Guest Feature Article: This Time It's Different: Avoding the Costly Mistake of Not Taking Bitcoin Seriously, by Ned Horsey

This month we’re doing something different. I’ve long wanted to write a series of articles exploring cryptocurrencies, like Bitcoin and its competitors. With the unprecedented amounts of sovereign debt being issued to fund the fiscal response to the COVID-19 pandemic, uncertainty about future confidence in fiat currencies has increased.

One result of this is increased recognition of the potential role of gold in a portfolio, as a hedge against widespread loss of confidence in “traditional” currencies. However, some analysts have argued that crytocurrencies can also play this role.

A number of subscribers have recommended Ned Horsey as a young analyst who can effectively make this case. He has graciously provided this article for our readers to consider.

In a future article, we will also present the other side of this discussion, and present the case for not (or perhaps not yet) including crypto in a portfolio.

But for now, it’s over to Ned.

Why Bitcoin?

$10,000 invested in APPL a decade ago would yield $115,000 in returns today, the same amount of money invested in Bitcoin would have returned $1.3bn. As of 9/4/2020 Bitcoin is up 44% for 2020, aside from the 6 weeks of Bitcoin’s 2018 blow off top (a few trades cleared at $20,000), the current price range of $10,400-$11,000 represents a decade long all time high. By any reasonable metric (energy usage, user base, valuation, ecosystem growth, institutional adoption or legal clarity) Bitcoin appears healthy, growing, and becoming more valuable on a daily basis.

Given these rosy facts, the question remains, why is Bitcoin absent from most large portfolios? Even a small allocation of an asset that goes from a $0 to $10,000 valuation could substantially change portfolio returns, more so if it uncorrelated with traditional financial assets. The answer is that Bitcoin is new, strange, associated with anti-social behavior, and did not have a clear regulatory status until recently.

The purpose of this analysis is twofold:

(1) To explain the nature and properties of Bitcoin in a general, no technical way to give an investor confidence to start their own research

(2) To propose a specific portfolio strategy for a Bitcoin allocation, namely, a gold-type inflation and macro hedge

1. What is Bitcoin?

The emergence of Bitcoin is most analogous to the emergence of the internet and e-commerce in the 1990s. Both are built on new, poorly understood (outside of a few technical communities) technologies. Both rely on network affects that drive increasing adoption.

Because network effects are non-linear, it’s a difficult trend to catch. Come in too early and you invest in Pets.com, too late and you are buying FANG stocks at their 2020 highs. The only way to evaluate our current place on the adoption curve is to understand the technology, it’s capabilities, the context it exists in, and finally make an investment thesis.

Bitcoin is a token similar to the digital dollars or euros in your bank account. Bitcoins or fractions of a Bitcoin can be transmitted directly to any participant in the Bitcoin network through a communications channel.

Scarcity

There will only ever be 21 million Bitcoins. 90% will be issued by December 2021, but each coin is divisible into 100 million sub-units so there are enough units to fully represent the entire global economy.

Bitcoins are fundamentally scarce, there is literally no way to create additional Bitcoins as their cryptographic nature makes them unforgeably costly. If the price of Bitcoin rises to six figures, there will still be no way to mint additional units.

Bitcoins can, however, be lost if the secret key that controls a Bitcoin is misplaced or destroyed. This means that over time, the total number of usable Bitcoins will decrease, which transfers the purchasing power of lost Bitcoins to holders who have stored their Bitcoins carefully, via deflation.

Final Settlement

The technical innovation of Bitcoin is that transactions are final.

Similar to paying cash for an item, there are no charge backs, and no third parties can censor transactions. This means that Bitcoin is a trustless medium of exchange, unlike say a credit card, so two parties can exchange large amounts of value without the fear of a charge back or third party blocking the transaction.

Trustless systems are highly preferable when it comes to financial transactions. This means that two parties do not need to trust each other to transact, they don’t even need to know significant details about each other, merely the relevant information to perform a Bitcoin transaction.

The concept of trustlessness is very foreign in the context of traditional banking. The bank can change your balance, deduct fees, and in the case of bankruptcy, even fail to return a depositor’s money. So traditional finance runs on trust, KYC, and entails taking significant custodial risk. Bitcoin changes this.

Previous to the invention of Bitcoin, there was no such thing as an irreversible digital payment. Paypal, Visa, ACH and wire transfers are all ledger entries on a third parties balance sheet. In the case of a dispute, lawsuit, or other breakdown of trust, participants in any of these transactions can attempt to recover there funds. This means that most digital payment mediums are not suitable for large transactions since there is a possibility that a buyer can take possession of the asset and then initiate a charge back.

