Note: I am long on Bitcoin. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice. Before you proceed further, please see Disclaimer at the bottom of this post.
This is second post of two part series on my understanding of Bitcoin as an Asset. You can find the first part here.
In the previous post, I laid out my understanding of Money, Gold and Bitcoin from economic standpoint. In this post, I will trying list out my understanding of why Bitcoin is worthy of being an asset.
Price to What?
In traditional markets, assets (primarily stocks) are valued based on several ways like Price to Earnings, Discounted Cash Flow etc. But all these measures assume that underlying asset has earnings. But bitcoin doesn’t have any earnings. This is reason why I feel any method to measure Bitcoin is somewhat speculative in nature. Now, speculation by itself does not need to be wrong. But it means the measure has associated risks with it.
In the next sections, I try to understand the case for Bitcoin through lens of individual investor’s actions and also how the Corporate strategy seems to evolving around Bitcoin.
Case Through Lens of Individual Investor
Stock to Flow
Stock to flow (S2F) is a measure of scarcity of any commodity.
Stock to flow = Stock/Flow
Stock = Total amount of commodity available in the world
Flow = New amount of commodity produced every year.Historically, there is a relationship between price of a given commodity to its S2F value. For example, here is S2F for Gold and Silver (two of the most precious commodities).
Gold S2F = ~58
Silver S2F = ~33.3Another way to understand S2F is by inverting its value. The inverse of S2F is supply growth (or can be loosely termed inflation). If you notice, Gold’s inflation is ~2%. That is, if you gold 1 ton of Gold in a reserve. Next year, % of your reserve in relation to total amount of Gold available will reduce by 2%.
This is also happens to be reason why Central banks historically tried to keep inflation to 2%. Because in past Currencies were pegged to Gold, banks needed to make sure inflation is under 2% to make sure currencies dont lose their value with respect to gold.
Since price of commodity tends to be related to S2F, one of the popular techniques to measure Bitcoin is using S2F model popularized by an anonymous blogger Plan B . This method takes Bitcoin’s supply growth (which is not constant unlike Gold), model’s its price as factor of this.
Historically, Bitcoin’s pice followed this model. But history does not guarantee future. There are certain caveats in this approach of comparing Bitcoin to gold.
Gold has centuries of history. Also, as we discussed in previous post current financial system evolved from Gold Standard. So, gold was not the first entrant. Gold is a physical material. Some of the Gold’s value comes from industrial usage (thought not a huge percentage), jewelry (virtue signaling). Rest of it is a hedge against inflation. How much of this value will Bitcoin capture is yet to be known.
A Digital Scarce Asset
Bitcoin has been around for 10 yrs and during its time it proved to be secure, durable, scarce, transferrable. It has been widely considered as digital commodity which is scarce with all properties of sound money.
Even though there were other digital cryptocurrencies that popped up during this time, Bitcoin seems to have clearly distinguished from them. It is truly decentralized (trustless), scarce (fixed supply cadence), secure. Also technologies like Lightening Network are bringing Bitcoin mainstream increasing its utility. Network affect is very critical for cryptocurrencies especially for security and evolution of ecosystem. Because of huge head start is hard to catch up for new entrants.
Along with this, Bitcoin’s scarcity achieving through halving cycle makes it a good inflation hedge. Over 88% of all available bitcoin is already mined. More and more of existing bitcoin is coming out of exchanges into private wallets (which are usually long term holders). This means as adoption of bitcoin increase, new demand will chase after smaller supply of bitcoins which automatically increases price of bitcoin. Last two halving cycles have proven this to be right. Here is a tweet that explains this phenomena.
Inflationary Policies
In the post: Inflation, QE – Lemonade Economy, Government & Central Bank I detailed how current monetary policies have adopted inflation. Current US treasury yields are <2%. The rates have got so low and central banks are talking about negative interest yield. Most investment portfolios recommend bonds as a safe haven for money. But with such lower interest rates will force people to look for alternative forms of investment as hedge against inflation.
Apart from that, these inflationary measures have increased the asset prices disproportionately. For a new graduate, even with high paying salary owning a home in places like San Fransisco, New York in increasingly hard. Only way to upward mobility is to invest in assets which have higher risk/reward. So we can expect more and more people turn away from saving cash (at low/negative rates). I have touched on this in a previous post about inflation
It is hard to guess how much of that demand will look for bitcoin. But it is clear, that whoever turns to Bitcoin has to compete for limited supply of Bitcoin available.
Case Through Lens of Corporate Strategy
Corporations using money in BTC as hedge
Just like individual investors, even corporations have to save their treasury somewhere. In a negative interest rate environment these corporations have to put their cash in an inflation hedge because of shareholder pressure.
We are already seeing early signs of that. Microstrategy, an enterprise software company has already moved about $400 Million worth of its reserve to bitcoin. Square, followed up by allocating about 1.8% of its cash ($50M) in to bitcoin as long term investment vehicle. Such movements can cause spike in Bitcoin’s price and also bring Bitcoin more in to mainstream narrative.
Fintech Disrupters using BTC as Orthogonal Vector
Fintech is one of the most crowded place with lot of giant corporations like Banks, Payment processors etc. In such a market best place for The best way to for some new entrant to compete is by picking a very small part of a market that goes relatively unnoticed by these big corporations. If that small market happens to be complete new technology then these big companies might not be initially interested in competing there. Bitcoin can very well be that orthogonal niche place for small fintech companies to compete.
