the transaction per second count Ethereum can validate. The highly anticipated general-purpose ZK-rollups, which offer faster finality and lower costs than other layer 2 scaling solutions, are also arriving soon. All these updates are expected to increase demand, and with demand comes potential investment opportunities.
Additionally, we expect …
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