What are the attractions of owning Bitcoin?

One of Bitcoin’s main attractions is that it offers person-to-person payment without the participation of a bank or other intermediary and can therefore be used to hide the name or identity of the user.

Consequently, it is widely associated with tax-dodging and the evasion of exchange or capital controls.

This is a major reason why central banks and regulators in some countries have outlawed it (e.g. China where the banks are prohibited from making payments on behalf of clients for the purchase of Bitcoin, and Initial Coin Offerings were banned in 2017.

The desire to ensure conventional money can compete with digital forms is why the US Federal Reserve (Fed), the People’s Bank of China, the Bank of England and other central banks are actively investigating the development of digital monies that would be operated either by the central banks, or in any other way that could be tracked and traced.

Therefore, despite the fact that many people call Bitcoin “digital money”, “digital gold” or a “new form of money”, we view Bitcoin as a dollar-denominated, commodity-like asset. In 2020 its price benefited from the extraordinary money-printing operations of major central banks around the globe (and especially by the Fed) in response to the pandemic.

This tsunami of money creation has been impacting dollar-denominated assets materially since March 2020 and we think that Bitcoin has ridden on the back of this inflation in the money supply. It seems to us as if digital currencies of this kind may be easy to buy, but very hard to sell, i.e. it will probably be subject to a very wide bid-ask spread, especially in a falling market.Institutional investors who have bought Bitcoin must therefore expect a real roller-coaster!

A key test for Bitcoin and other digital currencies will be how they react to accelerating inflation (in consumer prices) and higher interest rates. Advocates of Bitcoin claim that it is an inflation hedge within a portfolio, analogous to real assets such as gold or silver. If this is true, then Bitcoin is seemingly all things to all people: both a cyclical, dollar-denominated commodity (as attested to in Figure 1) and an inflation hedge.

Bitcoin is a relatively new financial asset, with liquid futures markets on the Chicago Mercantile Exchange having commenced in December 2017. As an inflation hedge its role is relatively untested.

CPI inflation in the US has been relatively low for the past thirty years, but with the current growth rate of money and credit (of around 25% year-over-year) it is likely a period of higher inflation and higher US interest rates is on the horizon.

In our opinion, if US interest rates start to turn upwards to any significant degree, Bitcoin will surely plummet again.

Conclusion

It is clear that digitalisation of currencies is the future, primarily driven by the lowering of costs associated with settlement of transactions.

However, there are two potential architectures society will have to choose from: either the payment system will rely on a trusted central authority (central bank) or a decentralised system akin to Bitcoin.

Future regulation of privately issued digital currencies will therefore be absolutely crucial to their survival; currently the opinion of the Bank of International Settlements (BIS) is that “private stablecoins cannot serve as the basis for a sound monetary system”. ¹ They argue that the Bitcoin system will be increasingly vulnerable to “majority attacks” on the network, and that there are perverse incentives for private entities to deviate from appropriate asset backing, investing in riskier assets to achieve higher returns. The digitalisation of currencies will therefore only be successful as part of the existing financial system.

To summarise our position on privately issued digital currencies, a quote from Milton Friedman is relevant:

“Something like a moderately stable monetary framework seems an essential prerequisite for the effective operation of a private market economy. It is dubious that the market can by itself provide such a framework. Hence, the function of providing one is an essential governmental function on a par with the provision of a stable legal framework”.¹

The value of digitalisation lies in the associated technology (distributed ledger technology), not the asset (Bitcoin).

The longer-term question is whether there will be a sustained demand to hold Bitcoin within a standard portfolio rather than other assets such as equities, bonds, or real estate. We are yet to be convinced that Bitcoin has any intrinsic, long-term advantages over other asset classes. Essentially, we view it as a highly speculative asset class.