Bitcoin

Updated 14 October 2020

Almost exactly three years ago during the cryptocurrency bubble that really brought forward digital assets into the mainstream media, Bitcoin was largely viewed as nothing more than a speculative asset in the mold of the tulip bubble of 1637. To your average investor and particularly those of the baby boomers generation, Bitcoin is not seen as anything worthy of consideration or analysis on any level. However, proper due diligence and second level thinking will reveal there is utility in (some) cryptocurrencies and certainly to my mind, Bitcoin.

I do not believe Bitcoin’s journey will mirror that of the tulip mania which came before.

What is Bitcoin?

Developed by the pseudonymous person dubbed Satoshi Nakamoto in 2009, Bitcoin is a complex technological system. In its simplest form, Bitcoin exists as a peer-to-peer cryptographic payment network with its own native currency, whose members verity all transactions taking place between one another and with no reliance on a centralized authority to monitor or control the network. Each unit (or Bitcoin) on the network (Blockchain) cannot be duplicated digitally in any way and can only be assigned to one single owner.

The Bitcoins themselves are not stored on any single electronic device or central server, but rather on the Blockchains distributed public ledger. The owners of their respective Bitcoins can thus transact with one another via the Blockchain from anywhere in the world at any time.

Whilst there are approximately 18 million Bitcoins in existence at present, the total supply available is fixed at 21 million. These new coins are created through a process called “mining”, whose term is coined from the parallel process of mining gold. The supply and availability of said Bitcoins is predetermined by the Bitcoin protocol. This protocol cannot be altered in any way unless 100% of the users of its network were to agree on any change, of which there is no incentive to do so.

Bitcoin is a decentralised payment system immune from a single ruling authority of its network or currency. This is the exact opposite of how our global financial system of today functions.

In its origin, Satoshi’s motivation for the creation of Bitcoin and the implementation of the Blockchain technology was to combine the necessary features of physical cash (that being its lack of an intermediary when transacting) with a digital currency who is without a centralized monetary authority who can manipulate its supply. Bitcoin is able to remove the need for trust in any entity via the ingenious way the protocol is structured. Every transaction that takes place on the network is done so via a public ledger which is shared among all member, and whose member must verify each transaction themselves. By doing so, the members compete with one another to update the ledger with this new transaction. This verification process is completed via the solving of complex mathematical puzzles which require a great deal of processing power to do so, but the solution of which is easy to verify. This creates a real cost (i.e. electricity, hardware, software etc.) for those verifying the transaction. Upon solving the puzzle and once its solution is verified by other members of the network, the member who solved the puzzle is rewarded with a new “block” consisting of a predetermined number of brand new Bitcoins. This is the proof-of-work dynamic that is self-reinforcing, encouraging members of the network to spend processing power to verify its transactions, thus securing its network, and in turn receiving an economic reward in the form of new Bitcoins for doing so. This is the basis of the Bitcoin mining process.

The reward of new Bitcoins compensates the miners for expending purchasing power and the resources they commit. This is Bitcoins advantage over the fiat currencies of today; the new supply is only rewarded to those who spend their resources, as opposed to those who the omnipotent government dictates.

The protocol is pre-programmed to issue a new block roughly every 10 minutes. Initially set at 50 coins per block, the protocol halves the number of Bitcoins rewarded per block every four years. This is known as the Bitcoin “halving event”, the most recent of which took place in May earlier this year.

