Bitcoin: Ignorance is Not Bliss
Lane Generational believes Bitcoin is a unique and compelling investable asset, despite mainstream media’s attempt to paint it as a scam, a Ponzi-scheme, an enabler of financial crime, and a hackable network. Bitcoin is none of these things and should no longer be ignored as a long term investment.
- A Brief History of Money
- The Birth of Bitcoin
- Bitcoin Mechanics
- Framing Bitcoin as an Investment
- Potential Use Cases and Valuations
A Brief History of Money
An understanding of the history and the key principles of money is required to set the stage for Bitcoin’s potential. There are three basic properties money must fulfill: it needs to be a medium of exchange, a unit of account, and a store of value. These characteristics boil down to salability, which refers to the ease with which money can be sold at any time the holder desires. Money must be salable across scale, space, and time. Scale refers to varying quantities, space refers to transportability, and most importantly time refers to a store of value. Aside from surviving physical decay, the supply of money must be held relatively stable over time to preserve value.
“The relative difficulty of producing new monetary units determines the hardness of money: money whose supply is hard to increase is known as hard money, while easy money is money whose supply is amenable to large increase”. -Saifedean Ammous, The Bitcoin Standard
Throughout human history, there have been various forms of money, everything from precious metals to seashells and large stones. The longest standing form of money has been gold, first used by King Croesus of Lydia in 550 BC[i]. Gold’s unique chemical properties make it the only element impossible to destroy or recreate from other materials. It also happens to be among the rarest metals in the Earth’s crust. This scarcity is a critical factor in maintaining a stable money supply. The stock-to-flow ratio is a useful metric in quantifying scarcity across assets. In gold’s case, the stock is equivalent to the total supply of all above-ground gold, while the flow is represented by its annual production. In other words, it is the inverse of the inflation rate of supply. Gold has consistently inflated at roughly 2% per year, as seen in the chart below.
Currently, at a little under 2% inflation, gold’s stock-to-flow ratio is 62, far superior to the next scarcest metals silver (22) and palladium (1.1)[ii].
Money, as we know it, is government-issued, also known as fiat. Every modern-day fiat currency, when first brought into circulation, was redeemable in gold or silver. The government was responsible for minting standard units or paper backed by their gold reserves and fulfilling redemption obligations. In the classical gold standard years (1815-1914), the world’s currencies were simply names for a defined weight of gold, creating a fixed exchange rate environment.
The clash between the Austro-Hungarian Empire and Serbia snowballed into the First World War, and within a matter of weeks, all major nations suspended gold convertibility, instead funding their war efforts by printing money without gold backing[iii].
“This war cannot last longer than a few months” was a widely held conviction at the outset of World War I. All involved would go bankrupt shortly and be forced to come to terms, perhaps without a decision, on the battlefields. The belligerents would simply cease to be creditworthy. Such was the frame of the European mind in 1914; the idea that credit and the printing press might be substituted for genuine savings was “unthinkable.” “Sound money” ruled supreme, supported by the logic of the free market. -Melchior Palyi, The Twilight of Gold
Switzerland’s neutrality relieved the need to devalue its currency. Consequently, the loss in purchasing power of neighboring nations can be examined on a relative basis versus the Swiss Franc.
Following the war, all participating countries faced the difficulty of returning to the gold standard. A return to prior exchange rates would lead to an overwhelming demand for physical gold, and a fair market valuation of current reserves would publicize the significant depreciation of their currencies[iii]. Instead, they chose to increase their central banks’ power and restrict gold ownership. Not coincidentally, the Federal Reserve was established in 1913, following the Bank Panic of 1907. Woodrow Wilson gave the 12 Federal Reserve banks the ability to print money to ensure economic stability, giving birth to the Fed’s dual mandate to maximize employment and keep inflation low.
The Birth of Bitcoin
Fast forward over a century. The world has tried and failed centrally planned versions of the gold standard. The Bretton Woods Agreement of 1944 attempted to peg currencies to the U.S. dollar, which was then pegged to gold. It ultimately collapsed when Nixon closed the gold window in 1971.
In 1984, Austrian economist, Friedrich Hayek eloquently said “I don't believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can't take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can't stop”[iv]. That something might just be Bitcoin.
