Bit-Crazy? Why we can no longer afford to ignore Bitcoin

Bit-Crazy? Why we can no longer afford to ignore Bitcoin

Tue 23 Feb 2021

Summary

By passing the 10-year mark, Bitcoin has gained some acceptability by major institutions.  Unprecedented liquidity conditions have contributed to a renewed narrative which is now pushing the asset’s price above the $50,000 level. Our position is that Bitcoin’s overall nature fall outside the standard definition of “money” or “commodity”. It is a genuinely “new” asset. However, the associated risks (lack of regulation, custodianship, concentration, extreme volatility) could be deemed as “too high” for an average investor portfolio. There are portfolios where this asset might be applicable but, should clients want the asset, they always need to be informed of the potential risks.

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Bitcoin is now 10 years old and trading at above $50,000 Dollars. Assuming a figure of 21 million final Bitcoins mined, this would mean a “market capitalisation” of roughly $1tn. If it were a stock, it would squarely be in the top 10 in the US (Google has a market cap of $1.5tn).  If it were a precious metal, it would be worth nearly 8% of all global gold reserves. A billion dollars’ worth of investment in 2017 would be enough to solve a developed country’s debt problem. Just recently, major asset managers such as Ruffer and Blackrock have taken positions on the world’s foremost Crypto-currency. No wonder it’s making front page news all across the financial press.

Warren Buffet famously said that “price is what you pay, value is what you get”. Our fundamental position was one of scepticism on the value proposition of holding that particular currency.  While that position hasn’t fundamentally shifted, it is clear that, after hitting a 10-year survivor mark and attracting serious institutional money, Bitcoin can no longer be ignored. Thus, we must analyse it and think what value this asset can add to client portfolios.

We will focus around answering three questions relevant to clients: What is Bitcoin, is it money and is it appropriate for an average investor portfolio.

What Is Bitcoin in simple terms?

Bitcoin is a digital currency, created in January 2009. It takes advantage of the Blockchain, a technology which promises to remove a lot of intermediary services (and lower costs), which exist to verify transactions on behalf of all parties involved. It is called a “Cryptocurrency”, because strong encryption is used to ensure anonymity of transactions. It is the first “virtual money” to win widespread popularity.

Bitcoin is created, or “mined”, in computers with great processing power, without the backing of any governments. It is a fixed-amount currency (unlike modern fiat money), with only 21 million bitcoins set to be mined, an additional 2.5 million to the current stock.

Simple answer: Bitcoin is a fixed amount, new-age, blockchain-friendly financial asset with no institutional backing.

Is Bitcoin Money?

Bitcoin might be called a “coin”, accompanied by an imagery of gold coins, and a symbol resembling the Dollar, but it’s good to remember that its nature, and its attraction for that matter, is that it is completely intangible. It exists only in bits and bytes and has no physical form. Still, most modern money is intangible, moving seamlessly through credit and bank accounts. Even credit cards, a plastic reminder of physical money, are losing ground to intangible methods like Apple Pay and Paypal.

Intangibility does not preclude an asset from being called “money”. We must thus look to the properties of money and compare to Bitcoin.

According to the St. Louis Fed, there are three key functions of money: a store of value, a unit of account and a medium of exchange.

First: Money is a store of value. If I work today and earn 25 Pounds, I can hold on to the money before I spend it because it will hold its value until tomorrow, next week, or even next year.

Bitcoin’s volatility does not meet the definition of “store of value”. To be fair there’s no perfect store of value. All currencies rise and fall in value, both against each other and in terms of their purchasing power.

At 77% Bitcoin’s volatility far exceeds currency volatility (c.7%) or inflation (c.1%-3%), or gold and commodity volatility (16%-17%). In fact, it far exceeds stock and bond volatility (16% and 5% respectively).

What does 77% volatility mean? It practically means that an event of total capital loss within a year would be statistically acceptable, as would a doubling of the initial investment at the same time. So in terms of “store of value”, it’s volatility puts it very far from the currency definition.

Second: Money is a unit of account. We set prices in money because it is a common measure of value across the economy.

