This article was inspired by an investor of ours who was looking to present the case for bitcoin to his firms investment committee. I thought this would be a helpful update to share with the broader finance community.
The rabbit hole
I didn’t get into bitcoin because I am a libertarian or because I am a technologist or a cryptographer. I was first attracted to Bitcoin by the asymmetric investment opportunity it presented.
The optics really were like nothing I‘d ever seen: this was the first investment open to everyone in the world and the fixed supply schedule presented a very clear route to mania should it grow in popularity.
I remember being presented with a few statistics early on….
- There are ~60m millionaires globally, but there will only ever be 21m bitcoins which is just 0.35 bitcoin per millionaire. At current prices that’s only $2,550 per millionaire, so you can see the stage is well set for the retail fervor.
- Outside of being a store of value and jewellery, gold is fairly useless and has achieved a market cap of $7.5tn. Does a digital store of value, or Gold 2.0, make more sense as more economic and social activity occurs digitally? If so, bitcoin should be much more than 1.5% of gold’s value
- Total supply does not equal “available for sale”. To date the have been 17m bitcoins produced or “mined”, but far fewer than that are actually available to buy. Large quantities were lost, exchanges and OTC desks hold inventory, and real believers have allocated permanently.
…and thinking, this is too good to miss. I would argue that the asymmetry is still compelling and despite the short term price trend of 2018, the fundamentals are improving.
A brief introduction to bitcoin
Bitcoins are transferable, divisible and immutable digital tokens that are created by a process called “mining”. The algorithmic schedule is predetermined, public and final. By 2140 a grand total of 21m bitcoins will have been mined and every four years the number of bitcoins mined halves, ie inflation falls. While the mining process does serve to dilute holders, we are fast approaching a time where its stock-flow characteristics will be favorable to gold and mining also results in egalitarian distribution and wider decentralization.
Bitcoin’s architect thought long and hard about setting a fixed supply while also providing rewards to stimulate adoption. Like all monetary assets, bitcoin is not backed by a physical commodity or asset. While this may leave it open to the criticism that it’s overvalued vs intrinsic utility, the same criticism could be labelled at all monetary assets.
While a fixed supply does not equal demand, the value proposition for bitcoin is simple: it’s the first fully decentralized store of value that can be transferred without verification or oversight from a third party. It’s cheap and quick to transfer, portable, is sovereign censorship resistant and its scarcity makes it inflation proof. Thinking from a generational perspective it is relevant and in touch with the large amount of activity that now happens digitally.
Over time bitcoin’s ownership fundamentals are improving. This chart from Pierre Rochard explains the positive feedback loop that develops from hoarding or “hodling”. More generally, the Lindy curve would argue that the longer bitcoin is in existence the more ingrained it becomes.
The security of bitcoin’s network is enhanced as hashpower grows (chart from Blockchain). Hashpower is a measure of competition for new blocks, the higher the number the harder it is to take control of a network or a successful “51% attack”.
Mining is also a critical feature of bitcoin’s security, and also its distribution. It’s a simple process, which particularly in the early days had very low barriers to entry. Mining is set up so as new bitcoins are mined, miners are “forced” to sell a proportion of these to meet their (mainly electricity) costs. This is egalitarian as it ensures there is a stream of supply available for purchase, which should increase decentralization. The below chart shows the distribution of hashpower between mining pools. The wider the distribution the greater the security of the network and that has been the trend all year.
As bitcoin is a network, in fact the largest decentralized network ever, we should also look at Metcalfe’s Law, which looks at the relationship between size and value of a network and argued, that the value of a network is is proportional to the square of the number of connected users of the system. Wallet growth is the best available measure or proxy for user growth — one of the features of bitcoin is privacy so it’s impossible to know exactly how wallet growth relates to user growth, but it is reasonable to assume some correlation. The trend here is also clear.
Much of bitcoin’s demand is driven by societal rather than economic forces. There is a growing mistrust of the motivations of politicians, central bankers, the media and large corporations that now dominates news wires. Edelmancompiled a large study of global and institutional trends in trust — the table below shows most countries “distrust” institutions and there has been a large recent decline in the US.
The rise of populist governments, uncertainty over “fake news” and the misuse/monetization of data by companies like Facebook fuel this distrust and create demand for more privacy and self-sovereignty over data and digital identity.
The preference for decentralized institutions is both about ownership and control. Why should any third party hold or extract value from your data? Furthermore what if that centralized institution is secretly using your data in a way that you disapprove?
There is also a technology evolution and efficiency angle. Bitcoin is part of a the info-tech revolution, which is enabling more P2P trustless activity, so the importance of trusted third parties is diminishing. Energy utilization is often levelled as a criticism of bitcoin mining, but this is significantly overstated — much of bitcoin’s energy is renewable and miners seek out excess energy supply.