Bank payments, while harder to reverse than a credit card, are similarly subject to censor and reversal in the case of political crisis, regulatory encroachment, and bank failure. Prior to Bitcoin, the most final transaction possible was to exchange physical gold, which is still how sovereign nations settle some transactions.

Bitcoin as it exists today, creates transactions that are as final as central bank gold settlement transactions, but can be participated in by anyone and executed online for relatively small fees (much smaller than a wire transfer fee at the moment).

Validated and Genuine

Bitcoin transactions are public and can be validated, meaning that the entire supply of Bitcoin is known at every point in time and there is no ability to inflate the supply and tax holders of Bitcoin via inflation. It is also impossible to force a fake Bitcoin transaction to publish on the Bitcoin blockchain. Bitcoin is cryptographically verifiable, meaning that as long as participants in a Bitcoin transaction are both independently verifying the network (easily achievable with a basic personal computer), it is impossible to falsify Bitcoin transactions.

This overcomes a weakness of physical gold settlement, namely the incentive to counterfeit gold bars and adulterate the gold with tungsten or another heavy metal. Having metallurgical verification of gold transactions is prohibitively expensive, on top of the high cost of security and impracticality of using gold as a monetary instrument. Paper money backed by gold was a 19th century innovation to increase the usability of gold as a monetary medium but opened the door for monetary default and inflation.

Underlying Technology

Bitcoin is actually a distinct technology that uses a blockchain to create a decentralized network of trustless participants. The structure of the network and its rules incentivize cooperative transaction as breaking the rules is not profitable and can lead to loss of funds.

Since the creation of Bitcoin, there has been a ‘blockchain not Bitcoin’ narrative, which can be summarized as “Bitcoin’s core technology is interesting, but it’s similar to MySpace or Napster, a prototype for a business model that will eventually become successful.”

Nothing could be further from the truth.

In fact, blockchain is an old and simple technology. A blockchain is a distributed database that updates in regular intervals called ‘blocks’ and stamps each block with a time. If this sounds underwhelming, then the mass failures of ‘blockchain not Bitcoin’ startups from 2018 will not be a surprise to you. Blockchain is a solution in search of a problem, a way to create decentralized, slow, database systems that happen to be great platforms for decentralized money, but not much else.

Bitcoin’s technological innovation is not blockchain or decentralized networks. It’s not a single technological innovation that can be stolen and repackaged into a disruptive startup. The genius of Bitcoin is it’s design, a system that weaves together public key cryptography, blockchain, distributed networks, and game theory. The combination of these well-understood technologies has created something new: a way to hold value and transact via the internet without any authorities or intermediaries.

Network Structure

This general description of the Bitcoin network is intended as an introduction to the basic network structure and game theory. If you don’t want to learn what a ‘Node’ is, skip ahead.

Nodes are the fundamental unit of the Bitcoin network. A node is a computer that has a copy of the Bitcoin blockchain and connects to other nodes to share new transactions and receive new blocks.’

Nodes can be thought of as users, since a node can be run on basic computer hardware such as a laptop, cloud server in AWS, or even a cellphone. However, participating in a Bitcoin transaction does not require a node, but it is the most secure way to participate.

Some nodes are miners who attempt to win newly emitted Bitcoins by processing pending transactions into a new block with a timestamp that the miner tries to add the Bitcoin blockchain.

This newly created block connects to the previous block using a cryptographic signature, this creates the blockchain as all of these cryptographically frozen, time stamped blocks are connected together via cryptography. Changing a block in the past invalidates every single block that comes after it, meaning that the Bitcoin blockchain is frozen once a block is mined and then transmitted to all of the nodes in the network.

Miners validate transactions but nodes validate blocks. This creates a counterbalance to miners’ power on the network because if miners attempt to change the rules, then nodes will reject these rule-breaking blocks.

Changing the blockchain is impossible after a few blocks because an attacker would have to “dig down” into previous blocks of the chain, re-construct the target block, then reconstruct every block afterwards with new signatures (since changing any element of a block alters it’s cryptographic seal and every block afterwards in a cascading fashion), and then race to construct the next block before any other miner.

Bitcoin mining is a competition for receiving the next scheduled emission of Bitcoins. If you make a block quickly and win this competition, then you receive this compensation for processing transactions. Cheaters doing extra work to fake transactions cannot statistically win all of the new blocks and so once the non-cheating chain wins a block, all of the cheaters’ work is invalidated.