Source: Incrementum AG, In Gold We Trust Report 2020 — *Source:* *Incrementum AG, In Gold We Trust Report 2020*

What’s perhaps a more important aspect of the protocol is its “difficulty adjustment” mechanism. As the demand for Bitcoins grow and thus its price appreciates, this increase in price results in the miners becoming more profitable, as they are able to sell their mined coins at a higher price, whilst there cost of mining those coins remains the same. This is no different for the producers of any other commodity, an increase in demand is met with an increase in price (temporarily), thus increasing the profitability of its producers. For Bitcoin, the increasing profitability of the miners allows them to spend more resources on mining new coins, which thus increases the rate at which new coins are mined, as more processing power means more puzzles being solved. To rectify this an ensure the rate of new blocks being generated remains around the pre-determined rate of 10 minutes, the protocol will increase the difficulty of the puzzles, and thus increase the cost of their being solved. This is the difficulty adjustment process and works in such a way that the rate of new coins being mined remains at its pre-determined rate. This process works in reverse if the coins are not being mined fast enough, i.e. the mathematical puzzle becomes easier to solve.

This difficulty adjustment dynamic allows Bitcoin to retain its scarcity. The said increase in price for a generic commodity would attract more producers and increase its supply in order to satisfy the increase in demand, pushing down the price. Only physical commodities whose undiscovered supply is limited, that primarily being gold and silver, match Bitcoin in this regard.

The fundamental case for Bitcoin

Bitcoins value is not derived from its transactional properties, nor is its purpose of today to provide a transactional alternative to fiat currencies, but rather it is the worlds first organic digital currency who meets all the criteria of sound money, all whilst being decentralised and not susceptible for the influence of political gain or irresponsible monetary policy.

A good that has assumed the role of money throughout history is one that has widely been accepted as a medium of exchange, a store of value and a unit of account. It has been a good whose primary use has not been for consumption or production but for the use of its value properties, and its ability to be exchanged for the purchase of another good. Hard money has historically been a good who has been able to retain its value throughout time and space, allowing its owners to use it as a store of value as a reward for their work. Such a good must be immune to deterioration and whose supply is constrained in some capacity. Its existing supply (i.e. stock) must be high relative to its annual production (i.e. flow), or what is referred to as having a high stock-to-flow ratio. The higher the ratio, the more likely a good is suited to being a store of value and can potentially fill the role of being money.

Historically, gold has been widely accepted as money and as the people store of value. Gold has a the highest stock-to-flow ratio relative to all other realistic alternative of money, whether they be shells, cloth, copper or even fiat currency.

Having sound money that fulfils these criteria has been beneficial to society throughout history. Furthermore, a good that has fulfilled the role of sound money has always been chosen freely on the market by its participants. A good chosen by society to be their money and thereby be their reward for work and store of value, allows its user to protect their purchasing power across time, thus incentivizing its users to only spent their money on profitably endeavors that will add value to their lives, or whose return on investment will be greater than the opportunity cost of retaining their money. This is an important aspect overlooked in todays society given the debasement of our fiat currencies facilitated by the excessive monetary printing by our central banks. A store of value whose value is being inflated away and printed at will encourages its owners to find any possible way to ensure they can retain their purchasing power. This incessive malinvestmnet is increasingly evident today.

Bitcoin is the first monetary asset that exhibits a perfect price elasticity of demand. No matter how much its price changes, its supply cannot deviate from that determined by its pre-programmed protocol. Bitcoin provides the people with the first real digital solution to the lack of sound money available today. It provides a monetary medium for those who wish for a store of value outside of their fiat currency whose supply is fixed. Its purpose is not to replace the transaction properties of fiat currency, but to provide a digital and accessible alternative money that is scarce and will hold its value so long as their is sufficient demand. Bitcoin is representative of the digital age we are in.

So long as the governments are intent on manipulating and debasing their currencies, the demand for alternative ways to store ones wealth outside of the financial system will only increase. Bitcoin is the first of its kind in that it offers a technological escape. It is not reliant on anything physical and as a result can never be destroyed, confiscated or influenced by any political or criminal force. Bitcoin offers a way to correct the imbalance of power between the government and the individual. It is a bet on the future direction of the global financial system.

Saifedeam Ammous said it best in his book The Bitcoin Standard, Bitcoins “mere existence is an insurance policy that will remind government that the last object the establishment could control, namely, the currency, is no longer their monopoly. This gives us, the crowed, an insurance policy against an Orwellian future.”

