Bitcoin as an investment for retirement funds.

Bitcoin has established itself as the first and most popular cryptocurrency of our time. A digital currency for a digital age. The value of one Bitcoin in US dollars appreciated by more than 60% last year. This exceptional investment performance and rapid growth have created enormous interest in Bitcoin, as well as for cryptocurrencies in general, among the general public, the media, and investors.

The growing popularity of Bitcoin among investors

Its popularity has recently been reinforced by endorsements from top industry figures like Tesla founder Elon Musk, meaning that you could now use Bitcoin to purchase a new Tesla. However, from 13 May 2021, Tesla subsequently suspended Bitcoin vehicle purchases owing to climate change concerns, with Elon Musk expressing concern about the rapidly increasing usage of fossil fuels for Bitcoin mining and transactions, particularly coal, which emits the most greenhouse gasses of any fuel. Many payment platforms, including Bit Pay, Square, and PayPal, have begun to accept Bitcoin and other cryptocurrencies as payment. In May 2020, El Salvador became the first country in the world to accept Bitcoin as a legal tender. Furthermore, trading Bitcoin on established platforms has become much easier. On behalf of UK pension funds, some multi-asset funds are now investing in Bitcoin.

With such astronomical profits, is it worthwhile for Trustees to invest their members’ money into Bitcoin?

Despite the growing popularity of Bitcoin, many factors still need to be considered when taking into account the feasibility of Bitcoin as an investment for Retirement Funds.

#1: China’s Central Bank announced on 24 September 2021, that all crypto-currency transactions are illegal, thus prohibiting digital tokens like Bitcoin. The Chinese government argued that cryptocurrencies are illegal, a risk to the entire financial sector, and the government itself cannot regulate and control cryptocurrency effectively.

#2: The South African Government Gazette 45396 Notice 1460, with draft amendments to Regulation 28 published for comment, explicitly prohibits Retirement Funds from investing in Cryptocurrencies.

#3: Bitcoin’s scalability problem; which refers to the Bitcoin network's limited ability to handle large amounts of transaction data on its platform in a timely manner. This is due to the Bitcoin blockchain’s limitation on the number and frequency of records known as blocks. Cryptocurrencies like Bitcoin and Ethereum have very limited transaction capacity when compared to traditional payment providers like VISA or PayPal. The transactions on the Bitcoin network are stored in Bitcoin blocks. The Bitcoin network's on-chain transaction processing capacity is limited by the average block creation time of 10 minutes and the 1-megabyte original block size limit. The network's throughput is constrained as a result of several factors working together. Using an average or median transaction size, the maximum transaction processing capacity is predicted to be between 3.3 and 7 transactions per second. For instance, VISA, the world’s leader in digital payments, can process over 65 000 transaction messages per second with an average of 150 million transactions each day. PayPal, on the other hand, handles 193 transactions per second and 5 million transactions each year. As a result, network speed and security are the two most important factors in determining a payment network's reputation. The present infrastructure of cryptocurrency networks will need to be expanded appropriately to absorb increasing transaction volumes, along with an increasing number of users.

Bitcoin becomes a legitimate investment currency but fails to gain traction as an everyday means of payment

Despite its popularity among investors, Bitcoin has been sluggish to gain traction as a means of payment. It was designed in 2008 to function as an electronic equivalent of currency, allowing two people to digitally trade value as if they were physically exchanging cash.

It hasn't worked out that way in practice. Normal day-to-day transactions have become difficult due to the high cost of using Bitcoin and its volatility. Because of the accompanying fees, Bitcoin is an undesirable payment option for consumers who wish to buy something little, such as a cup of coffee.

The time it takes for a Bitcoin transaction is determined by a number of factors. To begin, we need to understand how a Bitcoin transaction works. Person A, for example, plans to send some of their Bitcoin to Person B, both of whom already have Bitcoin wallets. Each Bitcoin has a unique BTC address that identifies the rightful owner. Person A gives the Bitcoin a new address to deliver it to Person B by transferring it. Once Person A has set up the transaction, the Bitcoin miners must verify it on the blockchain. Person B can locate the Bitcoin in their separate digital wallet after the miners have verified the transaction. A Bitcoin transaction can take anywhere from 10 minutes to an hour to complete, depending on the volume of traffic.

According to the website BitInfoCharts.com, the average Bitcoin fee is more than $US11 and ranges significantly depending on network traffic (when there's a lot of traffic, the fee goes up). The daily average cost has fluctuated between $US2 and $US17 during the last three months.

Bitcoin, on the other hand, has found a place in luxury purchases for large-ticket items, such as buying a $US100,000 Tesla, where such costs are unlikely to be an issue.

