Cryptocurrencies at crossroads

By Peter S. Kim

The hottest investment theme of the pandemic era has to be cryptocurrency, a virtual asset used as a medium of exchange based on groundbreaking blockchain technology.

Cryptocurrencies' champion, bitcoin, saw a dizzying rise but recently corrected almost 50 percent within a couple of weeks, causing diverging views between the bulls and bears.

In 2009, then-Fed Chairman Ben Bernanke rolled out quantitative easing (QE), a novel policy measure considered by most economists for use only under exceptional circumstances. QE has since gained acceptance as a mainstream policy, raising heated debate over its long-term repercussions.

The COVID-19 outbreak and the stimulus policy response have cemented the place of QE as a measure of last resort. During its early design, one of QE's roles was to encourage investment portfolios to shift into risky assets from the safety of low-yielding financial products like bank deposits.

Despite the global lockdown, the soaring risk appetite in investment assets has certainly made QE's mission a spectacular success. Amid the prolonged global shutdown, the “animal spirits” from investors are now spreading to many non-traditional asset classes, most notably cryptocurrencies.

The unequivocal assurance from the U.S. Federal Reserve and other central banks provides investors a license to take on ever more risk. However, in recent weeks, emerging fears over inflation and talks of the need for regulation placed the cryptocurrency universe at a crossroads.

Korea's love affair with cryptocurrencies dates back to 2016 when bitcoin famously traded at a massive premium to global prices, known as the “kimchi premium.” Back then, Korean investors single-handedly drove prices by taking up more than half of global trading volume. Korea's herd-mentality investing culture is on display once again, with the kimchi premium rising in recent months.

Bitcoin's second coming is much more potent than the fervor seen five years ago when a regulatory crackdown doused its fire. Many governments, South Korea included, raised concerns over cryptocurrencies' role in money laundering, tax evasion and even drug trafficking. Predictably, there are concerns about the return of the regulatory scrutiny.

The South Korean government announced plans to investigate illegalities involving cryptocurrencies last month as individual investors chase the gold rush. In particular, the Korean government will investigate cross-border transfers of virtual assets. Scrutiny on tax evaders is also expected with taxation on cryptocurrency traders from next year.

China and South Korea are two governments that have clamped down on cryptocurrency in different ways. The surge of cryptocurrency presents a dilemma for China which is in the middle of clamping down on its internet and fintech industries. Recently, Chinese authorities issued a warning to investors by banning banks and payment firms from facilitating cryptocurrency transactions.

China signaled a diverging policy path from South Korea by carefully formulating a regulatory framework without stifling innovation ― Chinese leaders would be keen to pursue the powerful and game-changing blockchain technology that cryptocurrencies are founded on. Historically, Chinese policymakers have proven their foresight by tightly supervising internet industries without stunting the innovation and competitiveness of its corporate champions.

With U.S.-China trade tensions set for the long haul, Beijing would be keen to ensure it does not get left behind on the cryptocurrency evolution as Washington seeks to curb its advances in technology. To prove the point, the deputy governor of China's central bank openly declared bitcoin as an “investment alternative,” a meaningful endorsement from a high-ranking official. How China manages the balancing act could provide a playbook for other nations to follow.

Despite the policy uncertainty, there is a paradigm shift in cryptocurrencies as an investment asset. With central banks losing their policy discipline with unlimited monetary and fiscal support, their credibility is declining as the leaders of financial markets. Over the past 10 years, the central banks' inflation mandate has been phased out by politically driven objectives like financial market stability, economic growth and even job creation.

Also, with interest rates at an all-time low, central banks have painted themselves into a corner for future policy flexibility. The time-honored independence of central banks has also come under fire, most famously by former U.S. President Donald Trump.

Cryptocurrencies' peer-to-peer ecosystem circumvents political involvement in financial transactions, a meaningful positive considering the anti-establishment sentiment sweeping the world. The central banks' fading credibility ultimately is leading to the loss of credibility of their respective currencies, whose inherent value lies with the unquestioned trust by the holders.

The long-term viability of bitcoin and other cryptocurrencies requires investor trust and following. Bitcoin is thriving on both fronts, with a growing number of institutions (and a billionaire) pledging their support. Bitcoin's sheer value is already threatening, as an alternative to the mainstream asset class.

Cryptocurrencies led by bitcoin have arrived as a mainstream investment asset, alongside crude oil and precious metals such as gold, whose value lies with supply-demand or investor fund flow. But for bitcoin to be a legitimate currency, it will have to resolve regulatory and legal hurdles.

Bitcoin and other cryptocurrencies' place alongside major sovereign currencies and income-generating assets like bonds or equities is still far off. A final word of warning has to be made for investors against flirting with unproven emerging cryptocurrencies and derivative exchanges and products. For those products, easy gains go hand in hand with equally easy losses.

Peter S. Kim (peter.kim@kbfg.com) is a managing director at KB Financial Group.