The macro case for Bitcoin

The macroeconomic case for Bitcoin is largely similar to that of gold. The extreme money creation we are witnessing via quantitative easing and now direct cash payments, or “helicopter money” as Ben Bernanke has popularized the phrase, illustrates how far the manipulation of fiat currencies has come. There is no doubt the inherent scarcity of gold and Bitcoin will eventually lead to them becoming accepted as mainstream investments as the general populace begin to lose faith in government currencies. Albeit this will likely be a slow process.

As I have detailed, the problems with government money lie in the fact its owners are required to trust that those in charge of its supply will not abuse that privilege. It is an inherent to succumb to temptation and sacrifice long term prosperity for short term gratification.

Since the end of the Gold Standard, economic literature and education has been built around the idea that governments intervention in the economy and their distraction of its supply is necessary and beneficial. Whilst argued for and against by many, it is clear the experiment that has been fiat currency has largely failed. We have reached a point whereby nominal interest rates are the lowest in recorded human history and the real interest rates (that is nominal interest rates less the rate of inflation) are negative for most developed economies. There is over $15 trillion in negative yielding debt worldwide. Such is the amount of negative yielding debt that the entire fixed income asset class offers the lower risk reward over the long term of any major asset class.

As a result, the opportunity cost for investing in gold and by extension Bitcoin as an alternative is almost nil. Whilst I do not disagree that bonds offer value in the short term, particularly if you believe nominal rates in the US are heading negative, why would you want to own an asset whose owner is guaranteed to receive less than their principal upon maturity? This is most appropriately been coined “reward free risk”. If we begin to see a spillover from large institutions and pension funds into these alternative assets that effectively have a real yield of zero, the potential price appreciation for precious metals and Bitcoin may present a generational buying opportunity for astute investor.

Furthermore, we are seeing numerous countries around the world attempt to move away from dollar hegemony and its status as the worlds reserve currency. Various central banks continue to accumulate gold as a potential escape for this paradigm, the adoption of Bitcoin as a decentralised alternative to US dollar in some capacity no doubt offers them another route. Only time will tell.

The quantitative case for bitcoin

As I have discussed, a commodity with a high stock-to-flow ratio has historically been adopted as the primary monetary medium of its people, so long as its fulfils the other criteria of sound money. Industrial commodities like copper and oil have low stock-to-flow ratios, that being their existing supply is easily influenced by their level of production, whilst scarce and therefore more valuation assets such as gold and silver have high ratios.

As you can see in the above chart illustrating the stock-to-flow ratios of Bitcoin relative to gold, silver and platinum, following May’s four year halving event Bitcoins ratio has surpassed that of silver and sits almost equal to gold. Come the next halving in 2024, the stock-to-flow ratio of Bitcoin will be effectively double that of gold.

As the production of Bitcoins being mined continues to halve every four years, the ratio will continue to increase. The number of Bitcoins rewarded within in each block will reduce to zero after approximately the 33rd halving event, and at this point in time the stock-to-flow ratio will effectively be infinite.

The question is though, what does this imply for Bitcoins price?

In 2019 a Dutch institutional investor who goes by the pseudonymous twitter handle “Plan “ (@100trillionUSD) published a paper modelling Bitcoin’s stock-to-flow ratio and the predicted price path as determined by his model. In analyzing the data via regression analysis, Plan B has created a model that predicts Bitcoins total market capitulation and thus its price.

Source: Modelling Bitcoin Value with Scarcity — *Source:* *Modelling Bitcoin Value with Scarcity*

As you can see, the small dots illustrate the historical market capitalization of Bitcoin (as of March 2019), whilst also illustrated that of gold and silver compared to their respective stock-to-flow ratios. The regression line indicates a clear correlation between the historical stock-to-flow ratio and Bitcoins price. The following chart better illustrates the relationship of the price as implied by the model versus Bitcoins historical price (as of July 2020).