There is simply no way profit in attempting to cheat on the Bitcoin blockchain. There isn’t even a way to use more computing power to ‘cheat’ as the Bitcoin network uses more cryptographic compute than any network in the world, and far more than the entire supply of global supercomputers.

This emission of new Bitcoins is predictable and written into the code of the software, so this is not surprise inflation. Bitcoins need a route into the world, and since miners are providing a commodity service by processing new blocks for the network, they generally need to sell all of the coins they receive to pay for electricity and computer hardware.

The electricity that miners sacrifice to hash the blocks of the Bitcoin blockchain is directly proportional to the cryptographic security of the network. As more miners compete for Bitcoins, the network becomes more cryptographically secure, meaning the cryptographic signature on each Bitcoin block becomes harder to discover, while the rate of Bitcoin emission stays the same.

That was quite confusing, what’s the takeaway?

For a functional understanding of Bitcoin technology, it’s sufficient to understand that Bitcoin is a combination of several technologies including blockchain to create an adversarial network that incentivizes productive cooperation.

Nodes validate the blocks of the blockchain so that miners can’t just make up transactions. Nodes also store the entire chain so that the network can be resurrected from a single node if it is attacked.

Miners secure the chain, create a fee market for transactions, and spend real money in their operations, which ties Bitcoin activity to real world energy markets. They also distribute Bitcoins to pay their costs to secure the Bitcoin blockchain.

Most users don’t have a node, so it’s possible to use the network with little investment in hardware and understanding, but for users with large amounts of Bitcoin wealth, it’s possible to fully validate the chain and take full self-custody of their Bitcoin assets.

No one can steal a Bitcoin by attacking the Bitcoin blockchain, the cryptography is too costly to subvert, the network too distributed to fool, and the adversarial structure of Bitcoin makes it difficult to create an incentive for groups of users to collaborate to attack the network.

This system is unique in producing the only absolutely scarce asset in the world, which can also be self-custodied by the holder, transacted with no intermediaries, is distributed, robust and difficult to attack.

More gold is mined every year, more dollars created every minute, but there will never be more than 21 million Bitcoins.

Why is Bitcoin here to stay?

Better Macro Hedge than Gold

Gold has been the crisis hedge of choice for the last 5000 years of human history. However, during extreme economic crisis such as the Great Depression in the United States, privately held gold assets were confiscated. Gold holders were sold dollars at the official dollar to gold conversation price, then the US dollar was taken off the gold standard and the price of gold went parabolic. Investors were deprived of their inflation hedge and experienced a lost off purchasing power

Today, the proliferation of gold ETFs and centralized bullion vaults like the LBMA make seizure and manipulation of gold assets during a demonetization event easier than ever before in history.

For the minority of gold holders who take physical possession of their specie, securing these assets is expensive, dangerous, and significantly reduces the liquidity of their asset.

Bitcoin can be physically held by anyone who can remember 12 words in their head, it is not bound by capital controls and cannot be seized once physical possession is taken.

Network Effects Kill Competing Crypto Currencies

In 2017 it was not clear if Bitcoin was scarce, in the sense that competing cryptocurrencies also promised digital scarcity, immutability, and censorship resistant transactions; some even offered new features such as private transactions, or complex ‘smart’ contracts.

These competing projects resulted in Bitcoin dominance (the percentage of total cryptocurrency market cap attributed to Bitcoin) briefly falling to 40%. While market cap is a poor measure due to the ease of small float manipulation, this generally indicated some uncertainty as to the dominant cryptocurrency moving forward. Over the past three years, every other cryptocurrency has trended downwards, buoyed up in price only when Bitcoin rallied, and Bitcoin dominance is now 80%.

The analogy of Bitcoin network effects is similar to social networks: it is difficult to start a new social network in a world of Facebook, since the network effect of Facebook users gives it an insurmountable first mover advantage. A social network without users is worthless. Conversely as a social network gains users, it has more utility, attracting more users, resulting a virtuous cycle of adoption and value creation.

Illiquid small float cryptocurrencies with centralized development teams and VC backers can stave off the death of their blockchain by burning cash. A marketing budget can help buy adoption and run the network at a loss in the face of low organic demand. But network effects cannot be bought, beyond the small window at the beginning of an exponential adoption process were minute advantages compound over time. It’s now been 10 years and no cryptocurrency seems able to counter Bitcoin’s market dominance.