In fact this already happened. Cash app (from Square which is not a small company) took this bet on Bitcoin recently. Cash now lets its customer buy and send bitcoin. This makes huge sense for Cash app. It is a great way to compete against existing companies like PayPal while also reducing transaction costs by letting customers store bitcoin in Cash and transact from there. PayPal immediately followed up and started supporting bitcoin.
This creates a network affect for Bitcoin ecosystem. More non-tech people have on-ramp to Bitcoin without having to go through effort of setting up hardware wallet. It means more fintech companies might have to follow suite (especially ones in peer-to-peer money market).
Institutional Adoption
As this adoption on bitcoin grows, Bitcoin will become more viable investment vehicle for investors. This might force, institutions to start supporting it. For example, a relatively new company – Choice IRA offers saving bitcoin in IRA (retirement) accounts. If Bitcoin price keeps going up, other larger institutions will have no choice to follow. We are already seeing some Hedge funds (more) investing in Bitcoin. This further spins the fly wheel of Bitcoin adoption.
Risks for Bitcoin
While last few sections listed out bull case for bitcoin (largely speculative), it doesn’t mean that it is without risks. Here are few I can think of.
Regulatory Risk
As bitcoin’s march towards form of money continues, it is unlikely that Governments will let their currencies be replaced. It is very likely that they will put more restrictions on exchanges and other on ramps to Bitcoin. But whether this will trigger Game theory mechanics and make other countries adopt Bitcoin as a competition will be interesting to watch.
Protocol Risk
As we saw earlier, one of the factors in Bitcoin’s superiority compared to another cryptocurrencies is its security. If Bitcoin was ever hacked or proven to be hacked, it could completely derail its narrative. Arguably such risks are more likely early in the lifecycle, with more years it gets harder and harder for hacking as network grows. But with technology we should be always be wary of security risks (quantum computing ?).
Adoption
Lot of current value in Bitcoin is derived from its potential as Digital Gold. But Gold is a real physical commodity with long history. It has proven resilient to inflation for centuries. If Bitcoin and efforts like Lightening network dont pan out, then Digital gold will be only narrative for Bitcoin. Will people really adopt Bitcoin as digital gold is a question hard to answer right now.
See this post from Peter Schiff for counter point to Digital Gold narrative.
Gold is an inflation hedge because it’s also a commodity. When inflation reduces the purchasing power of fiat currencies, it takes more units of the inflated currency to buy a given commodity. Since #gold is also a commodity, it maintains its value relative to other commodities.
Since gold retains 100% of its properties over time, and is easy to store, it’s an ideal asset for consumers to hold during periods of high inflation. While more units of currency are need to buy commodities, the same quantity of gold can still be exchanged for other commodities.
Unlike gold, #Bitcoin is not a commodity so it has no historic price relationship to any other commodity. As such it has no measurable purchasing power that can be stored for use as a medium of exchange. Its price exists in a vacuum. It’s only worth what the market will bear.
Originally tweeted by Peter Schiff (@PeterSchiff) on December 19, 2020.
Even if Bitcoin technology can eventually scale (through efforts like Lightening Network), it is hard to imagine how Bitcoin can became a default money without integrating into existing financial system. Because ultimately societies are controlled and served by governments. Financial system is one of the core pillars of a society with its own sets of rules and regulations. Some of these regulations (like Knew your customers) go against the ethos and one of the founding principles of Bitcoin.
If Bitcoin integrates into financial system; if so, how will its network react to this ? and will it be continued to be viewed as a hedge against currencies?
If Bitcoin does not, then will run the risk of being a “hard to adopt” technology?
These are some interesting questions that will surface in near future.
Here is an excellent write up by Tyler Cowan on why Crypto assets can be either useful hedges or useful forms of payment — but not both.
Conclusion
At this point, best case for Bitcoin seems to be a reserve asset (Digital Gold). It has strong security and scarcity along with being truly decentralized. There is a lot of momentum in the ecosystem (Lightening Network) which could potentially increase the use of Bitcoin beyond store of value but it is yet to be realized. In the meanwhile, we are seeing adoption of Bitcoin by both Institutional investors and corporations.
However, there is lot of uncertainty Bitcoin as an asset. My choice of work – “uncertainty” as opposed to “risk” in above sentence is intentional. Risk is measurable (you can attribute a probability of winning) but uncertainty is not measurable hence every more dangerous and could cause permanent loss of capital.
Disclaimer
I am long on Bitcoin. I might sell Bitcoin in future anytime. This post is NOT a recommendation to buy, sell, or hold Bitcoin. I wrote this post to organize my thoughts about Bitcoin and shared it so that you might find it useful. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice.
References
- Inflation-QE-Lemonade-Economy-Government-Central-bank
- The Bitcoin Standard – By Saifedean Ammous
- Macro Impact On Bitcoin :: Pantera Blockchain Letter, April 2020
- Bitcoin as Reserve Asset
- Bull case for Bitcoin – Vijay Boyapati
- Podcast: BITCOIN & MICHAEL SAYLOR – A MASTERCLASS IN ECONOMIC CALCULATION
- Podcast: Once BITten – People-Know-Something-Is-Wrong
- The Greatest Game – Jeff Booth
- The Price of Tomorrow – Jeff Booth
- Youtube: Chamath Palihapitiya: Why Bitcoin Will Be ‘the Category Winner’
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