The white line in this chart represents the implied price of the stock-to-flow model, whilst the coloured dots illustrates Bitcoins historical price, with the specific colour indicative of the time until the next halving event. What is clear is that in the 12-18 months after each four year halving, the price of Bitcoin tends to increase dramatically to the point where it overshoots the models implied price. This makes intuitive sense given bull markets tend to attract speculators who push the price well beyond fair value. This exact dynamic is what occurred during the 2017 mania, prior to Bitcoin falling back to its implied price.

If history is any guide in this regard, Plan B’s stock-to-flow model implies a Bitcoin price somewhere in the vicinity of $100,000 (USD) in the next 12 to 18 months.

To be clear, this is a purely quantitative model which is based upon historical data. There are concerns regarding Plan B’s model. Firstly, it only incorporates supply side factors as per the stock-to-flow ratio and does not take into account the demand side (i.e. institutional adoption). Furthermore, is purely based upon the statistical correlation between Bitcoin’s price and its stock-to-flow ratio, which only infers correlation, no necessarily causation.

There is certainly some level of historical validity to this model and does do a good job of explaining its historical price action, there is no guarantee this model will continue to be valid, but it does provide a roadmap of the potential price direction for Bitcoin and thus is certainly worthy of consideration in ones investment thesis.

Perhaps the foremost message the model sends is that the halving event provides a significant tail wind for Bitcoin in the following 12-18 months, I expect the next 12 months to be no different.

Why not gold or another cryptocurrency?

The two biggest arguments against Bitcoin revolve around whether Bitcoin has true value given it largely fills the role occupied so well by gold historically, and what advantage does Bitcoin have over other cryptocurrencies that exist.

I agree gold has served and will likely continue to serve the purpose of being the preeminent store of value , however, I do also believe Bitcoin will have an ever growing role to play, not only as a complementary piece to gold but as a digital alternative for the digital age.

My bullish cash for gold has not strayed, but, gold is not perfect and is not without its flaws. Bitcoin is a money without a government or centralized authority. It is free of trust of anyone or anything. As for gold, the argument can be made this is not necessarily the case. Unless you own the physical bullion locked away in a safe in your bedroom closet or your safety deposit box, at the end of the day banks have the custodial control over the majority of investible gold. Most paper gold investments (be it an ETF or derivative) are reliant on the banks for the storage of the gold allocated to their investors (and in some cases unallocated, meaning some paper derivates of gold are not backed by any physical bullion at all). What is to stop the government confiscating the gold within the bank vaults? This has happened before and I am sure will happen again. This is not the case with all gold investments, but is most certainly the case with the more popular trading vehicles, such as the popular GLD ETF. Bitcoin does not have this problem.

The same concern can be said of transaction. The banks largely control the transaction game of gold in a similar way they act as the intermediaries for cash transactions. Again, Bitcoin does not have this problem.

Going forward, I do believe gold will likely be the better investment and the better store of value to be sure, however, its rise will likely be following closely by Bitcoin’s.

What differentiates Bitcoin from the other cryptocurrencies that exist today and the inevitable crop of digital currencies we are yet to bear witness is its network effect. Whilst I am sure there is validity and utility in (some) of the other crypto’s, they are largely inferior and most will eventually become redundant. Currencies have historically functioned as a winner takes all game.

Since the cryptocurrency bubble of 2017, Bitcoin has increased in total market share relative to all other cryptocurrencies from around 40% to around 60%. This is what is known as Bitcoin dominance. The reasons; Bitcoins simplicity, its decentralised nature and its network effect.

The strength of Bitcoin and all cryptocurrencies lie in their adoption rate. The more users on the network, the more people there are securing said network is a self-reinforcing manner. This works in the same way as the Facebook network effect, the more of your friends who use the platform relative to an alternative will only encourage more of their friends to join and so on. By default, any new digital currency introduces will be inferior to Bitcoin in this manner. They will be less secure as there are less users and therefore provides less of an incentive for anyone to use anything but the most secure network.

