- Martin Fridson, CFA and Michael Livian, CFA
Is Bitcoin For You?
On February 13, Bitcoin reached an all-time high, climbing above $50,000 for the first time and peaking at $52,400.42 on February 17 (up +81% since the end of 2020). Less than a year earlier, on March 16, 2020, Bitcoin was trading at $4,904.48. The cryptocurrency’s stellar performance in reaction to central banks' unprecedented pandemic-related actions has many investors wondering if Bitcoin can be a suitable and lucrative investment for them. The views on Bitcoin are as polarized as they could possibly be. Some consider the digital asset the “mother of all bubbles,” while others swear by it. Below we review and contrast the positions of both camps.
What is Bitcoin?
Bitcoin is a decentralized cryptocurrency invented in 2008 by an unknown person using the name Satoshi Nakamoto. Creating each Bitcoin unit (mining) is done through computer systems by solving a complex algorithm. All transactions in the life of a Bitcoin are recorded in a “blockchain” and are stored anonymously on all the computers that are part of the network. This method ensures both anonymity and legitimacy while bypassing central bank controls. Bitcoin is increasingly being used as a form of payment, hence the term “cryptocurrency.” Additional unmined supply can be accessed only via “mining” of new Bitcoins through a vast computer processing effort. The total supply of Bitcoin is capped at 21 million and over 85% of Bitcoin has already been mined. Bitcoin is one of several cryptocurrencies now in circulation.
Digital Currency or Digital Asset?
A variety of controversies surround Bitcoin. Many of its advocates esteem it as an instrument for freeing the individual from state control. These controversies and ideological motivations are extraneous from the investor’s standpoint, so we shall devote only a minor amount of space to them.
Critics expend a great deal of energy disputing the possibility of Bitcoin ever becoming a viable currency. They argue that:
Its transaction costs are too high to make it a practical means of paying for routine purchases.
The main characteristic of a viable currency is its stability and, therefore, its acceptance as a form of payment. Bitcoin’s extremely high volatility certainly speaks against its suitability as a payment medium.
Furthermore, critics say the Bitcoin system’s transaction-processing capacity is too low to make it competitive with other payment methods. Bitcoin’s network can process approximately 5 transactions per second, while Visa’s can process roughly 1700 per second. These issues highlight the limitations on Bitcoin’s current scalability.
David Tawil, president of the hedge fund ProChain Capital, contends that early investors in Bitcoin never expected it to be widely adopted as a medium of exchange. Accordingly, developments such as PayPal’s October 2020 approval of cryptocurrency as a funding source for digital commerce are merely icing on the cake. All along, says Tawil, the investment opportunities have arisen mainly from cryptocurrencies’ ability to serve as stores of value. US regulators seem to concur with the view that Bitcoin is a digital asset and not a digital currency.
Investment Merits as a Digital Asset
The notion of Bitcoin as a store of value is highly controversial.
Critics argue that unlike income-producing assets such as stocks, bonds, and real estate, cryptocurrencies lack any intrinsic value. In deriding Bitcoin as a hedge against higher inflation, which could result from currency debasement by central banks, skeptics commonly contrast it with gold, which has industrial uses as well as reliable demand from jewelry makers. This is a specious argument. On a given day, gold’s price far exceeds its value as an industrial commodity and a fashion item. The excess derives from the metal’s millennia-old acceptance as a store of value.
A more practical consideration in deciding whether Bitcoin is an investment rather than speculation is its expected volatility. A long backward look does not inspire confidence. Let us compare selected assets’ price volatility, which we define here as monthly standard deviation as a percentage of the chosen period’s mean price. In the ten years through 2020, gold’s price volatility was 15.6%. The S&P 500 nearly doubled that, at 29.2%. Bitcoin was the wild man of the group at 147.1%. One could argue that a brand-new asset class should have been expected to exhibit exceptionally high volatility. Indeed, Bitcoin compares somewhat more favorably when measured over just the past two years. Price volatility was lowest on the S&P 500 at 9.3% and somewhat higher on gold, at 14.2%, while Bitcoin’s was 53.8%. However, in absolute terms, Bitcoin has been much more volatile even in recent times than the asset classes we consider suitable for our particular set of clients. Some of them may cast an envious eye on the 81% month-and-a-half gain mentioned above, but they should not overlook the 47% decline of just a year-and-a-half ago, between July 9 and December 17, 2019. Unlike some major, recent price swings in other asset classes, that was not a Covid-19-related event.
Bitcoin denigrators attribute its large ups and downs to manipulation. Vocal critics such as Professor Nouriel Roubini of NYU Stern claim that the vast majority of Bitcoin miners are a colluding oligopoly of entities in Russia and China. Bitcoin is thought by many to be used primarily to pursue illicit activities, circumventing the scrutiny of the authorities. Once the regulators decide to act, they contend, the price of Bitcoin will come crashing down. Defenders maintain that such allegations are outdated, but Boston’s Federal Reserve Bank president very recently expressed severe reservations about Bitcoin. He also indicated that his staff is exploring the possibility of the US central bank introducing its own version of a digital currency.
Supporters of Bitcoin believe that:
Unlike any other asset or currency, Bitcoin has a fixed and limited supply (21 million units), and an increase in demand cannot be met by an increase in supply. This is in contrast to gold, for example. Should the demand for it grow, gold miners would expand production by beginning to extract higher-cost ore. This would not be possible with Bitcoin.
Bitcoin is increasingly finding acceptance by both the public and businesses (think of the recent announcements of PayPal, Tesla, Mastercard, and so on), translating into an exponential price increase.
As a form of payment, Bitcoin cannot be debased by central banks.
In a world of high equity valuations and abnormally low-interest rates, Bitcoin is a very desirable investment for enhancing future portfolio returns.
A final factor in assessing Bitcoin’s suitability involves Environmental, Social, and Governance (ESG) considerations. Bitcoin mining consumes massive amounts of electricity, especially in highly carbon emission inefficient countries. Cryptocurrency skeptic Nouriel Roubini claims that mining and related activities use as much power as the country of Argentina. A plausible rejoinder is that further digitization of the monetary system will offset mining’s energy intensity by eliminating the need for many energy-consuming functions.
In this note, we have attempted to depict, unemotionally and objectively, an asset that excites strong passions, pro and con. Although we consider it premature to allocate funds to cryptocurrencies, we can envision a possible future role for them in protecting against an inflationary surge. Conceivably, cryptocurrencies could complement gold, an asset to which we already make a modest allocation in our typical portfolios.
Regardless of Bitcoin’s future compatibility or non-compatibility with our clients’ risk profiles, sound investments may emerge elsewhere in the cryptocurrency ecosystem, i.e., in businesses created to serve an increasingly digitized monetary system. That is one more reason for us to stay abreast of developments in this rapidly evolving segment of the financial market. As we monitor events, a long-term view of our clients’ financial wellbeing, rather than the lure of short-term speculative profits will remain paramount in our thinking.