Actual Utility

The first uses of Bitcoin were to purchase illegal goods on dark web markets in 2011. No other payment mechanism in the world was capable of transacting in such an illegal, untrustworthy, unregulated environment. While this was initially seen as evidence of Bitcoins ‘illegitimacy’ it actually highlights the technological innovation of exchanging value digitally, without fear of buyer chargeback, payment processor censorship, and requiring very little trust between participants.

Fast forward to 2020 and Bitcoin is a means of avoiding US financial sanctions, Chinese capital controls, and Wirecard COO Jon Marsalek used Bitcoin to flee with his ill gotten gains to Russia, a situation where traditional money transmission would have prevented his financial exit while under investigation.

Other than black and grey market utility, Bitcoin is the primary reserve asset of MicroStrategy, which invested over $400 million, and will likely show up on the balance sheet of more global companies as central bank monetary expansion increases currency risk and inflation expectations. Because Bitcoin is independent of the entire legacy financial system its an ideal uncorrelated asset to reduce tail end financial risk.

Security and Decentralization

Bitcoin is provably secure. The Bitcoin blockchain, if compromised, would be the most profitable hacking target in the world. It’s never been hacked and the mining hash rate that secures the Bitcoin blockchain is the most powerful cloud compute network in the world. In 2013 Bitcoin mining exceeded the capacity of the world’s top 500 super computers and has grown from 61,000% since.

Bitcoins have only been stolen in 2 situations: when an exchange or centralized custodian of Bitcoins mismanages their IT infrastructure and allows hackers to control their Bitcoin withdrawal system. Or when users have used compromised hardware or software to store their Bitcoin private keys.

While securely storing a private key is mentally complex (the discipline to write down a secret and then never allow that secret onto the internet is the core problem), it is achievable without monetary investment, i.e. a skill that can be developed as opposed to a security flaw.

Bitcoin security, because it involves private keys (large alphanumeric secrets) can also be distributed in complex multi-signature schemes, for example a broker, a client, and her lawyer might all have a key. Any two keys can initiate a transaction, but the client’s key is a ‘master’ key that can transact on it’s own. This security technology will develop into ever secure, ever distributed models that contrast the naivete of the legacy financial model: absolute trust in third party custodians, banks, and brokers.

Bitcoin is a decentralized network, meaning that banning Bitcoin or restricting its use is only possible by restricting existing regulated financial entities. Physically attacking the network is impossible as there are over 10,000 Bitcoin nodes world wide (and as many as 45,000 based on some estimates) and even if 99% could be destroyed a single surviving node preserves the entire transaction history and thus can ‘resurrect’ the network. This makes Bitcoin an anti-fragile network in contrast with the legacy financial system that is vulnerable to shocks that can wipe out whole countries worth of financial history (can anyone confirm the ownership of plots of land in Caracas or the trading accounts of Lehman Bros clients).

But what about quantum?

Quantum computing is still in a proof of concept phase as evidenced by the two most publicized projects disagreeing on simple benchmarks of quantum test performance. Whether or not quantum is a field that will eventually disrupt traditional O(N) cryptographic problems, there is not yet irrefutable proof that current quantum computer prototypes can even theoretically outperform current silicon electric computers.

Furthermore, cryptography is not a fast moving, disruptive industry, because of the sensitivity of data privacy and the huge risks to making changes to cryptography, as quantum develops it will be slowly integrated into the cryptographic literature and then the standard cryptographic software libraries. It is very unlikely that some breakout startup or inventor will crack quantum computing and then immediately break all global cryptography (this would also probably end civilization as it currently exists). Given that the major players in this space are IBM and Google; they will need to quantum harden their own systems, which will be a massive infrastructure upgrade involving closed and open source software.

Quantum may be an issue in the future, but it will be an issue for all computer systems and if it does deliver, it will be a slow rolling technological upgrade as opposed to a sudden disruption.

The Bitcoin Investment Thesis

1) Scarcity – Inflation Hedge and Currency Risk

There are 3500 publicly traded companies and there’s $5Tr in their treasuries and it’s all melting and at some point, you have a fiduciary obligation to not lose the money.

– Michael Saylor

MicroStrategy CEO Steven Saylor recently made a $250 million allocation into Bitcoin as the company’s new ‘primary reserve asset.’ His corporate treasury of $500m was not creating any value premium to his stock while large corporations are awash in cheap liquidity.

Simultaneously, traditional cash management strategies such as money market accounts and T-bills yield nearly zero interest. Mr Saylor described this situation as ‘holding a melting ice cube.’

