Cryptocurrencies like bitcoin are in a "speculative bubble" and are unlikely to become mainstream currencies, according to UBS.
There are over 1,000 cryptocurrencies, bitcoin being the biggest by market capitalization, and many have seen huge rises in value over the past few years. Bitcoin for example is up over 470 percent year-to-date.
"We think the sharp rise in cryptocurrency valuations in recent months is a speculative
bubble," UBS wrote in a white paper published last week.
The investment bank said that it is "highly doubtful" that these will ever become mainstream currencies.
"The need for companies and individuals to pay tax receipts in government-issued currency, and the potentially unlimited crypto-money supply, pose significant barriers to widespread adoption," the note said.
UBS said that governments set taxes and this is the largest single income for almost any economy. Therefore, people will always want government-backed currencies to pay tax. Even though a company could accept cryptocurrency as payment, it would need to pay different taxes in government-backed currency. And so the company would be taking an exchange rate risk.
"If governments refuse to accept cryptocurrencies for tax payments, the single most important transaction in an economy, that significantly reduces demand for cryptocurrencies. Governments are highly unlikely to ever take this step," UBS said.
Currencies also act as a store of value, which is achieved when supply of currency matches demand, according to the note. But this is not possible with cryptocurrencies as supply cannot go down. And while the supply of individual cryptocurrencies cannot be readily changed, the overall supply of them can be "infinitely increased" by the creation of new virtual currencies.
"The possibility of limitless supply of different cryptocurrencies creates the risk of further collapses in value. If a new cryptocurrency were created which is easier to 'mine,' and which allows more transactions to take place more quickly, demand for that cryptocurrency might naturally increase," UBS analysts said.
"Existing cryptocurrencies would likely see demand fall; a cryptocurrency that has been superseded by a new cryptocurrency with superior technology has little value. As the supply of existing cryptocurrencies cannot fall to match the decline in demand, the result would be a collapse in the value of existing cryptocurrencies."
'Almost certainly a bubble'
UBS described what makes a "bubble" in any asset and concluded that cryptocurrencies, with their massive price rises, meet the definition.
"The relatively high volume of cryptocurrency turnover, against limited real-world use, suggests that many buyers are seeking speculative gain, never intending to use cryptocurrencies to make a real-world transaction," the investment bank said.
"With each of the other characteristics of typical bubbles in evidence, a twenty-fold increase in bitcoin prices in just two years, and an absence of any fundamental economic backing, cryptocurrency prices are almost certainly a bubble."
UBS is not the only organization in the banking world to pour cold water over cryptocurrencies. JPMorgan Chase's CEO Jamie Dimon has previously called bitcoin a "fraud" that "won't end well."
Blockchain 'significant impact'
Despite its skepticism on cryptocurrencies, UBS said blockchain technology is likely to have a "significant impact" on a number of industries.
The blockchain is the technology that underpins cryptocurrencies. In the case of bitcoin, its a distributed ledger that records all transactions. It is tamper-proof and the technology is hailed as something that could be used in a number of different processes across many industries.
For example, it could be used in trade finance to create "smart contracts" where a deal goes through automatically once certain conditions are met by all the parties involved. The promise of blockchain is that it could make processes more secure and faster.
Groups such as R3 or the Enterprise Ethereum Alliance, which contain a number of banks, are currently exploring how this could work.
"Investing in the blockchain wave is akin to investing in the internet in the mid-nineties. Blockchain could lead to significant disruptive technologies in the coming decade," UBS said.
"But for the time being, technological shortcomings still need to be resolved, it remains unclear which specific applications will prove most useful/profitable, and actual revenue and profitability associated with the industry is currently limited."
