Leveraging cryptocurrency to hedge against inflation

Leveraging cryptocurrency to hedge against inflation

By David K Donovan 

With its potential to transform the traditional financial system, cryptocurrency has been hailed as the most important innovation to take place in financial markets in decades. Many speculators wanted in on its meteoric growth. Investors also flocked to cryptocurrencies in hopes it would be a hedge against rising inflation. The reality of ongoing inflation and the “Crypto Winter,” now bringing down industry giant FTX, has stymied that plan, though. Let’s see why the theory does not hold.

Misplaced correlation between cryptocurrency and inflation Cryptocurrency came into prominence in 2017. Some people think it’s a currency and some a commodity. I believe it’s not a currency yet because currencies react to inflation. Crypto is neither inflationary nor anti-inflationary; it is still young in terms of adoption, and it has not spent enough time in the system to ascertain its status.

Crypto’s rise can be attributed to the fact that it rose when there was liquidity in the system and interest rates were low. Back then, it made sense for investors with excess capital to invest in riskier assets. That’s true not just for crypto but also other risky assets, such as high P/E stocks, which are often tech industry darlings. Cut to the present, with liquidity getting tighter, we are witnessing problems with the crypto market. Pressure for withdrawals throughout the system has certainly been a contributor to the collapses of notable firms like FTX and Celsius.

Is crypto the new digital gold?

Cryptocurrency is barely five years old. People tend to associate it with a commodity such as gold. The truth is cryptocurrency is neither a coin nor a commodity. Although acknowledged as a part of the financial system, it’s more nebulous in nature.

Gold is widely considered a store value and has been used for exchange far longer than even paper money. Gold prices do not fluctuate during inflationary periods as much as digital currencies have.

While prices of gold rally during times of high inflation, that correlation has broken down in recent years. Its value went up in the last five years even when there was no inflation. While gold has proven itself over a millennium, as the new kid on the block, crypto is only now facing its first inflationary macroeconomic environment. Its potential is yet untapped, and it needs to stabilise. Five years is simply not enough time to conclude if it is a good hedge against inflation. 

Cryptocurrency versus digital assets

With rare experimental exceptions, cryptocurrencies are not backed by any government. Some stablecoins are at least pegged to a currency or commodity. For instance, gold-based stablecoins in some ways resemble other gold-linked products like derivates or ETFs. The tokenisation of gold into stablecoins makes for another way to get exposure to gold without physically holding it. Some believe the blockchain method may be more secure for their investment. Indian investors are already familiar with this concept in the form of Sovereign Gold Bonds, issued by the Reserve Bank

of India.

Systemic stability

There is a polarising debate among crypto enthusiasts, how much would the industry benefit from regulations and protections? Let’s look at the Binance / FTX situation again to understand this better. While FTX has filed for bankruptcy, Binance on the other hand is apparently more stable. However, a clear pattern has been established. FTX went under, at least in large part, due to its inability to meet liquidity demands. And while this may not be the case with Binance, they will still suffer from the FTX fallout, as it only takes a few bad actors to hurt the reputation of an entire

system. The whole incident has injected a lot of uncertainty in digital assets across the board. Risk management is the key Every time there has been a crisis, the 2008 housing bust, for instance, it all came down to the fact that the investments were not hedged properly. Cryptocurrency is young, but that’s not why FTX is filing for bankruptcy today. The reason it is going under is that it didn’t follow the fundamentals of good risk management and hedge its investments correctly. Risk management is

a time-tested exercise regardless of the asset you are investing in. If you don’t manage risk the right way you will always be at risk – especially when markets are as volatile as they are today.

The ongoing crisis in cryptocurrency does not mean the industry itself will go away, as there are many advantages to digital assets, such as stablecoins. Cryptocurrency can also play a huge role in onboarding the underbanked people in India.

What made cryptocurrencies attractive, besides a low-interest rate environment encouraging speculation, was the fact that most of it is unregulated and there are no middlemen involved. Those very reasons are working against it now.

What recent incidents have also proven is that digital assets need safeguards to not only maintain liquidity but to also assure people that it’s safe for investment. Regulating the cryptocurrency industry will bring confidence, and the confidence in turn will bring more adoption and thereby lead to more liquidity. These measures, coupled with systemic maturity, are how we will have a clearer picture of how ‘inflation-proof’ this asset really is.

The author is the executive vice president, Financial Services, Publicis Sapient US

Also Read: FTX fires three of its top executives

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