It is safe to say that the crypto kitten is out of the bag. Over the past seven years, cryptocurrencies have skyrocketed from roughly $5.2 billion in market cap for the top 100 coins to almost $1.7 trillion as of January 2022. Cryptocurrencies now represent the fourth most popular type of investment among investors, trailing only stocks and mutual funds. and bonuses. Only Bitcoin has a market cap that would rank among the top 10 largest companies in the S&P 500.[1]
There are a couple of key things you need to understand about the crypto universe early on: the different types of cryptocurrencies and how they work with different blockchains.
Although bitcoin is the most well-known cryptocurrency, there are many others available. The second largest cryptocurrency is ether, whose main difference from bitcoin is its purpose: where the construction of bitcoin is quite simple and is primarily intended to serve as an alternative currency, ether also contains the code to trigger sales and purchases when certain criteria are met. (known as “smart contracts”). And then there are “altcoins,” a category that includes all other cryptocurrencies, such as ripple and litecoin.
These cryptocurrencies are powered by the underlying blockchain technology, which records every transaction and cannot be changed. The permanence of this mechanism is, for example, how non-fungible tokens, or NFTs, obtain their certificates of authenticity. And different blockchains support different types of cryptocurrencies: Bitcoin, for example, lives on the bitcoin blockchain; ether exists on the ethereum blockchain.
As the cryptocurrency market attracted the attention of the rest of the investing world and shook off some of the initial skepticism around its viability, we decided to take a deeper look at the forces behind its unlikely rise. That effort culminated in the release of Morningstar’s Cryptocurrency Outlook 2022, the first of its kind.
As Bitcoin loses market share, new entrants are major drivers of cryptocurrency growth
We were not surprised to find that bitcoin accounted for most of the growth of the cryptocurrency market as a whole during its early history, but it was surprising to see that bitcoin has rapidly lost market share to these other cryptocurrencies in recent years.
As shown in the chart below, from January 2017 to January 2022, a market capitalization-weighted index of the next 100 largest cryptocurrencies outperformed bitcoin by more than 75 annualized percentage points.[2] Although it returned 103% on average each year, bitcoin’s share of the cryptocurrency market plummeted from nearly 90% in December 2016 to less than 43% in January 2022, as ether and altcoins expanded. .
The ether represents the first stage of that unbalanced growth. And while altcoins are often overlooked, their market share has grown substantially over the last five years.
Ether has seen sharp spikes and drops in its price as enthusiasts speculated on a wide variety of applications for the ethereum blockchain. However, since January 2021, ether has consistently oscillated between 15% and 20% of the market, while bitcoin’s market share has continued to decline steadily from 70% to close to 40%, even as it posted a cumulative return. 32%.
That’s because so many users have flocked to ethereum that the cost of trading on that network has become prohibitive. Enter the unloved cryptocurrencies: altcoins. Encompassing all other cryptocurrencies other than bitcoin and ether, altcoins like solana have developed blockchains that lower ethereum’s transaction costs while offering comparable applications, especially decentralized financial services, and have taken share of ethereum as a result. market to ether
Altcoins, meanwhile, tend to be more specialized than bitcoin, a cryptocurrency with hardly any spin-offs (that is, products whose value depends on an underlying asset), or ether, a cryptocurrency whose blockchain offers so much flexibility that programmers can wear. for virtually any derivative project.
For example, the altcoin terra exists on a blockchain that only creates stablecoin tokens, a class of cryptocurrencies backed by assets like the US dollar or gold. The polkadot altcoin, on the other hand, transports information or assets between other blockchains.
Specialization has dampened investor interest in the past, but as the cryptocurrency market matures, we expect diversity among altcoins to become a key strength for the asset class, breaking the historically close correlations we have observed between bitcoin and other digital assets.
With great returns comes great volatility
From ether’s historic 9500% run in 2017 to solana’s 11100% tear in 2021, much of the interest in cryptocurrencies has been a self-fulfilling prophecy. Investors see staggering profits and enter the market, putting further upward pressure on prices. But every impressive rally has given way to an equally painful crash at the other end, and cryptocurrencies lack a fundamental anchor like the face value of a bond or the discounted cash flows of a stock. Ether lost almost 90% of its value between December 2017 and December 2018, while solana lost more than half of its value between November 2021 and January 2022.