Commonality also implies a modicum of stability. While items like Tesla Cars can be quoted in Bitcoin, prices could swing violently even intra-day causing severe transaction and valuation problems.

Consider a Mr. Smith taking Elon Musk up on his offer and buying a Tesla car on the Sunday 7 February 2020. At a cost of roughly $60,000 (£43,000), and with the price of Bitcoin at $38,000, the cost would be 1.56 Bitcoin. On the next day, Monday, Bitcoin rose to $46,000, and the price of the car would have fallen to 1.3 Bitcoin. If the transaction was cleared on the spot, Sunday, Mr. Smith must have felt very stupid, because he just lost $8000 by not waiting 24 hours. If, for bureaucratic reasons, the transaction was cleared by Monday, then he would have the right to ask for $8000 back, since the car is now worth less in bitcoin terms. And Mr. Musk, who had pocketed the money, could very well say no! A simple day’s volatility for one bitcoin could be worth 2-3 (hefty) paychecks. With every day currency volatility, the differences in prices are small. Bitcoin’s volatility could cause huge transactional problems if accepted as tender around the world.

The fact remains that Tesla would have to make a choice. Either it can keep the price of cars steady in Dollar terms or in Bitcoin terms. Whatever choice it makes it accepts that unit as currency and the other as a form of barter. Chances are, for all of Mr. Musk’s tweets, expensive Tesla cars are going to be priced in the unit of account that corresponds to costs, i.e. US Dollars. Accepting Bitcoin is in fact dangerous for the company, as a sharp depreciation could hurt the company’s bottom line.

It is natural for Mr. Musk to ask to be paid in Bitcoin, if he feels it’s going to rise. But why would a consumer pay if he feels that the price of the asset will soar? Transactions would be difficult and hoarding the more probable outcome. 

Third: Money is a medium of exchange. This means that money is widely accepted as a method of payment.

Bitcoin meets only that third definition, as it is increasingly accepted as a method of payment. Apart from Tesla, Wikipedia, Microsoft, AT&T, some off shore Burger Kings, KFC Canada and some US Basketball and Football (the US variant) teams also accept it as payment. Still, 10 years on, the rates of adoption are still too low to consider it a widespread “medium of exchange”. Just for measure of comparison, the value of daily transactions of the Indian Rupee against just the US Dollar topped $110bn. The value of Bitcoin transactions near the end of January 2021 was a mere $7.1bn. Yet the world isn’t flocking to buy the Indian currency.

Simple answer: Bitcoin can’t be called “Money” just yet.

Is it appropriate for an average portfolio?

First of all, to be clear, all – legitimate – products may be appropriate for some client, with some risk profile in some portfolios. So we will just examine whether the asset is fit for a market-average portfolio, with given risk profiles.

Due to its large volatility, a simple investment in Bitcoin would be the equivalent of 6 times the equity risk. So a 2% position in Bitcoin would have to be offset with 12% in equities reverting to cash.

Put it differently, Bitcoin looks like a very leveraged equity position. But that shouldn’t matter if extra returns outpaced extra risks. 

Here came a surprise in the data. A quick check of reward versus risk (and assuming a 0% risk free rate) in this cycle suggests that Bitcoin might significantly improve a portfolio. The relationship for Return vs Risk is 0.8 for stocks and bonds, 0.3 for gold, near zero for the US Dollar and slightly negative for commodities, who now may just be entering into a new 15-year super-cycle.  This means that for all the risk of Bitcoin, the rewards were greater.

This relationship is probably what made big asset managers consider the asset.

However, we feel that:

Those numbers are too short-term. Bitcoin really took off after 2016-2017, a period of extraordinary liquidity conditions. We are looking at the high-growth phase right now. With so much money chasing few opportunities, just a fraction of that money poured into this new asset could launch it. Simply put, compared to the stock or the bond or the wider currency market, Bitcoin is the very small cap stock that shot through the roof because demand was so much higher than supply. As the asset class matures, the risk/reward could be very different. Granted, a limited Bitcoin supply could keep prices elevated. But, where there’s lack of supply, new currencies could experience inflows. Ethereum is already trading at higher volumes than Bitcoin.

