From Skeptic to Believer: Investing in Bitcoin in 2020
Google Trends for “bitcoin” , 2017 spike coincided with Bitcoin’s all time high in price
Bitcoin is a polarizing subject for polarizing times. Adherents espouse a cult-like devotion (“hodl”) while public sentiment ranges from ambivalence to outright scam. Warren Buffet famously called the cryptocurrency “rat poison squared” in 2018 and remains thoroughly unconvinced of Bitcoin’s long term prospects. Like many people, I first became acquainted with Bitcoin during the 2017 bubble. By nature, I am a skeptic. I am especially skeptical when there is excessive excitement about an asset. When I spoke to people investing in the digital currency, most were driven by price movements (FOMO) rather than the potential of the technology. This was enough for me to stay away. The subsequent crash in December 2017 reinforced my perspective and I didn’t pay attention to Bitcoin for years.
Before describing why my attitude shifted favorable towards Bitcoin, I want to write briefly about what Bitcoin is for those who are unfamiliar.
What is Bitcoin?
Bitcoin is digital currency with a finite supply built on a distributed ledger.
Digital currency. This is the most straight forward aspect. Currency or money is a unit of exchange which holds value. Unlike dollars, Bitcoin is natively and exclusively digital.
Finite supply. Bitcoin is programmed to create a fixed supply of currency (21 million coins). The supply of new bitcoin created decreases geometrically roughly every 4 years (halving). By 2040, all the Bitcoins which will ever exist will have been mined. Today there is an estimated 18.5 million coins that been mined and around 3-4 million coins lost forever.
Distributed ledger. Digital currency has what is known as the “double-spend problem,” when a transaction occurs how are we to know that currency is now owned by exclusively one person? What if someone was to keep the serial number and then spend the same currency somewhere else? Bitcoin solves this challenge using a distributed digital ledger. Every node in the Bitcoin network keeps a ledger of all transactions in the Bitcoin network. When new transactions occur, a given node will verify a transaction as authentic using this historical ledger. As a reward for participating in this verification process, nodes are rewarded with new Bitcoin (this is what is commonly called “bitcoin mining”). These sequential “blocks” of transactions are what form the “blockchain”.
For those who are technically inclined, I would recommend reading the Bitcoin whitepaper.
Since April 2020, the market correction and subsequent Federal Reserve intervention have changed my opinion on Bitcoin. The rapid price recovery of stock market, and in particular in technology companies, revealed multiple secular trends that are all bullish for bitcoin.
Central Bank Policy and Monetary Expansion
Money Printer Go Brrr GIF
Much has been written about the fiscal deficits of the U.S. federal government for economic stimulus (in fact I did so last week). Less has been said about the policy actions of U.S. Federal Reserve (the central bank of the U.S.). Aside from cutting interest rates to zero, the Fed embarked on another quantitative easing (QE) program to alleviate liquidity concerns after the March 2020 economic crisis caused by COVID-19 (What Is Quantitative Easing?). QE is a program where the Fed creates dollars and buys financial instruments, typically government treasuries, to credit large financial institutions. Thus far, the Fed has expanded its balance sheet from $4 trillion to nearly $7 trillion today (aka created $3 trillion new dollars).
“The way you and I have checking accounts in our banks, that’s how all these other banks have accounts at the Fed,” said Pavlina Tcherneva, an economist at Bard College in New York. “All the Fed does is literally credit them. They just type it in.” - full article
The Fed’s QE program combined with zero percent interest rates have flooded the markets with cheap credit and facilitated a risk-on attitude (especially for growing companies). This is why there is a dramatic divergence from the real economy and asset prices. Stock prices and housing prices are increasing in value relative to a devalued currency. Every company has a fixed number of shares (which can be sporadically expanded), each of these shares represent a fraction of the revenue and profits of a company which are traded for currency. If the currency supply is expanded and the risk-free return on treasuries is now 0%, riskier, higher yielding assets such as stocks become more attractive. This not just occurring in the US. The European Central Bank and the Bank of Japan both increased their QE programs to boost their own economies.
The Fed intends to maintain zero percent interest rates beyond the 2% target inflation rate (link). It is also unlikely the Fed will end QE. Before the crisis, the Fed attempted to ramp down QE, but due to a slowing economy and a declining stock market, the U.S. central bank resumed the program in September 2019. With low rates, the injection of trillions of dollars of liquidity, and guarantees of future Fed stimulus it’s not surprising that US stock prices recovered swiftly and why the US dollar has declined in value since March (around 10% compared to a basket of other currencies). The most likely outcome from this policy are low interest rates, low inflation, and a rapidly increasing stock market, like we saw from 2009-2019. The second but far worse situation is runaway inflation due to the rapid increase in money supply. In both of these situations Bitcoin will increase in value faster relative to other asset classes since it is both an inflation hedge and a risk-on asset correlated with stock markets.
Demographics and Bitcoin as Digital Gold
In my opinion the best use case for Bitcoin is not as a currency but as a store of value that is uncorrelated with the currency-based financial system. Typically, gold has occupied this position; however, there is reason to suspect Bitcoin could become an equally viable reserve asset in the future.
