• Henry Mason

So why Bitcoin?

Updated: Dec 31, 2020

In the most recent post, we looked at the effects of low interest rates (and low government bond yields) on the workings of a 60:40 portfolio. We used America as the higher yield environment and Japan as the lower yield environment and it was seen, as one would have expected, that the lower return on government bonds and reduced hedging effect it has resulted in the 60:40 portfolio's benefit on risk-return metrics being less in the low interest rate than the higher interest rate scenario. If you want to read it in greater depth, read it here.

It was explained that the rationale for holding government debt is two fold: first, you receive a decent coupon return and second, you would expect to see some capital appreciation should equities sell off, as the risk-off environment might mean that bonds' cashflow is valued more highly.

Looking around the world, with near-record levels of even negative yielding government debt, it seems that the first point does not stand as strong - which leaves the hedging benefit as the main reason for holding government debt.

This left us with the question: well, what alternative assets can be used as a hedge going forward?

As hinted at the end of the last post, we want to start with Bitcoin. This is an unusual place to start, we know, but we would like to shed some light on it, as from a personal viewpoint, I have pivoted from a Bitcoin cynic to an owner of it in about a month.

To put it simply, about a month ago, I listened to a Real Vision Daily Briefing podcast. In this podcast, Real Vision CEO Raoul Pal dedicates the briefing in almost its entirety to Bitcoin.

He explains that the slow adoption and acceptance of Bitcoin by mainstream financial institutions like Paypal, Square and J.P. Morgan will result in the increased uptake, use of (and therefore increased value of) Bitcoin. Continuing, he explains that from his perspective as an investment professional, the trade of Bitcoin versus almost all asset classes, the cryptocurrency wins out.

He also cites other macroeconomic factors, such as the increased monetary easing across the developed world and the increased monetary base will feed into higher crypto prices. This trade, he says, is the trade for everyone - it is quite easy to buy an exchange traded product or set up a cryptocurrency wallet and buy into it.

Other headwinds such as an ageing population, a massive debt cycle as well as a resurgent coronavirus will also feed into issues for traditional asset classes that will result in a benefit for alternative asset classes.

He goes into many more reasons for buying into the cryptocurrency, but the section of the podcast that spoke to us was just at question just shy of the 33 minute mark. He says:

"... as a 30 year old millennial that you're starting to get into [a] decent part of your income curve, so you're putting money into the 401k and you're stuck with equities at all-time highs, property at all-time highs, bond yields at all-time lows, credit spreads at all-time tights, right - you're almost guaranteed to lose money over the first 10 years - so why do it? But when you've got crypto, it's got a risk-reward skew unlike anything else, it's basically the same as a baby boomer got in the equity market in 1981, when the PE [was] seven and you just bought and held it for the rest of your life and you became the richest generation in the world - this chance is setting up again"

Now, there are certain parts that, as students, did not necessarily match with our experiences: we are not 30 for starters and we are not into a decent part of our income curve (hopefully). However, with whatever monies we do have to save and invest, the problem painted above is the same for all of us - most asset classes do appear to be generally expensive right now - meaning that we are staring down the barrel at the possibility of significant losses. And this is where cryptocurrencies come in - the risk-reward dynamic, as Raoul Pal states, is skewed to the upside. This, I found particularly motivating to at least look into the possibility of holding Bitcoin as an asset.

From sceptic to owner

The first hurdle I found myself struggling to get over, was trying to find some intrinsic value to Bitcoin - rather than just "well I think it might go up in value because of these macro factors". An earlier post on this blog, suggested that currently, we "have no need to hold them without tax obligations or similar essential fees" - hence these will not be used as currencies and hence have no intrinsic value.

Now, this does seem like a slightly tautological argument - "if it has a definite use, then Bitcoin will have intrinsic value because it will be used". However, this nevertheless does stand as a point - there needs to be widespread use and acceptance of Bitcoin as a medium of exchange in order to have long-term sustainable value.

This is a hard hurdle to get over - if you take some of the basic requirements of any medium of exchange, for example price stability and widespread acceptance, Bitcoin fails on both accounts. And this is why the news highlighted above influences this perspective - whether you think it fails or not as a currency - it seems as though that financial institutions are accepting it regardless. Therefore, again in the tautological sense, as more and more economic actors and institutions begin to use and buy into Bitcoin, the more value it has to society.

There are more reasons for buying into cryptocurrencies however. Take one radical argument - that cryptocurrencies can radically change the entire payments industry and replace traditional currencies. Lower transfer fees, no governing bodies, and anonymity are some of the attractive features that may aid this transition, despite replacing currencies seeming far-fetched. *Additionally, there is belief amongst some that Bitcoin will become the equivalent of digital gold - in so far as a hedge against inflation. Looking at the drastic expansion of central bank's balance sheets of late, you have to wonder (even if inflation isn't right around the corner) if the increase in money supply would also increase the price of an asset with fixed supply.

A more balanced opinion is that cryptocurrencies might exist alongside an existing and established monetary framework. This scenario does not seem too far fetched at all - a range of central banks, from Sweden's Riksbank to People's Bank of China and also the European Central Bank have indicated that they are either trialling, or at least seriously looking into, the development of digital currencies - which would exist alongside standard currencies and cash, as well as cryptocurrencies.

This is the kind of indication that might lead a more cautious investor to believe that the widespread acceptance of cryptocurrencies might not be a million miles away.

And this is precisely why I bought into Bitcoin recently, to put it shortly: (1) risk-reward skew, (2) increasing adoption from financial institutions and finally (3) indications of central bank belief that digital currencies do have a place in the transfer and payments system of tomorrow.

*This was added as of 24th November

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