Bitcoin was conceived following the 2008 Financial Crisis by pseudonymous programmer Satoshi Nakamoto. His whitepaper outlined a peer-to-peer electronic cash network, which bypassed trust-based financial intermediaries through an elaborate Proof-of-Work system. Early attempts at digital cash networks date back to 1989 when David Chaum started DigiCash. He correctly realized that a digital payment system needed security without identification. Using blind signature cryptography, DigiCash was able to facilitate secure payments while protecting its users’ identity and landed pilot programs at major banks before its eventual bankruptcy in 1998[v]. As the web cemented itself as the internet protocol of choice, there were many attempts at digital payments in the late '90s, including the founding of PayPal. However, none could solve the infamous double-spend problem and therefore continued their reliance on third-party intermediaries.
Here is the double-spend problem: say Bob wants to pay Alice $5. In the physical world, Bob hands Alice a $5 bill and there is visual evidence that Bob no longer holds that same $5 bill. Digitally, without a trustworthy intermediary, Bob would be free to send the same $5 to Joe. This is double-spending, and the global solution has been a centralized model of third-party financial institutions that verify Bob indeed has $5 to spend. This makes intermediaries the single point of failure. The highest level of centralized authority is not banks, but instead central governments, as the creators and administrators of fiat currency. The entire monetary system relies on the simple notion that a U.S. dollar is money good. Bitcoin’s decentralized model solves one of the world’s longest standing problems: trust.
The complexity of Bitcoin’s solution is partially to blame for public ignorance. Grasping how the network works is the first step to understanding the benefits and acceptance of Bitcoin as a viable asset class.
The Bitcoin network is an array of decentralized nodes, which are computers running the Bitcoin protocol. These are the enforcers of the network and are often referred to as miners. When Bob goes to send Alice $5 a transaction is created, broadcast to the network and consolidated by nodes onto ledgers called blocks. Miners then expend computing power to solve complex math problems. This system is called Proof-of-Work. The first block to be solved is then broadcast to the network and accepted only if transactions are valid and not already spent. Once it is established that the new block is the most up-to-date version of the network it is added to the chain of blocks that make up the entire history of the network, hence the term blockchain[vi]. To approve a new block, 51% of the network must agree on it; therefore, to compromise the network, hackers need to control 51% of its computing power, an impossible feat. The network’s computing power is currently 80.7 million petaflops, and ever-increasing as the difficulty level of the “math problems” solved by miners rises[vii]. To put this number in perspective, the top 500 supercomputers in the world combined can output 1,650 petaflops, making the Bitcoin network nearly 49 thousand times more powerful[viii].
A key component of the network is incentives. Since miners are expending increasing amounts of CPU power and electricity to verify transactions, they need to be compensated. Currently, miners are rewarded for each block they solve with freshly minted Bitcoins. The maximum supply of Bitcoin is a predetermined 21 million coins, and so far over 18 million have been mined. The inflationary schedule dictates the rate at which coins are distributed as reward, and roughly every four years the reward is halved. The most recent halving occurred in May 2020, whereby miners went from receiving 12.5 Bitcoins per block to just 6.25 Bitcoins per block, effectively cutting the inflation rate in half. It is important to note that the Bitcoin supply is perfectly inelastic and does not respond to changes in price the way precious metals do.
On the front end, users interact with the network via wallets. A wallet address on the Bitcoin network is nothing more than a random string of letters and numbers, keeping user identities anonymous. If Bob wants to send Alice 5 Bitcoin, he simply selects her wallet address, which can only be accessed by Alice using her private key. Stories of “lost” Bitcoin stem from a user losing their private key and thus access to their Bitcoin. A recent study estimates up to 1.5 million Bitcoin have been lost, which theoretically caps Bitcoin’s terminal supply at 19.5 million[ix].
Most users buy Bitcoin via exchanges. Exchanges are a necessary feature in any market to efficiently match buyers and sellers. Popular exchanges include Coinbase, Kraken, and Gemini. Exchanges act as intermediaries and therefore are a point of failure on the network. They store Bitcoin in hot wallets, which are Bitcoin wallets connected to the internet. This makes their private keys vulnerable to hackers and is the only way Bitcoin has ever been stolen. The media projects hacks as a flaw in the design of the Bitcoin network itself, when in fact the Bitcoin network is impenetrable.
Framing Bitcoin as an Investment
Bitcoin does not exist in a vacuum. It was born out of concern that our financial system was susceptible to a central point of failure. Today, the future of the world’s monetary system has perhaps never been so uncertain. The Covid-19 pandemic has accelerated concerns of mounting sovereign debts, as governments have been forced to provide the global economy a lifeline to bridge the return to normalcy. U.S. Federal debt has jumped to 135% of GDP, up from 63% before the Great Financial Crisis[x]. This debt expansion has been propelled by monetary creation. The U.S. money supply (M2) is up 21% since February[xi].
