Family offices downgrade ESG in hunt for crypto returns
Many investment offices of wealthy families are more concerned with making money from cryptocurrencies than fretting about their environmental impact.
As cryptocurrencies continue to gain demand, asset owners are slowly weighing their best approaches to build exposure to them. For many, this requires a mixture of assessing their inherent volatility, plus their sizeable environmental impact.
However, some institutional investors are focusing more on the innovation and investment potential of cryptocurrencies, even if the assets are not environmentally friendly.
Family offices, particularly the younger generation of high-net-worth investors, have shown increasing interest in digital assets – an irony pointed out by a North Asian chief investment officer, who spoke to AsianInvestor on condition of anonymity.
“There is a very strong contradiction among millennials – they really care about ESG issues. However, they are investing in anti-ESG-related asset classes such as digital assets. As time goes by, that kind of ESG-related issues could hurt investors’ interest in digital assets,” he said.
Eric Woo, co-founder of Revere, a venture capital firm that counts family offices as clients, told AsianInvestor the ESG debate is a distraction from some useful applications of blockchain technology that underpins cryptocurrency.
Many investors who are interested in cryptocurrency focus most upon the applications of technology and the disruption of monetary models, he pointed out.
“From that perspective, the projects that people are working on are touching all aspects of our lives. We have a good friend who runs a gaming company, and they’re using the NFT (non-fungible token) protocols [and applying them to] the gaming industry,” he said.
Woo’s partner Chris Shen, who used to run single family office West 22nd Capital Advisers, added that the Bitcoin price volatility after Musk’s tweets could also be a result of quant fund reactions rather than investors divesting because of ESG concerns.
“It’s always the systematic funds that are doing language processing. And they give more weight to certain tweets, like they did from Trump and geopolitics,” Shen said. “Then there’s contrarians that go the opposite way. So after [Bitcoin prices] hit a certain level, it pops right back up because funds are flipping those positions immediately.”
THE DARK SIDE
Price volatility has been another oft-cited drawback for cryptocurrencies, along with limited liquidity and ESG concerns.
“Digital currencies like Bitcoin have increased in popularity. The advent of Covid and the unprecedented monetary easing from central banks across the world have stoked fears of fiat currency debasement.
Given its limited supply, Bitcoin is being viewed as a form of ‘digital gold’,” Francesca Fornasari, head of currency at BNY Mellon IM’s Insight Investment, told AsianInvestor.
However, the use of Bitcoin as an inflation hedge has never been proven, because there has not been a major period of price rises since the invention of the cryptocurrency, according to a recent paper by the institution.
And “given its decentralised nature, anonymity of ownership, and lack of regulation, Bitcoin can be easily used for illegal activities. An example of this was Silk Road – an online black market which was shut down by the US government in 2013,” she added.
However, on the environmental front, Fornasari agreed that blockchain offers some opportunities. She noted that “innovators in the space are increasingly aware of investors sensitivity to ESG… For example, blockchain could be used to enable a more efficient facilitation or financing of ESG friendly activities.”
“In short, if the cryptography underpinning blockchain is ESG friendly, the overall impact depends on the ultimate use,” she added.
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THE ENERGY COST OF CRYPTO MINING
The heavy energy consumption associated with the cryptocurrency Bitcoin comes from mining, a process used to create new Bitcoin and maintain the security of the cryptocurrency’s network. Altogether, 75% of Bitcoin mining has been traced to China, which primarily uses coal to generate its electricity.
Bitcoin transactions are essentially created through a network of participants around the world, who add transactions in the form of “blocks” on a blockchain by solving complex cryptographic problems. These participants, known as miners, compete to solve these problems to complete the transactions, for which they are rewarded with transaction fees and Bitcoin of their own.
The complex cryptographic problems requires a great deal of computational power to solve. Bitcoin’s protocol, known as “proof-of-work”, is designed in such a way that miners must prove they have invested a certain amount of computational power to solve these problems, Johannes Sedlmeir, who researches applications of blockchain technology at the University of Bayreuth in Germany, told AsianInvestor.
“Computational power basically corresponds to energy. So, if I compute a lot, I need a lot of energy. And so, this proof of work mechanism is basically energy intensive by design,” he said.
In addition, the Bitcoin algorithm was designed so a new “block” on the block chain can only be created every 10 minutes on average.
This means that as miners put in more effort to compete to create blocks, the more complex the cryptographic problems become, which require higher amounts of energy to solve.
That means that as Bitcoin rises in popularity, driving up its price and transactions fees, miners will try harder to compete to create blocks.
That will lead to a higher amount of energy being used to both maintain and grow the cryptocurrency.
PROOF OF WORK VS PROOF OF STAKE
Bitcoin, and all other cryptocurrencies, are underpinned by blockchain.
This is a distributed ledger technology that updates all parties involved in a transaction at the same time. Not all blockchains use Bitcoin’s energy-intensive “proof-of-work” protocol.
Ethereum, the second-largest cryptocurrency by market capitalisation after Bitcoin, has said it is looking to change its network from a “proof-of-work” to “proof-of-stake” protocol. It would make sense for Bitcoin to also do so, at least from a sustainability perspective, but that is unlikely to happen.
First, the cryptocurrency does not have a leader to make decisions over its functions. Instead, its supporting network consists of thousands of miners (or millions, as it is unknown how many miners there are). Most of them would have to agree to change the Bitcoin protocol.
“It’s like a democracy. Everybody has a say on what’s going on,” said Ipek Ozkardeskaya, senior analyst at online trading platform Swissquote. “And there’s also one more problem with the proof-of-stake is for a purist, the proof-of-stake means that those who have the biggest stake have got more power and more say.”
While proof-of-work requires miners to prove their work, i.e., computing power, proof-of-stake gives more weight to miners with a larger stake i.e., higher percentage of coin ownership.
“Bitcoin purists don’t want it to happen this way, even though we know that mining leaches so much energy,” she said.
“There’s also some religious aspects behind this. [Some people] think that Satoshi Nakamoto’s protocol should not be changed that significantly,” Sedlmeir agreed, referring to the mythical founder of Bitcoin whose identity has never been verified for sure.
“There are also a lot of people who argue that proof-of-work is more secure,” he added. “But I don’t personally see that.
“There are a lot of researchers that have demonstrated that proof-of-stake can be secure. And so far, experience shows that proof-of-stake cryptocurrencies that are already there seem to work quite fine. Algorand, Cardano, Polkadot, Tezos, there are a lot of them.”
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This article was first published in the summer 2021 edition of the AsianInvestor print magazine. Click here to read part 1 of this story.
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