Furthermore, unlike almost all other cryptocurrencies, there is an ever increasing ecosystem being built specifically around Bitcoin. It is becoming far easier to trade and invest in Bitcoin relative to the alternatives. A perfect example of this can be seen in the widely popular Australian investing app RIAZ, who have recently introduced a portfolio utilising a 5% allocation to Bitcoin, an ever increasing trend as Bitcoins popularity continues to grow.

Bitcoin has won the battle of the cryptocurrencies so far, and its ever increasing adoption rate will only solidify its strength in its network effect and reinforce the Bitcoin dominance dynamic.

Risk of Bitcoin

Clearly, I believe there is a solid investment case for Bitcoin. However, like most investments it is not without its risks.

Cryptocurrencies remain a relatively new technology. Like with all new technologies, there will be hiccups and groundbreaking advancements along the way. It is probably the cryptocurrencies of today are a first generation technology and will thus be improved upon and surpassed by newer technologies. There is no guarantee this will occur however especially given Bitcoin’s strength in its network effect, but, if this is the case it is most likely Bitcoin will continue to play a role in the imminent digital monetary revolution. For the meantime, as has been articulated by Real Vision’s Raoul Pal, a good way to think of Bitcoin may be as a call option on the future of the financial system.

A common misconception of Bitcoin is the belief of its use by criminals, and its susceptibility of being hacked. To be sure, there concerns are misplaced. Bitcoin’s blockchain is a public ledger, with an identifiable source of all transaction. It is only an anonymous as the internet itself, and thus is not ideal for privacy or criminal use. The protocol and blockchain are also highly secure and have never been directly hacked. Whilst individual exchanges and peoples personal private keys have been hacked or stolen, this has been done so in the same manner as hacking an individuals online banking account would be. Unlike most electronic payment and security systems, Bitcoin has no central computer or server, nor does it store anything on any one persons computer; by its very nature Bitcoin is decentralised and continually secured by its proof-of-work system.

Another factor potentially holding Bitcoin back is the fact it is yet to truly be tested in a financial crisis. After its inception post GFC, the only time Bitcoin has experienced a significant market downturn was the COVID-19 crash of early this year, whereby it sold off in a manner similar to most risk assets. However, encouragingly Bitcoin has rebounded in a manner very similar to what we have seen in gold, who too sold off during the crisis.

Investing in Bitcoin

Bitcoin is a highly volatile and risky asset, and anyone looking to invest in Bitcoin should do so with these factors at the forefront of their mind. A small allocation to one’s portfolio is most likely all that is required. Depending on your personal risk tolerance, anywhere from a 1% to 5% allocation should suffice if you believe in the bullish thesis for investment.

The incredible performance of Bitcoin to date and its implied future performance allows you to afford such a small allocation whilst still enjoying the upside potential and limiting the downside risk. If you held a 1% allocation to Bitcoin at its inception with the remaining 99% in cash, your performance would have matched the S&P 500. Bitcoin offers tremendous upside similar to a microcap security would offer to ones portfolio, not to mention the fact Bitcoin is effectively correlated to nothing. For me, I am happy with dynamic 5% allocation.

For once, Bitcoin offers retail investors an opportunity to front run the institutions.

Update: 14 October 2020

We recently saw a bullish breakout for bitcoin from its pennant pattern that has been developing since mid year. This, coupled with a bullish crossover of the 20-day moving average above the 50-day moving average and a bullish breakout of its 50 day momentum pattern seems is an encouraging development.

What’s more, this shorter-term breakout comes amid a longer-term bullish breakout of a similar pennant pattern whose development dates back to 2017.

As these bullish technical breakouts are occurring at a time where the fundamentals for bitcoin, both macro and stock-to-flow, it appears the stars may be aligning for a new significant leg higher for bitcoin. I have slightly increased by core holdings by around 1% as a result.