Bitcoin - questioning the foundations
While many are questioning Bitcoin’s foundations, perhaps even more importantly, Bitcoin is questioning the foundations of the central banks. Cryptocurrencies challenge the monopoly status of national fiat currencies, and — just as central banks around the world are pivoting from money creation ("Quantitative Easing") to money destruction ("Quantitative Tightening") — the existence of Bitcoin heightens our awareness of just what, exactly, money is. With fiat currencies beset by a flurry of new uncertainties, hard assets, such as commodities, real estate and infrastructure, are an attractive hedge for the year ahead – not only against shares and bonds, but also against cash.
What is Bitcoin?
The mechanics of Bitcoin are eyebrow-raising, but not unfathomable, and here in 2018 the shock of the new is increasingly wearing off amongst generalist investors and the public at large. Bitcoin is the first, largest and best known of the cryptocurrencies, an asset class which is now nearly a decade old. A Bitcoin is one of a growing, but ultimately limited number of pieces of cybercode, held in the private cyberwallets of individuals. Bitcoin is created by ‘miners’ who validate and provide security for Bitcoin transactions in public blocks across a widely spread set of computers, known as distributed ledger technology, or blockchain. There are currently around 17 million Bitcoins in existence, with the maximum allowable being 21 million.
The Bitcoin concept
From the point of view of an asset owner, super fund, or multi-asset investment manager, Bitcoin poses further definitional questions of a more conceptual nature. Is it cash? or a currency? or a commodity? And indeed, as many fund executives have been questioning, we could also ask whether Bitcoin is “investment grade”.
From an asset management point of view, it’s more helpful to classify Bitcoin as a commodity, than as money or currency. Which commodities does it most resemble?
The first that comes to mind is aluminium which, like Bitcoin, is expensive to produce; has a rising marginal cost curve; and has a cost profile overwhelmingly dominated by electricity costs.
The second commodity that Bitcoin resembles is gold. Both gold and Bitcoin are “mined” at great expense, but are then immediately parked rather than used; both can theoretically be used for transactions purposes, but only clumsily and at considerable expense; both are “monetary” commodities although—given their price volatility relative to everyday goods and services— more as a “store of value” than as a “unit of account” or “medium of exchange”; and both leave the owners vulnerable to theft, be it physical or cyber. Crucially, both gold and Bitcoin are hostage to economist Adam Smith’s dictum, that “all money is a matter of belief” – the value of each, depends heavily on a widespread belief, that they do indeed have a value.
Why is Bitcoin booming now, and what happens next?
Ten years after the global financial crisis, and after a very extended period of quantitative easing and near-zero global cash rates, it’s not surprising that investor confidence is finally returning and that assets are being strongly bid. Bitcoin is technologically exciting, can sustain a “new era”, “currency-of-the-future” interpretation, and has the advantages of being both disparaged and underheld by a sceptical establishment. It’s “scarcity” value and rising marginal cost have both been well-designed. A further advantage is that – at least in the short term – it’s “true” value is undefined.
The case for it moving even higher is that it has only recently been dignified with contracts on mainstream exchanges such as the Chicago Board Options Exchange and the Chicago Mercantile Exchange; the naysayers, including central bankers and senior fund executives, remain deeply sceptical; the upside remains open-ended; the interest rate on (traditional) money remains very low; and the global economic backdrop remains benign. Chronic geopolitical anomie, and associated distrust of national governments, is also helpful to Bitcoin.
That said, the risks—including government and regulatory crackdown—are high. We’d also see it as a cautionary sign, that forecasts for the future value of Bitcoin are spiralling higher, with numbers of $US40,000, $US400,000 and $US1,000,000 all having been touted recently.
An immediate and obvious risk with Bitcoin is that it violates the first law of investing, viz: "Before you get into anything, make sure you have a reliable way to get out again". Scams and exchange fraud are persistent, if intermittent, and it’s also salutary to remember the “Icesave” episode of 2008, when a bevy of young European savers thought that an online savings account based in Iceland was far more “cool” than a bricks-and-mortar high-street offering; until the day the funds disappeared from their accounts.
Parallels with the dotcom bubble of 1999 are also suggestive – a major, technology-related, speculative bull market, with telephone-number sized predictions about where prices were headed. Faux-scarcity is another important link with the 1999 tech boom – in the same way that “.com” addresses were the “new Florida real estate – they ain’t making any more of it!”, but turned out to be far more price-elastic than claimed.
Those with even longer memories will recall the run-up of Radio Corporation (RCA) in 1928/29, when a 10-fold rise in a new-era technology play over a 2-year period, was followed by a 90% fall, over the subsequent 2-year period.
What can investors do?
The market capitalisation of Bitcoin is currently still small enough for global investors with a conservative mindset to choose to exclude from their portfolios. Australian super fund and multi-asset investors who wish to participate in cryptocurrency investing can perhaps best do so within the hedge fund asset class, by dint of including Bitcoin on approved lists of investments.
Direct exposure aside, there are also plenty of valuable insights to be extracted from the rise and fall of Bitcoin, such as:
- Diversification of return drivers continues to be important in this new and uncertain world, where the government’s monopoly on money supply is being challenged and the definition of money itself is changing with the rise of electronic commerce and the corresponding demise of cash transactions. Diversification of return sources includes both nominal assets like bonds and shares, as well as real assets, such as physical property, infrastructure and commodities.
- Is the Bitcoin mania a contemporaneous symptom of the broad equity market approaching its peak – comparable to the Cisco and WorldCom blow-off in 1999? Our cycle, valuation and sentiment framework helps us dynamically position portfolios relative to where we are in the market cycle.
- Analogous to fossil fuel stocks being potentially “stranded assets”, what is the enduring value of bank stocks when central banks will soon be technically capable of maintaining individual computer-based accounts for all of a nation’s citizens through this technology? Access to new investment opportunities through best of breed portfolio managers is the key to sustainable future investment returns.
This article was also published in ASFA’s Superfunds Magazine February 2018