Surveyed as a whole, the volatility of cryptocurrencies is unparalleled by any other measurable asset class. From January 2015, when regular price data begins, through January 2022, the MVIS CryptoCompare Digital Asset 100 Index posted a standard deviation that was more than double that of the second most volatile index we identified and more than 5 times as volatile. than the MSCI ACWI Index. Incredibly, this measure includes stablecoins, which are often pegged to a fixed peg. That means unpegged cryptocurrencies in the aggregate are likely to fluctuate even more than this figure suggests.
Crypto performance in a league of its own
Even outside of its volatility, the cryptocurrency market does not behave like any other investment, piquing the interest of institutional investors looking to increase their exposure to uncorrelated returns. Over its history, crypto market price returns have more in common with international developed market stocks, but with a correlation of just 0.28, there is still quite a bit of light between the pair compared to other classes of crypto. assets.
That said, cryptocurrency correlations with risk assets have increased in recent years, especially after the stock market crashed in 2020.
However, it is important to examine those numbers in context. Cryptocurrencies are far from alone in experiencing closer correlations with global market capitalization. In fact, the sensitivities of several key sub-segments of the bond market increased at the same rate as cryptocurrencies during this same period.
This is not surprising. Correlations for all asset classes tend to increase during periods of market stress when liquidity is compressed, and those relationships generally relax once more favorable winds come along. The highest correlations tend to persist as long as the measurement window captures the stress event and then disappears. Relatively speaking, cryptocurrencies still have virtually no correlation to stocks.
Still, while the rise in correlations may seem like a problem to an investor accustomed to rough and tumble financial markets, it suggests that unpegged cryptocurrencies are a poor replacement for fiat money. Unlike financial securities, safe havens like cash don’t tend to act like the rest of the market when it falls. Quite the opposite: fiat currencies are designed to hold up better during market stress, due to consumer confidence earned over centuries of injecting liquidity when economies overdraw.
All That Glitters: Does Bitcoin Price Move With Gold?
Which brings us to another asset that the market has compared to bitcoin: gold. Hailed as “digital gold,” bitcoin’s fixed supply and decentralized nature have attracted the attention of those who believe it could act as a viable competitor to the bars stored in bomb shelters by doomsday planners.
The argument has intellectual merit, but in the short term, Morningstar analysts agree that Bitcoin is unlikely to dim the shine of gold. People have used metal to conduct business since at least 600 BC. C., while Bitcoin has only been around for 14 years.[3] Alternative use cases for gold buffer the metal during periods of market stress so that it does not rely solely on market sentiment to create liquidity. We believe that compared to gold, bitcoin lacks sufficient external applications to offset the impact of market events on its price, limiting its usefulness as a store of value. Also, the first bitcoin-denominated transaction didn’t happen until 2010, which means we only have 11 years of price data to study. During a market correction in our time horizon, gold’s correlation with equities remained low, while bitcoin followed the crypto market in an upward trend.
What we expect for the future of cryptocurrencies
With a total market cap of $1.7 trillion, cryptocurrencies can no longer hide in the shadows of Reddit forums. The surprising growth of the asset class warrants both caution and excitement.
While cryptocurrencies have spawned entire parallel economies from scratch in just 14 short years, which is no small feat, today the decentralized infrastructure of cryptocurrencies still sets significant barriers against real-world use cases. As a result, cryptocurrencies remain a completely new, highly concentrated and highly volatile investable security. Rather than a quick acquisition, we expect that integration with existing systems in financial services and other sectors will likely determine future adoption rates in the space. If that path develops, the opportunities for investors will increase at a rate matched only by the potential risks.
1) CNBC|Momentive poll: “Invest in yourself.” August 2021.
2) Sources are CoinGecko and Morningstar. Data as of January 31, 2022.
3) Goldsborough, R. 2013. “A Case for the World’s Oldest Coin.” http://rg.ancients.info/lion/article.html