Non-fungible tokens (NFTs) are digital assets that give ownership to unique physical or digital assets, like works of art, real estate, music, or movies. NFTs can be bought and sold online and represent a digital proof of ownership of any given item. NFTs are recorded on a blockchain, which is the same technology that underpins cryptocurrencies and assures that each asset is unique. Altering or counterfeiting NFTs will be more difficult with this technology. However, just because NFTs are most commonly employed in the digital world does not mean they can only be utilised to store digital goods. NFTs can also be used to represent physical possessions or real estate ownership. Fractional ownership is a good example of this. By releasing tokens on the blockchain, homeowners can sell a portion of their property to a big group of small investors. These tokens could be held for a rental income, a profit split on capital appreciation upon sale or a mix of the two. This would allow many more people to invest in property as well as provide better options for those who need to unlock equity without borrowing or relocating.

Our team at RISE looked at the pros and cons of Bitcoin as an investment for Retirement Funds to help trustees and other investors make a more informed decision about its prospects.

The advantages of Bitcoin as an investment for Retirement Funds

#1: Potential for high returns

One of the main arguments in favour of Bitcoin is the potential for high returns. For example, the JSE All Share Index (ALSI) which represents all ordinary securities listed on the main board of the JSE has compounded at an annualised growth rate of 36.1% over the five years to 31 December 2020, while the price of Bitcoin in USD has compounded at an annualised growth rate of 131%.

#2: Limited supply

Currently, a maximum of only 21 million Bitcoins can be mined. With roughly 18.5 million Bitcoins having been mined at the moment, this leaves less than three million to be created. A related aspect is that the rate of generation of Bitcoins slows over time due to a process known as halving. Following the most recent halving in May 2020, each block created is currently worth 6.25 Bitcoins, down from 50 Bitcoins in 2009. Furthermore, it is estimated that roughly 20% of the current Bitcoin supply has been lost or cannot be accessed because the owners forgot or lost their passwords. For some investors, Bitcoin's scarcity adds to its attractiveness. If the demand for Bitcoin grows more and the supply is constrained, the price should rise even more.

#3: Protection against depreciating currencies and the possibility of rising inflation

The 2008/2009 Global Financial Crisis (GFC) as well as the COVID19 pandemic prompted many central banks around the world to pursue monetary policies that had never been used before. These included massive acquisitions of assets by the central banks e.g. the US Federal Reserve (the Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ) which have each increased their balance sheets by up to US$6 trillion. There are fears that this may lead to a significant depreciation of each of these country’s currencies. Bitcoin provides an alternative that cannot be deliberately debased in a similar way partly because supply is limited and also because cryptos are not subject to the same political and economic pressure as central banks, which require intervening in currency markets and supporting a struggling economy by purchasing financial assets.

#4: Growing acceptance and usage

As mentioned in the introduction, an increasing number of payment platforms are now accepting Bitcoin and other cryptocurrencies for transactions. Coinbase reported that it had executed $135 billion in cryptocurrency merchant transactions, up 600% from the previous year. A survey done by Skynova reported that a third of small companies in the United States now accept cryptocurrencies for purchases, and there has been a substantial increase in the number of Bitcoin electronic wallets. In addition, a growing number of institutional investors like Blackrock, the world’s largest asset manager, are looking at investing in Bitcoin and other cryptocurrencies. Grayscale, the world leader in digital currency investments, also revealed that institutional investors, primarily asset managers, accounted for 86% of the US$5.7 billion it received in 2020.

The risks of investing in Bitcoin for retirement.?

Despite all the benefits of the use and gradual adoption of Bitcoin and other cryptocurrencies, the hazards of investing in cryptocurrencies need to be understood. The Financial Conduct Authority (FCA) in the United Kingdom recently issued an article on cryptocurrency investments, where it advised that investing in crypto assets entails incurring extremely high risks and thus anyone investing in these assets should expect to likely lose all their money. There are many risks that need to be considered when evaluating Bitcoin as a sound investment.

Legal issues for pension fund Trustees

There are various legal hurdles that Trustees must cross before considering investing a portion of their portfolio into Bitcoin or other cryptocurrencies.

#1: Do they have the power?

Trustees should first check whether they have the legal authority to invest in cryptocurrencies. They should check their Investment Policy Statement, as well as any legislative documents like Regulation 28. Given that cryptocurrencies are a relatively new asset class, the regulations may not specifically allow investing in them, as seen in the latest South African draft Government Gazette which explicitly prohibits Pension Funds in South Africa from investing in cryptocurrencies.