Milton Friedman famously stated, “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output”[xii]. Over longer time horizons, money supply growth in excess of economic growth has been predictably inflationary.
“The issue is whether a large monetary overhang in the recovery phase will eventually stoke consumer price inflation. To answer this question, we need to ask, how reasonable is it to expect that in the recovery phase the Fed will be able to deliver an increase in interest rates of a magnitude sufficient to suck back the money it so easily printed during the downswing? The current Fed leadership has made it a centerpiece of its new monetary policy framework to do whatever it takes to overshoot the inflation target in the recovery phase.” – Paul Tudor Jones, The Great Monetary Inflation[xiii]
Levered economies do not respond favorably to interest rate hikes, because the debt levels become unserviceable. Therefore, the Fed projects its zero interest rate policy is here to stay until at least 2023. While economic theory puts inflation risk on the horizon, globalization and technological advancement have contributed as deflationary forces in recent decades. Moore’s Law, which states that the number of transistors on a chip doubles roughly every two years, has led to ever-decreasing cost for electronics as the cost per component is nearly inversely proportional to the number of components. Moore’s Law is physically limited by the size of an atom and most scientists agree we are within ten years of reaching that boundary. In the absence of any future revolutionary developments in the semiconductor manufacturing space, this will weaken what has been a key deflationary tailwind.
Secondly, the Covid-19 pandemic greatly diminished globalization. International trade, travel, and investment flows have all declined. Perhaps more alarming are the increased tensions between the two global superpowers: the U.S. and China. China’s growth as a global manufacturer has enabled the exportation of inflation from the United States. Should some supply chains be forced out of China and moved back domestically, manufacturing costs would certainly rise.
The case for inflation has merit. Therefore, asset allocators should be seeking inflation hedges in the event these catalysts manifest themselves. Historically, gold has proven the best store of value through periods of high inflation. In contrast, bonds typically carry a negative real return, evidenced below through the 1970s when inflation annualized over 8%.
Looking across the investable asset universe, the traditional 60/40 stock and bond portfolio looks overvalued relative to historical averages. The US 10-Year Treasury yielded 6% in 1972, reaching nearly 15% in 1982 to combat inflation. Today, the US 10-Year carries a negative real yield, as nominal yields are hovering around 75bps and inflation is running at 1.4%. Similarly, the PE ratio on the S&P 500 is currently 34.5x, more than double the long-term average of 15.8x[xiv]. This extreme multiple expansion is a function of the zero-interest-rate environment, as the cost of capital is at an all-time low.
Many equity bulls advocate the phrase “TINA” (There Is No Alternative) as a fundamental reason to be long equities in the face of record valuations. We believe Bitcoin offers a compelling alternative with an asymmetric risk/reward profile.
Potential Use Cases and Valuation
To size Bitcoin’s opportunity let’s first look at the market capitalization of Bitcoin versus other major asset classes; Gold, equities, bonds, and real estate.
Bitcoin’s market cap pales in comparison to these core asset classes. Visa (V) alone is worth more than double the entire Bitcoin network. Still, there are several plausible use cases for Bitcoin and associated valuation estimates.
1. Digital Gold
Bitcoin not only carries similar store of value characteristics as gold, but is superior in its transportability, finite supply, and is publicly auditable. Since the Bitcoin issuance rate is constantly declining until the supply cap is reached, its stock-to-flow ratio or scarcity measure is increasing and will eventually be infinite.
Bitcoin will surpass gold as the scarcest asset on Earth following the next halving event in 2025. It stands to reason that an asset with not only similar desirable attributes to gold, but also several advantages would take some percentage share of the world’s gold market. ARK Invest assigns a 15% probability of Bitcoin replacing gold (i.e. the market value of the world’s gold market) to compute an expected 5-year valuation of $800 billion or roughly 4x bigger than Bitcoin is today[xv].
The many qualities that make Bitcoin a superior store of value also make it an attractive reserve asset for the private sector. $1.89 trillion in cash sits on the balance sheets of U.S. corporations alone[xvi]. Historically, this cash has been held in short-term money market funds, but in the face of inflation concerns and a lack of reinvestment options, some companies have looked toward Bitcoin to fulfill the role of a reserve asset. Recently publicly-traded MicroStrategy (MSTR), a $1.6 billion company, elected to put $425 million of their $500 million cash pile into Bitcoin[xvii]. Fintech company Square followed suit, investing an initial $50 million or 1% of its cash balance[xviii]. The private sector in search of a pristine reserve asset looks poised to be a source of incremental demand for Bitcoin’s store of value properties. Below is MicroStrategy's CEO using an analogy to highlight the available options for maintaining purchasing power over long periods.