Large macro trends are often driven by generational preferences. I would argue this is a tailwind for bitcoin adoption. Tom Lee notes that by 2029 the millennial generation will control the largest share of disposable income and they will have a preference for digital exchanges. Bitcoin is already 9 years old so for anyone born after 1991 it has been in existence for their entire adult life.
Looking to emerging markets, the turmoil we have see in 2018 has been accentuated by a liquidity squeeze as the Fed tapers its balance sheet. Many economies are reaching breaking point and are seeing huge wealth destruction (asset prices, currency depreciation and inflation) as a result. Savers across EM should be converting to bitcoin as it is a hedge against their local economy. Bitcoin is also a potential part of the financial infrastructure for the unbanked, and we may see its first major use case here, where it’s needed the most.
Sooner rather than later
I can see why this might be met with some skepticism, you don’t need to be a chartist to be somewhat concerned by bitcoin’s recent price trend. Looking with a wider lens, bitcoin has still returned over 50% in the last year and almost 700% in the prior year. It’s also worth bearing in mind that sentiment is currently extremely bearish.
The decline from last December’s high of ~$20K has been unnerving, but it’s clear to me that the downtrend has been caused by six major headwinds which I’ll examine briefly below. For more detail see my earlier work “What’s eating crypto?”
- Macro: As noted above, the dominant macro trend of 2018 has been a $ liquidity squeeze. Crypto has not been immune to this as the USD and US yields have risen and gold has fallen. I don’t think this is set in stone and after the market rushes to USD it can then re-focus. This was exactly what happened to gold in the financial crisis and if bitcoin is successful, it will be anti-fragile — something that benefits from disorder.
- Speculative dominance and reflexivity: In its early life, Bitcoin’s use has dominated by retail speculation. Given this and the lack of an accepted valuation framework it’s not surprising that bitcoin has experienced multiple hype cycles — something that is, of course, normal for new technology. For some, this volatility excludes bitcoin from ever becoming a legitimate store of value, but I would argue this reflexivity that will fade with time as its value proposition is better understood.
- Regulatory hesitance and the slow path to institutional adoption: Regulators across the globe have struggle with how to responsibly police crypto. A decentralized movement poses a lot of complications in classifying the assets and bad actors muddy the water. As a result, things have been moving fairly gradually, but overall regulators have taken a tone that shows they respect the potential innovation. The regulatory uncertainty has in turn slowed institutional investors, as have the lack of custody, insurance, data and risk management solutions. There is progress being made on all these fronts, and we are also starting to see tokenized assets, mostly real estate, sold and accounted for on the blockchain.
- Weaker projects or scams: The hysteria at the end of 2017 has been a bad hangover for 2018. Many projects reached valuations exceeding any sort of reasonable valuation and many are now anywhere between 70 and 90% from their highs. This multi hundred billion USD decline in aggregate market cap has affected the reputation of crypto as an investable asset class and resulted in large outflows. The marginal impact of these weaker projects on stringer ones will be smaller going forward, just based on the size of the assets.
- Natural supply: Bitcoin is prone to fairly deep bear markets because of both mining supply and exchange sales (bitcoin trading volumes are large and exchange fees are levied in crypto, much of which is sold). This flow headwind can dominate the market and extend lulls.
- Short selling: This has become a very profitable exercise and has attracted large retail flows and algorithmic funds. These short sellers have become accustomed to using bitcoin as it’s the most liquid, but I would argue that this position is extremely vulnerable.
In the medium term, I believe that digital currencies will co-exists with sovereign currencies. I believe that the trend of globalization is shifting the gaze of our imaginations beyond the nation state and it’s right to question why our savings should be dictated by the populist whims of politicians and the motivations of central bankers.
Bitcoin was born out of the financial crisis and central bankers preference to “print” our way out of trouble. For some, things are even more acute now — Venezuela and Turkey being the most obvious examples — and debt sustainability is a real risk to many fiat currencies. In looking for global stores of value gold has served a purpose, but it is archaic. A digital store of value is both more practical and more in touch with the growing millennial generation.
As a result, I believe that all investors should have an allocation to bitcoin, and be monitoring the early stage development of other cryptoassets and the security token market closely. The six headwinds I identified above are lessening in aggregate as the world gets more comfortable with distributed ledger technology.
The societal and generational preferences towards cryptoassets are tailwinds, and the relative size of the market make the asymmetry of the opportunity compelling. It also feels like we are getting closer to infrastructure that will enable institutional investors to start allocating and it’s this last point that recommends allocating “sooner rather than later”.
Buying bitcoin feels like asymmetric exposure to a transition to a more digital, private and global economy that is less reliant on third party intermediaries. Our investment thesis is that as a minimum bitcoin will grow as a store of value, and this is a great opportunity at these prices.
It’s very possible that bitcoin could evolve into a payment solution and there are a number of great projects trying to solve for scalability. We are hopeful, but not convinced that the technology is available yet so we will patiently observe its progress and be conservative in our projections.