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#2: Acting in members' best interests

If they do have the authority to do so, the Trustees should assess whether they would be performing in line with their fiduciary duties if they were to invest in cryptocurrencies. Trustees of pension funds must invest with the same care as if they were investing for themselves. Trustees should also consider investing in the best financial interests of their scheme members. To assist them in making this decision, Trustees are required to take written professional investment advice from appointed Investment Consultants. The investment advice should cover the ESG, i.e. environmental, social governance impact of investing in cryptocurrencies, particularly the energy-intensive mining process that is undertaken for Bitcoin. Bitcoin’s value is very subjective and thus cryptocurrencies are deemed speculative with no real fundamental value, and the mining costs are quite high.

#3: Trustee policies

Trustees should consider whether investing in cryptocurrencies would be consistent with their policies, such as their investment policy statement (IPS), and if their IPS needed to be amended.

#4: Investing in regulated markets

Trustees should also be mindful that, according to Regulation 28, "the scheme's assets must consist principally of investments admitted to trading on regulated markets," and that "investment in assets not admitted to trading on such markets must be restricted to a prudent level”. Since this Bitcoin market is still unregulated,

#5: Custody issues

Trustees would also need to think about how they'd keep whatever cryptocurrency they bought safe, and who would be responsible for looking after the private keys. They could consider asking current Investment Managers or Custodians to provide custody services for the private keys, taking into account that the most significant risk of investing in cryptocurrencies is that the cryptocurrency cannot be accessible if the private key is lost. The other option would be to invest in a cryptocurrency fund or investment trust on a regulated market where the Trustees are unable to find a custody arrangement for the private keys.

#6: Bitcoin as a store of value

Bitcoin cannot be considered a reliable store of value since it is not tied to any currency and its price is very volatile. One of its most appealing features, as discussed earlier, is how its value has increased in comparison to traditional national currencies. Unfortunately though, the price has plummeted quite significantly of late. Given that Bitcoin has no traditional intrinsic value, price volatility can be expected. Valuation is based on the price the next investor is prepared to pay for Bitcoin.

#7: Bitcoin as a source of capital growth

The future value of Bitcoin ultimately depends on its increased adoption as a digital currency. The number of daily transactions ultimately determine a currency’s value. Thus a substantial increase in transaction-driven users will be required to offset the existing Bitcoin owners holding it for speculation who will eventually quit the crypto market. Commodity markets can be used as a comparison because their major function is to facilitate supply chains rather than to provide long-term returns to investors. That said, some knowledgeable active managers make long-term returns by taking advantage of short-term imbalances in demand and supply. Even though the same might be said for Bitcoin, normal investors won’t make money trading commodities derivatives in the long run. Furthermore, the variables at play in the Bitcoin market are perhaps much more abstract and unpredictable.?

#8: Bitcoin as a risk hedge

Bitcoin could also protect against inflation from central banks printing money. Inflation arises from several sources. In theory, Bitcoin could protect investments from inflation resulting from Rand or other currency depreciation. In principle, holding Bitcoin may shield you from currency depreciation as a result of loose monetary policy; but it does not necessarily protect from other forms of inflation. Where inflation results from higher raw material costs or expansionary policy leading to a surge in demand, this can plausibly increase prices in all currencies. Furthermore, in owning Bitcoin one is exchanging modest inflation risk of Rand for substantial price volatility of Bitcoin.

#9: Bitcoin as a source of interest

Unlike lending money, which earns interest or interest-bearing securities like bonds, Bitcoin does not earn interest on its own. The creation of a Bitcoin lending market could be a source of diversified interest.

So while Bitcoin may have short-term gains, it is not a credible investment for Retirement Funds.

Bitcoin is currently not a reliable store of value, nor does it offer enough interest to justify the price risk. Bitcoin, for now, is not a credible investment property for long-term investment. It does not offer a clear reason for future price increases, nor does it act as a hedging asset. At the moment it can perhaps only be used in making very short-term tactical positions. With such imprecise core value drivers, it's difficult to believe anyone truly understands how much it should be valued at. Although more widespread and deeply ingrained Bitcoin usage could lead to more reliable value assessments and lower price volatility, Bitcoin is still not a viable investment option for institutional investors. To summarize, for now, we suggest one should proceed with caution and advise Trustees to not invest members' money in Bitcoin, especially in light of the recent draft Government Gazette prohibiting investment in cryptocurrencies.

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Disclaimer:

This article is intended as a general guide and should not be construed as legal or other professional advice. No responsibility can be taken for any mistakes or omissions, as well as any loss or damage resulting from the use of this material. For precise and thorough legal advice, always consult your legal advisor. Errors and omissions are not included (E&OE)