Inflation expectations are ticking up while yields on safe assets are suppressed and equity markets are increasingly volatile. Holding dollars is also less attractive as government fiscal interventions increase money supply at historic multipliers. Bitcoin offers the inflation hedge of gold with more upside as well as assurances to it’s scarcity.

The most surprising element of MicroStrategy’s Bitcoin allocation, was not that it happened, but that Steven Saylor opted to go all in with his treasury. A portfolio manager might more reasonably start with a 1% allocation in order to taste asymmetric upside price movements but not experience the high volatility.

The huge corporate balance sheet allocation of MSTR makes more sense, if you consider that MSTR generates large amounts of cash, so in an environment of low yields for safe assets, making a large speculative bet on Bitcoin is rational, given MSTR’s ability to rebuild it’s balance sheet.



2) Network Effects – Adoption and Value Accrual

Similarly Bitcoin activity is also dominant relative to the next largest chain, which together represent over 90% of total cryptocurrency activity. This winner take all dynamic of Bitcoin vs other cryptocurrencies is a corollary to the current USD world order, where the USD represents 79% of global transactions. Money has always been a network effect driven phenomenon, and Bitcoin follows the traditional model of a single currency accruing 80% of the total market.



3) The Stock to Flow Model and Low Cross Asset Correlation

The anonymous Dutch quant PlanB has created and back tested models to explain the price of gold, silver, and Bitcoin as a function of their various stock to flow ratios. Because Bitcoin’s issuance is front loaded, more than 18 million of the total 21 million Bitcoins have already been emitted, further demand/monetary inflows chases an ever fewer number of units. This creates a price feedback loop that results in blow off top bull markets that then calm to a new, higher, price floor.

PlanB’s model co-integrates and explains over 90% of historical Bitcoin variance. It also predicts a six figure Bitcoin price in 2021. While it is not clear if this bullish model will track future Bitcoin cycles, the emission schedule of Bitcoin, coupled with it’s absolute scarcity suggests that new monetary inflows highly stimulate price while a larger user base creates ever higher price floors.

From a macro perspective the importance of PlanB’s work is that there is a modeled, analytical framework to evaluate Bitcoin’s future price action. This is no longer a seed-stage project, rather a growing asset class under the microscope of institutional analysts.

Bitcoin’s low correlation with the DXY, S&P500, and other traditional asset classes, along with it’s asymmetric upside potential make it a candidate for a small portfolio allocation.

An interesting recent development is Bitcoins weakly negative correlation with VIX, making it a potential component of volatility based strategies.

The Risks

After 10 years of software development and 99.99% network uptime, the base Bitcoin technology is stable and secure. The likelihood of a catastrophic technological bug destroying Bitcoin value is low at this point and reducing over time as the network develops.

The largest price risk to Bitcoin investors is regulatory. Restrictions on financial institutions’ ability to trade and custody Bitcoin could temporarily reduce the dollar price appreciation of Bitcoin. However, regulatory momentum seems to be moving towards legitimizing Bitcoin as a financial asset in the United States. The OCC has clarified that banks and financial institutions can provide custodial services for cryptocurrencies and related businesses.

The other major price risk to Bitcoin is that the US Federal Reserve somehow manages to reflate the US stock market and property bubbles. If these markets get sufficiently frothy, this may attract speculative money that would have otherwise been directed towards Bitcoin.

The Next Decade: Bitcoin and Inflation

The Bitcoin bull in 2018 was capitalized on by a large number of ICO (initial coin offering) scams that obscured the value proposition of Bitcoin due to the sudden proliferation of blockchain projects. Bitcoin’s recovery of network share since could be a sign of its long-term value proposition.

This time, as Bitcoin breaks out to statistically significant historical upside, it is different. Increasing integration with financial institutions and legal clarity means that this bull market has a wider and deeper pool of potential participants. Furthermore, this bull market coincides with stress in traditional markets and levels of speculation hereto unseen, suggesting significant potential upside.

Bitcoin is perhaps the best inflation hedge that currently exists. Its absolute scarcity combined with its digital nature make it ideal for securing value as currency and political risk increases. Both gold and Bitcoin accrue value in bull runs that never fully unwind, setting successive price floors with each market cycle.

There is no realistic path for the US Government to reduce its budget deficits, which means that increasing fiscal and monetary cooperation will result in debt monetization. Inflation hedges work best when put on before inflation hits the tape. That’s why Bitcoin is an option.