A brief paper on the largest cryptocurrency’s investment thesis, and why investors shouldn’t be quick to dismiss the asset class.
In the aftermath of the COVID-19 crisis that saw one of the largest financial crashes in recent history, an esoteric asset known as Bitcoin experienced an unprecedented rise, recording an annual return of 303% in 2020. This has continued in the first quarter of 2021 with Bitcoin returning just over 100% in that period.
To some, this seems like the beginning of yet another crazed bubble for the crypto currency, with many sceptics comparing it to the Tulip mania of the 1630s. For most investors, however, the rise exemplifies the challenge that exponential technological growth poses to our comprehension of the world around us — Bitcoin is an asset whose value is driven by its underlying blockchain technology. Few people understand the impact of this technology and the way Bitcoin works, particularly in the wider context of the global financial system. For this reason, many investors simply choose to classify the asset as a bubble due to a lack of understanding. This note aims to address why investors should not be quick to dismiss the asset, and should go as far as considering it as a viable alternative within their portfolios.
So what is Bitcoin, and why would someone want to own Bitcoin? In my view there are three fundamental, coinciding arguments that together make it a sound investment. First, the current market environment of central bank dependency, i.e. an external force of money printing. Second, what is known as the Network effect, caused by rising adoption and usage of the underlying technology, both by investors and institutions, as well as by new infrastructure looking to reshape the financial system. Lastly, the internal properties of Bitcoin — most importantly the regular occurrence of a predictable cycle encrypted in Bitcoin’s code, known as a ‘halving’ event, which has been the trigger for all past bull runs in the asset.
Economic backdrop — the role of central bank policy
Following the great financial crisis, central banks around the world resorted to quantitative easing (QE) in order to support the global economy. This is the printing of money at a massive scale to buy risk-free assets in order to infuse money into the system. Initially, this policy seemed appropriate, as the economy and financial system were in great need of support following the debacle of the housing market and many financial institutions. However, years after the crisis, the money printing programme remains in place. This has led to financial markets being in an ‘Everything Bubble’, where most assets are in incredible bull runs unexplainable by any variable other than the reassurance of the Federal Reserve to backstop the financial system. This is an important issue, as QE has to a certain extent become a violation of the principle of free markets by largely dampening liquidity and interest rate risk (given money printing comes side by side with artificially low rates, which leads to other problems like the rise of zombie companies). It is no surprise new social media investors live by the motto ‘stocks only go up’.
To put QE in relative terms, in the first seven years of the 21st century the money supply of US dollars, measured by M1 Money Stock, grew at a rate of 2.3% p.a. Since the inception of QE (i.e. from 2008 to 2019) this has increased to 9.3% p.a., and due to the COVID-19 pandemic, during 2020 this money supply increased by a staggering 346%, unprecedented in global monetary history. The implications of this is clear in theory — based on the laws of supply and demand, such a significant annual surge in supply would greatly reduce the value (price) of fiat currencies like the US dollar (especially if this is not followed by economic growth. It is fair to say that it has not — GDP growth in the same period was only 2.7% p.a.) This is conceptualised by inflation — as the value of currencies decrease due to money printing, nominal prices of goods, services, and assets should increase in order for the real value of these assets to remain the same. This is where Bitcoin comes in, as the asset is programmed in a way where there will only ever be 21 million coins in circulation, with the amount of new Bitcoins entering the market reduced about every 4 years. Essentially, this is a stable, digital monetary policy, as intended by its developers. In the lead up to its creation, Satoshi Nakamoto, the person/s that built Bitcoin, stated “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust”. In this sense, Bitcoin has a clear advantage as a store of value over fiat currencies like the US dollar due to the fact that it cannot be debased by increasing supply. On the other hand, the supply of fiat currencies is in the control of financial entities who have ulterior motives and objectives. While these objectives may be rational (higher employment, for example) they do not necessarily translate to sound monetary policy, and in fact have proven the opposite.