The possible downside is not acceptable. Investing in an equity or a bond allows investors to divest at the first sign of trouble. Volatility doesn’t have to translate to a huge value-at-risk with active management. But the volatility in Bitcoin transcends the ability of most investment committees to make a reasonable decision in the time needed to avert disaster.  We are not presently ready to accept these risks within our portfolios.

Risk is not just volatility. While blockchain ensures minimal counterparty risk, so there’s no clearing risk, there’s the risk of “warehousing”. Traditional asset managers rely on “custodians”, established banks with very strict rules on where assets belong. The main proposition of the asset management industry is that even if a company implodes, the assets of clients are absolutely safe with the custodian. As crypto-currencies feature no custodians, they can be hacked or lost (if in external drives). In fact, an estimated 3 million early mined Bitcoin ($150 billion!) have been lost in old hard drives, making it the largest missing treasure in history.

And there’s of course the risk of manipulation. As ownership is opaque (as opposed to stocks and bonds) and the market unregulated, an asset which lacks institutional protections is very vulnerable to manipulation. The more the concentration, as supply is limited, the higher the risk of manipulation.

But by far the biggest risk of all is regulation. Bitcoin has been allowed to breathe in an unregulated market. The moment regulators fear it poses a risk for institutions holding them, it could be very easily regulated which could have as severe impact on availability and returns.   

Simple answer: Bitcoin is appropriate for some very aggressive portfolios who can afford a total loss, but it does not meet the basic criteria for inclusion in our portfolios. 

Our view

What is Bitcoin? It is not an established financial asset with a yield or an underlying fair value like stocks and bonds. It has no use, like industrial commodities do. And it has no aesthetic use, like gold is used for jewellery. No one can exhibit their Bitcoins, like they do art, or can they live in them, like with real estate and other real assets.  And it is not “money”, as it doesn’t really exhibit the properties of money. In fact it is an asset that has a completely different risk/reward profile than any established asset. It is, a “novelty”.

In Robert Shiller’s view, Bitcoin started as a narrative, of “new age money” outside the banking system, in a post-2008 era of excess liquidity and deep distrust of institutions, especially banks. The possibilities stemming from Blockchain technology were the icing on the cake for the Bitcoin story. For various reasons in the past few years, distrust for institutions has only grown. Boosted by huge liquidity, especially after September 2019, the crypto-currency soared, along with some less-watched stocks and other non-mainstream assets. In the process, as quantitative easing further eroded trust in fiat currencies, an additional narrative emerged, that of a gold-like fixed asset to come to the rescue of a global financial system ready to collapse from over-printing.

In a low growth world where non-leverage returns are scarce, the allure of a high growth/high risk asset is great, especially when the “first adopter” jitters pass. Especially when its growth is so steep that it outpaces volatility and creates a positive risk/reward profile. 

For us, the risks that accompany Bitcoin are still not acceptable. However, if regulation sets in and some of those risks are reduced to acceptable levels, we have done our homework as to how our clients may benefit from that. Having said that, we acknowledge that the asset might be appropriate for some buyers who would acknowledge those risks.

Having said that, we feel that “money” is too important a term to trifle with. US global geopolitical primacy is based on the global acceptance of its currency, more so than on the power of its arsenal. Europe reformed itself and went to extraordinary lengths to protect the Euro. The UK made the strategic choice in 1992 to split from Europe, mostly to maintain monetary independency. In a Modern Monetary Theory environment, money may be more important than assets in generating wealth, as twelve years of solid quantitative easing exemplify.

Central banks like Blockchain and digital currencies, in part because it would give them greater control over the money in circulation and enable more targeted policies. We feel that the near future of finance probably features a digital currency. However, we are not convinced that this will be Bitcoin just by virtue of first entry, any more than MySpace was the future of social media, or Yahoo! the future of search engines. A digital currency with widespread use will be carefully regulated, and will probably, unless the current geopolitical balance is materially upset, operate under the blessings of the Federal Reserve and maybe the European Central Bank. More importantly, supply won’t be fixed, to allow for monetary expansion, and there will be no “mining” except in central bank vaults.

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