“You want to cross the Atlantic. If you cross the Atlantic in a vessel made of fiat currency, it's like stitching together a bunch of inflatable rafts. You're crossing the Atlantic in an inflatable boat with a leak in it, or do you want to cross the Atlantic in a gold vessel? You're going to cross the Atlantic in a wooden ship. It's sort of good, but it's rotting. It's a wooden ship. It's better than inflatable. It doesn't have a leak in it. But it's wood, and it's going to decay. It's decaying 2%, 3% a year. You're crossing the Atlantic in Bitcoin? It's a steel-hull freighter.” -- Michael Saylor, MicroStrategy CEO - Real Vision Interview[xix]
2.Emerging Market Saving Vehicle
One of Bitcoin’s unique characteristics is that it exists outside the control of governments. For citizens in emerging market economies, subject to corrupt regimes and the corresponding demonetization of local currencies, Bitcoin is an important vehicle for maintaining purchasing power. Several countries undergoing hyperinflationary episodes have high rates of Bitcoin adoption, including Argentina, Venezuela, and recently Lebanon. An analysis of the Bitcoin blockchain scored Venezuela as having the third-highest adoption of cryptocurrencies globally, alongside nations with strict capital controls.
In 2019, the annual inflation rate in Venezuela was 10,398%. Any savings held in the local Bolivar were incinerated almost overnight, and this drove many citizens to adopt Bitcoin as both a vehicle to access the global financial system and a savings mechanism, including over 20,000 Venezuelan businesses[xx].
The second, and related, emerging market use case is remittances. In 2017, the global remittance market was $613 billion, the majority of which flowing into low-income countries with associated fees as high as 20%[xxi]. The average remittance fee is roughly 7%, meaning the current system is costing migrants over $40 billion a year. Comparatively, Bitcoin costs under $2 per transaction and can move money in a matter of minutes rather than days[xxii]. Assigning Bitcoin a 5% market share of all M2 supply outside of the top four largest nations results in a net present value of $60,000 per Bitcoin[xv].
3.Global Settlement Network
At this point, Bitcoin is not set up to act as real-time currency whereby daily purchase transactions are completed on-chain. Bitcoin in its current state can only process about 5 transactions per second due to block confirmation times, a tiny fraction of Visa’s 24,000 per second[xxiii]. The Bitcoin community is currently working on the Lightning network, which is an additional layer that sits on top of the underlying Bitcoin protocol and is capable of millions of transactions per second[xxiv]. For the time being, Bitcoin is best suited to settle low-volume, high-value transactions which make it a perfect candidate for a global settlement system, currently dominated by the Federal Reserve’s Real Time Gross Settlement (RTGS) or Fedwire[xxv].
While there is substantial focus on using Bitcoin as a consumer payments platform, the security of the system is in fact overkill. As Saifedean Ammous puts it “using Bitcoin for consumer purchases is akin to driving a Concorde jet down the street to pick up groceries: a ridiculously expensive waste of an astonishing tool. Consumer payments are a relatively trivial engineering problem which the modern banking system has largely solved with various forms of credit and debit arrangements”[xxvi].
Bitcoin is capable of settling one transaction per day with every other bank in the global network of 850 banks[xxv]. According to the above analysis, a 10% market share gain would equate to Bitcoin scaling more than 7-fold.
Bitcoin's Role in a Portfolio
The likelihood is that Bitcoin’s future will encompass some combination of these three cases: digital gold, savings vehicle, and global settlement network. The technology is capable of succeeding independently in all three, and even more likely is that the evolution will be binary, in the sense that ultimately Bitcoin will dominate a use case or not be used at all. This leads us to view Bitcoin as perhaps the most asymmetric risk/reward asset in the world. It has achieved critical mass through a community of developers, a mining industry, and a maximalist following that will not be disappearing any time soon. The combined market opportunity of these three use cases is an astounding $36 Trillion, even at a 5% market share across all three that would equate to a 9-fold increase in the size of the Bitcoin network and correspondingly the price per Bitcoin.