Traditionally, inflation has been measured by the Consumer Price Index (CPI), and under closer inspection, the CPI does not seem to reflect the devaluation of the US dollar, with inflation never increasing above 4% p.a. since the crisis of 2008. The explanation for this is simple, but crucial to understand — while CPI measures the change in prices of a basket of goods and services, the new money printed by central banks largely stays within the financial system, as central banks purchase government bonds and other financial assets. This is arguably also occurring with fiscal stimulus — a small survey by Deutsche Bank in March 2021 suggested that respondents in the United States would allocate 37% of their most recent stimulus checks to the stock market. Thus, what has occurred in the last decade is Asset Price Inflation, rather than inflation in goods and services, which has arguably exacerbated other issues like income inequality, a topic outside of the scope of this note. The forces of this phenomenon can be clearly seen in the historic rise of global equity markets in recent times. By many metrics, equities are currently disconnected from fundamentals, particularly in the United States, where central bank policy is most influential. The below charts, produced by former hedge fund manager Raoul Pal, clearly demonstrates this effect:
The above charts show the performance of the same index, the MSCI World Equity index, but the latter compares it against the balance sheets (i.e. the value of assets purchased by central banks via the printing of new monies) of the G4 Central Banks, rather than stating returns in dollar terms. This illustrates that the outstanding performance of global equities since the 2008 financial crisis can be to a large extent attributed to central bank action and money printing. Put another way, this could explain the increasing disparity between equity prices and their fundamental values, as price movements have been caused not by changing in earnings (while this is clearly an influential factor for individual stocks, it may not be the driving force for the broader market), but rather by the liquidity in the system. For example, the S&P 500’s price-to-earnings ratio sat at an estimated 38.6 at the end of 2020, more than double the historic mean average of 15.9. This has only been higher in two occasions — following the dot.com bubble crash in 2002, and in May 2009 following the financial crisis, where reported earnings of the index’s constituents fell by 78.0% year-on-year.
It is of course possible that QE also increases the liquidity in Bitcoin, however this impact should not be overestimated. Cash flows from central banks end in the hands of financial institutions that put that money to work through traditional asset classes like equities or government bonds. Historically it has been retail investors, rather than institutions, that drive demand for Bitcoin. It is only in the last few years that institutional money has begun to flow into the asset class. Nevertheless, the above chart exemplifies the asset’s characteristics as a store of value and an outperforming asset against the growing balance sheets of central banks. A key factor in this dynamic is the aforementioned fixed monetary supply of Bitcoin, especially relative to the exponential supply of traditional currencies, coupled with increasing demand and adoption of the asset class. This latter part will be addressed in the next section.
The Network effect and Bitcoin’s growing infrastructure
The Network effect is an economic phenomenon where the value of a good or service is directly correlated with the number of users of that good or service. This simple concept is relevant in the rise of many of the world’s largest firms. Social media companies like Facebook and Snapchat are a prime example, where the larger the social network is, the more useful and attractive it becomes for new users wishing to enter the network. Bitcoin enjoys this same effect in three ways. First, as a financial asset, where the more investors that trust Bitcoin as a store of value, the more it becomes institutionalised and accepted among all market participants. This growth is clear by looking at a range of examples. In 2020, well-regarded investors Paul Tudor Jones and Stanley Druckenmiller stated they own positions in Bitcoin, quoting inflation concerns and the asset having an attractive store of value proposition. Dozens of corporations from around the globe have also added Bitcoin to their balance sheet, most notably Tesla, Square, and MicroStrategy. Even institutional investors like the Harvard, Yale and Brown Endowment funds have had exposure to the asset and other crypto currencies since 2019[i]. These groups will continue to hold (or ‘HODL’, a term widely used in the crypto community) the asset not as a speculative one, but as one with a clear role in portfolios — to diversify against the financial system backed by central banks, weakening fiat currencies, and incoming inflation. As this group of investors grow, it removes the reputational risk involved in investing in such a new asset, given the range of respected names that already have exposure. More importantly, it sets out a framework for new firms, institutions and individuals on how to correctly go long on the asset and how to manage the risks involved. MicroStrategy, for example, hosted a ‘Bitcoin for Corporations’ event outlining their strategy for incorporating Bitcoin into their balance sheet — the event had a reported 6,917 firms attend. It is now not unreasonable to expect more firms, institutions, and even governments, to gradually incorporate the asset into their balance sheets, portfolios, or reserves over the coming years.
