By Jeff Mills, Chief Investment Officer
Introduction
The increased interest in Bitcoin is not surprising to us. When any asset experiences a meteoric price rise, it is hard not to notice. Google search trends for “Bitcoin” have recently jumped along with the price. We saw a very similar pattern develop in 2017.
Beyond that, the simplest explanation for the rise in Bitcoin is the increasing lack of confidence in the sustainability of the monetary and fiscal path on which America finds itself – money supply (M2) grew at a 25% annual rate in 2020, the assets on the Fed’s balance sheet have increased by nearly 10x in the past 12 years, and the twin deficits are starting to approach 20% of GDP.1 Along with gold, cryptocurrencies have started to serve as the go-to alternative for those seeking to hedge their wealth against currency debasement. There is growing interest in stores of wealth that are in limited supply, and we think that Bitcoin has evolved from a highly speculative asset that could quite easily “go to zero” into something that will remain very volatile, but is likely to maintain some value longer term. Standing here today, no one knows what the “right price” for a single Bitcoin should be, with several unpredictable variables ultimately deciding its fate.
Volatility is Likely to Remain High
We believe there are legitimate reasons to consider holding Bitcoin as a small allocation in one’s portfolio, but there are still many unknowns. Any investor who considers Bitcoin as an investment must understand how volatile it can be. 30%-plus drawdowns are business as usual for Bitcoin, with six such declines from 2016 to its 2018 high. Since then, the wild ride has continued, with drawdowns of 82% and 55% on its way to current levels.
There is nothing particularly wrong with this kind of volatility, but investors should understand that dramatic price fluctuations are likely to be a feature of a Bitcoin investment going forward. Greater adoption of cryptocurrencies as a medium of exchange (if/when that occurs) should render them more stable, but until then, properly sizing your Bitcoin investment is critical.
Bitcoin as a Medium of Exchange
In our view, there are challenges to Bitcoin becoming a widely adopted medium of exchange. This is not to say it is an impossibility, but clear hurdles exist. For example, the Visa network processes almost 25,000 transactions per second, while the Bitcoin network has trouble handling five. Bitcoin transactions can take 10 to 60 minutes to complete, and the average fee is around $30…and that number has been rising.2
Until such issues are resolved, it will be difficult for Bitcoin to be widely utilized as a medium of exchange.
An Uncorrelated Asset with Increasing Demand
Even if Bitcoin is limited as a medium of exchange (similar to gold), its fixed supply cannot be devalued by central bank money printing. As with gold, this makes Bitcoin a potentially attractive store of wealth. Besides being a hedge against the monetary and fiscal policy experiment through which we are currently living, the most obvious reason to invest is the uncorrelated nature of Bitcoin. The price fluctuations of Bitcoin have very little to do with what is happening in the stock market, so in that sense, the diversification provided by Bitcoin may be additive to a portfolio.
Institutional investors are becoming more attracted to Bitcoin for these reasons. Interestingly, although the price of Bitcoin has risen exponentially in the past 12 months, rising interest from institutional investors could drive the price even higher, according to the analysis below.
These are not particularly large portfolio allocations, but they have the potential to drive the price much higher given the amount of assets controlled by such investors. More institutional holders may also render the price somewhat less volatile, as the current daily turnover in Bitcoin is much higher when compared to gold.
Risks and Unknowns
As with any new technology, the potential risks are numerous. This does not mean Bitcoin or other cryptocurrencies won’t be successful, but it does mean the price will continue to fluctuate as investors vary their assumptions about the future. Ray Dalio, the legendary investor and founder of the world’s largest hedge fund Bridgewater Associates, highlights the following uncertainties3:
- Supply: although Bitcoin has a limited supply, digital currencies do not because new ones can be created. New digital currencies can and will come along to compete with Bitcoin. Mr. Dalio even assumes that better ones will come along, “because that is the way the evolution of everything works.”
- Demand: with a view that Bitcoin as a currency is far less appealing than as a gold-like digital store of value, the demand picture is very uncertain. What if 20% of gold assets flowed into Bitcoin? What if it was 50%? What if those that hold very large amounts of Bitcoin then wanted to diversify into other assets? There is a wide range of possible outcomes that will have significant implications on the long-term price.
- Cyber Security: this risk should be applied to the entire financial system, but a purely digital asset is particularly vulnerable at a time when cybercrime is becoming more frequent and more sophisticated.
- Regulation and government intervention: there are good, logical reasons that governments would want to control money and credit within their borders. Bitcoin is a threat to that control.
There are other, less obvious, risks that could pose a threat to Bitcoin over time. For example, the environmental impact of Bitcoin has been recently called into question. According to BCA Research, a single Bitcoin transaction uses more than 4-times the amount of energy as 100,000 Visa transactions. The annual electricity consumption of Bitcoin now exceeds the likes of Pakistan, Argentina, Norway, the UAE, Belgium, and many other significantly populated countries. In a world of growing environmental awareness, this could pose some impediment to investment demand over time.
The most significant of these risks, in our opinion, is that Bitcoin represents a threat to sovereign states’ ability to collect taxes. Bitcoin may end up being a victim of its own success, facing increasing regulatory scrutiny as its popularity grows. In the short run, absolutely anything is possible in terms of its price level. However, in the long run, it is open to attacks from central governments that have a significant interest in maintaining a monopoly on currencies.
Discussions about regulating cryptocurrencies are happening at the highest levels of government around the world. Janet Yellen, during her confirmation hearing as U.S. Treasury Secretary, said “We really need to examine ways in which we can curtail their use and make sure that money laundering doesn’t occur through those channels.” European Central Bank President Christine Lagarde said, “It’s a highly speculative asset, which has conducted some funny business and some interesting and totally reprehensible money laundering activity…There have to be regulations…It’s a matter that needs to be agreed at a global level because if there is an escape, that escape will be used.”
Although no actions have been taken in the United States, Switzerland, for example, now requires that exchanges only allow users to withdraw cryptocurrency to wallets linked to their identity. Supporters of cryptocurrencies have raised questions about how this might infringe upon civil liberties. The path of regulatory action is unclear but clamping down on Bitcoin and other cryptocurrencies in some form is likely given their ability to undermine the traditional fiat currency system. As pointed out by Strategas Research Partners, some have even argued for abolishing the use of cash itself because it renders the use of negative interest rates less effective as a monetary policy tool.4
The crypto market will continue to be a fast moving and rapidly evolving space. We have not taken steps to allocate to Bitcoin or other cryptocurrencies in our portfolios; however, we understand the interest and potential utility of things like Bitcoin today and in the future. For that reason, we wouldn’t discourage investments in digital currencies if the risks are well understood.