As a store of value, Bitcoin has aspects superior to gold. Unlike gold it is easily divisible (bitcoins are made up of 100,000,000 units called sats, after Satoshi Nakamoto, inventor of BTC), transportable (digital), and easily transferable (verifiable settlements using a decentralized ledger). Additionally, compared to gold there is an absolute finite supply (queue memes of Elon Musk mining gold in space). Gold has been considered a valuable asset for thousands of years. In truth, gold’s value is as arbitrary as any other precious metal. Its coveted status results from humanity’s belief in its intrinsic value. But I believe there is potential for Bitcoin to also become a safe-haven asset. For example, crypto-currencies have been widely adopted in countries with strict capital controls and high inflation rates. Iran and Turkey, countries with 41% and 15% inflation respectively, are prominent Bitcoin adopters. China, a nation with strict capital controls may have seen up to $50 billion in capital flight through the use of cryptocurrencies. This digital gold narrative is supplemented with a demographic tailwind.
Although gold is viewed as the best inflation hedge asset, ownership is heavily skewed demographically. An estimated 48% of Bitcoin holders are between the age of 25-34, while gold is held mostly by baby boomers. Younger people are “digital natives” and are less hesitant to assign real world value to virtual items. For example, Microtransactions in video games are all conducted “in-game” virtual currency. This is evident in the demographics of Bitcoin adoption.
Millennial friendly fin-tech companies like Square, Robinhood, and Coinbase make purchasing Bitcoin much easier than in the past. Square’s Cash App is now used by 30 million people and the application natively features crypto-currency and stock purchasing. In Q2 of 2020, Cash App users purchased over $875 million in Bitcoin. Subsequently, the number of active Bitcoin addresses is now at a two-year high. This increase in demand is contrasted by the recent Bitcoin halving, which has dropped the minting of new coins by 50% since May. The increase in demand, drop in supply, and market conditions point to a continued rise in Bitcoin value.
Digitization and Decentralization: Future Trends
Our world is increasingly reliant on digital technologies that run via the internet. Although the economic effects of COVID-19 mandated shutdowns were severe, had a similar pandemic occurred 10 or 20 years ago, the economic situation would have undoubtedly been worse. Internet-based companies enabled millions of people to be equally as productive as pre-quarantine. This trend hasn’t gone unnoticed. As a result, many businesses and governmental agencies are accelerating the pace of technological adoption.
One such program is digital currencies. The Federal Reserve has publicly announced that it is investigating the possibility of implementing a digital dollar. At the same time, the US Office of the Currency Comptroller officially clarified that state and national banks can custody cryptocurrency assets. This has officially opened the door for mainstream financial institutions to hold their customers’ cryptocurrencies. These events point to the eventual creation of a digital dollar.
A digital dollar would solve some issues with the current financial system. For example, a centralized ledger would help solve the double-spend problem and add transparency to important market functions (such as the repo market). If the future of currencies is virtual, stigma around cryptocurrencies will decline naturally as people become accustomed to using digital currencies for day to day transactions. If digital currencies are normalized, then monetary policies and security will become preeminent factors. With its finite monetary supply system, Bitcoin will shine as a more valuable asset compared with a digital fiat currency that can be created at will by central banks.
Furthermore, just as the internet today has democratized news and information, future internet projects will seek to decentralize other core functions in the economy. For example, in the modern era, banks function as middlemen for various financial transactions. In the future, blockchains could perform the same function. A smart-contract built on blockchains can act as a decentralized trust layer with no middleman required. These types of use cases are the ultimate aim of DeFi projects (decentralized finance), which have already accumulated almost 7 billion dollars in assets. A common use case for DeFi is to allow individuals to use their cryptocurrency as collateral to extend credit to borrowers in exchange for interest, just as a bank does with checking deposits. Although this sounds like a radical departure from 2020, the through-line of the information age is the disruption of established, physical, hierarchical systems by individuals using virtual tools. Bitcoin has the first-mover advantage to become the reserve asset of choice in a decentralized, internet-centric financial system.
Risk-Reward: Zero to One
Ultimately, the most compelling argument I have found in favor of investing in Bitcoin is derived from the asymmetric risk to reward. Cryptocurrencies have extreme risk-to- reward payouts that bring benefits to a diversified portfolio. For example, Bitcoin, the biggest cryptocurrency, has an estimated market cap of 240 billion, compared to gold at 9 trillion. With a maximum downside of 100% there is a hypothetical 3,750% return if Bitcoin reached gold’s present market cap. A common measurement for risk-reward calculation is the Sharpe Ratio. Moreover, Bitcoin typically outperforms most other asset classes (example calculation). If Bitcoin performs similarly to the past, investment outcomes are skewed to extreme over or under performance and as a result adding a small amount of Bitcoin will improve portfolio returns without adding much risk.
For example, if you have a 100k portfolio, with 99k in the S&P 500 and 1k in Bitcoin, with 8% annual growth in the S&P and a 10x increase in BTC over the same period, you would increase your portfolio to roughly $223,000 (~8.4% compound annual rate). If the 1k Bitcoin position goes bust (100% loss), you would end up with roughly $213,000 or about $2,000 in lost gains. The impact scales to the Bitcoin allocation, so 10% BTC you would suffer a maximum of $20,000 in lost gains or $80,000 in additional appreciation (6.9% vs 11.4% compound growth).
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I hope you have found this post helpful to understanding Bitcoin and cryptocurrencies. I write weekly about a variety of topics related to politics, technology and finance. Please subscribe to receive a weekly post direct to your email inbox.