We expect the adoption rate of Bitcoin as an asset class will be slow and then suddenly accelerate. Institutional investors have many regulatory hoops to jump through to gain approval and compliance within their organizations. We estimate that most institutions will require a minimum of six months from the day they decide on a Bitcoin allocation and the day they acquire their first Bitcoin. Michael Saylor and his team at MicroStrategy spent just under this time frame from start to finish while moving with assertion and without third party investors.
We believe all investors should consider “getting off zero” – that is above a zero percent allocation to Bitcoin. An analysis of allocating just 3 percent of overall portfolio value would have increased annual returns from 6.83% to 10.24% over the past five years.
All traditional inflation hedges are inherently a bet against human ingenuity, while Bitcoin is backed by crowdsourced intellectual capital and innovative technology. As Paul Tudor Jones states, “At the end of the day the best profit-maximizing strategy is to own the fastest horse. If am forced to forecast, my bet is it will be Bitcoin”[xiii].
Where there is innovation there is growth.
The above targets are estimates based on certain assumptions and analysis made by the advisor. There is no guarantee that the estimates will be achieved.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Investments involving Bitcoin present unique risks. Consider these risks when evaluating investments involving Bitcoin:
- Not insured. While securities accounts at U.S. brokerage firms are often insured by the Securities Investor Protection Corporation (SIPC) and bank accounts at U.S. banks are often insured by the Federal Deposit Insurance Corporation (FDIC), bitcoins held in a digital wallet or Bitcoin exchange currently do not have similar protections.
- History of volatility. The exchange rate of Bitcoin historically has been very volatile and the exchange rate of Bitcoin could drastically decline. For example, the exchange rate of Bitcoin has dropped more than 50% in a single day. Bitcoin-related investments may be affected by such volatility.
- Government regulation. Bitcoins are not legal tender. Federal, state or foreign governments may restrict the use and exchange of Bitcoin.
- Security concerns. Bitcoin exchanges may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware. Bitcoins also may be stolen by hackers.
- New and developing. As a recent invention, Bitcoin does not have an established track record of credibility and trust. Bitcoin and other virtual currencies are evolving.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Lane Generational strategies are disclosed in the publicly available Form ADV Part 2A.
For additional information and disclosures, please see our disclosure page.
[i] Money and Gold. World Gold Council.
[ii] Modeling Bitcoin Value with Scarcity. Plan B
[iii] The Bitcoin Standard. Saifedean Ammous. Ch. 4: Government Money. 2018
[iv] Friedrich Hayek. 1984 Interview with James U. Blanchard at the University of Freiburg.
[v] Blind Signatures for Untraceable Payments. David Chaum. / “DigiCash’s Ecash to be Issued by Deutsche Bank”. 1996
[vi] Bitcoin: A Peer-to-Peer Electronic Cash System. Satoshi Nakamoto. 2008
[vii] Bitcoin Network Statistics. Bitcoincharts.com.
[viii] Top 500 Supercomputer List. Top500. November 2019
[ix] Coin Metrics’ State of the Network Issue 26. Coin Metrics. 2019
[x] Federal Reserve Bank of St. Louis. Federal Debt: Total Public Debt as Percent of GDP. 2020
[xi] Federal Reserve Bank of St. Louis. M2 Money Stock. 2020
[xii] Inflation Causes and Consequences. Milton Friedman. 1963
[xiii] Paul Tudor Jones. The Great Monetary Inflation. 2020
[xiv] S&P 500 PE Ratio. Multpl.com. 2020
[xv] ARK Invest. Big Ideas 2020.
[xvi] S&P Global. US companies continued to fortify balance sheets in Q2 as cash levels hit record.
[xvii] Bloomberg. CEO Says Bitcoin Is Safer After Moving Firm’s Cash to Crypto. 2020
[xviii] Square. Company Press Release. Oct. 8, 2020.
[xix] Michael Saylor. Real Vision Interview. The Deliberate Corporate Strategy to Adopt the Bitcoin
[xx] Hanke, Steve. Forbes. Venezuela’s Hyperinflation Drags On For A Near Record—36 Months. 2019
[xxi] Elks, Sonia. Reuters. Migrants losing $25 billion per year through remittance fees - UN
[xxii] Y-Charts. Bitcoin Average Transaction Fee. Oct. 2020.
[xxiii] LearnBonds. Blockchain Transaction Times vs. Money Transfers: Blockchain Continues to Dominate. 2020
[xxiv] Lightning Network. https://lightning.network/
[xxv] ARK Invest. Bitcoin Whitepaper. Part 2: Bitcoin as an investment. 2020
[xxvi] Saifedean Ammous. Economics of Bitcoin as a Settlement Network. 2017.