Second, Bitcoin as well as other leading crypto currencies enjoy the Network effect when it comes to the infrastructure being built that surrounds their ecosystem, which adds to the utility of the asset class due to the larger number of applications (and thus users) of the underlying technology. To explain, block chain can be used as a platform to create further decentralised applications. It must be stated, however, that in the crypto world Bitcoin is not the leader in this area. As Bitcoin is mainly built for peer-to-peer cash transactions, other cryptocurrencies like Ethereum are better suited from a technological perspective to be used for the development of additional applications. This has created the rise of smart contracts, which are contracts between two parties coded into the Ethereum network that only execute once the predetermined conditions of the contract are met. This falls under the concept of ‘decentralised finance’, a range of financial services that are decentralised due to the use of block chain over traditional financial intermediaries. Smart contracts increase transaction efficiency by removing the need of these third parties, such as brokers or lawyers. The most recent, viral application built on block chain is the concept of Non-Fungible Tokens (NFTs), which allow users to have proof of ownership of a digital item. This has exploded in the digital art and collectibles sector — Beeple, a graphic designer who has earned a following of 2 million Instagram followers, recently sold a piece of digital art for $69 million. To be clear, I am not arguing that this sort of price tag for a piece of digital art is justifiable. However, this does signal the potential growth of cryptocurrencies as they increase their utility in the future via new applications — i.e. their network continues to expand. It is critical to have perspective here, and to recognise that this technology is still in its infant stage. Take the Internet, for example. The first real application of the Internet was the use of email in the 1960s and 1970s. It took 20 years for the World Wide Web to be developed, what we know as the Internet today. From there, it took another 20 years for the true dominance of the internet to be displayed — the first time more than one technology company (Microsoft and Apple) was among the biggest five in the world was 2010. Block chain technology within the financial system driven by the use of cryptocurrencies could see similar growth in the next decade. Thus, a bet on Bitcoin (and other cryptocurrencies) is not just a bet on its nature as a financial asset, but also on its growing infrastructure and network.
Lastly, Bitcoin’s network effect is also driven by more traditional third parties, which have identified the benefits of the asset and are creating new financial services around it. This includes crypto currency exchanges like Coinbase, who is expected to go public in 2021 at a valuation close to $90 billion. Other firms like BlockFi allow individuals to borrow against their crypto holdings. This has become a growing area in decentralised finance, as individuals prefer this option to selling their crypto as a source of liquidity. Through BlockFi, users can also earn a high interest by depositing crypto with the firm. Moreover, the rise of derivative contracts in crypto currencies has allowed hedge funds and other professional investors to get exposure to the asset in different ways. For example, by buying Bitcoin in the spot market and simultaneously going short a forward contract (i.e. promising to sell the Bitcoin for a predetermined price at a future date), they can lock in a risk-free return (difference between the agreed future contract price at which it will be sold and the purchased spot price). Importantly, this also adds to supply pressures for the asset, as Bitcoins are held by hedge funds for future delivery. This is a key reason why open interest in future contracts has continued to reach all time highs in the past year.
This growing infrastructure around Bitcoin is further cementing the asset in the global financial system, and is the reason why Michael Saylor, the CEO and co-founder of MicroStrategy, has described Bitcoin as the world’s first “monetary network”. This growing network breeds confidence that the asset will continue to play a role in financial markets, and certainly be a bigger asset class than it is currently, with a c$1 trillion valuation. This leads to the following issue — what is the endgame for Bitcoin? How do we know how to properly value it and determine a fair price as it continues to grow? The lack of clarity in this area no doubt contributes to the scepticism around the asset. The following paragraphs aim to answer these questions by looking at a published model known as ‘Stock to Flow’.
Internal Properties — Cyclical Halving and Stock to Flow
Looking at a normal price chart of Bitcoin, it is not irrational to label the asset as a bubble — the price growth in certain periods of time is unprecedented compared to any other asset class, and looks exactly how you would expect a bubble to behave. However, once this is seen from a logarithmic (nonlinear) perspective, the price action may make more sense:
The chart shows certain cyclicality to the Bitcoin price, where an intense boom is typically followed by a sharp correction until the next cycle begins. These cycles are preceded by halving events, which is where the amount of Bitcoin rewarded to miners once they complete an additional block in the block chain is cut my half. These halving events are encrypted into the Bitcoin network, and occur after every 210,000 blocks are mined, roughly every four years. Because of this, we know with a given certainty what the Bitcoin supply (Stock) in circulation is, and what the new supply entering the market (Flow) will be. This dynamic led to the Stock to Flow (S2F) model.
The S2F model was developed by an anonymous Dutch individual named ‘PlanB’, who is well regarded in the crypto community. I highly recommend anyone who is more interested in this to directly read his articles, as they go deeper into the technical aspect of the model. To summarise, the S2F model suggests that the value of a commodity (like Bitcoin) can be measured by the amount of Stock to the amount of Flow . Essentially, this is a scarcity measurement — a higher stock to flow ratio suggests a higher value as there is very little new supply being added to that already in circulation. As mentioned, since these two parameters are known for an asset like Bitcoin both currently and in the future, Bitcoin’s price can be predicted by interpolating with different assets based on their S2F ratio:
It is important to note that models like this are far from perfect, but serve as a useful framework to understand the price action of Bitcoin. Whenever a halving event occurs, the new Bitcoin supply added to circulation is cut by half. This puts a significant supply pressure on the Bitcoin market. Miners now receive half as many Bitcoin for their work, and thus require a higher price for their Bitcoins in other to meet electricity costs and sustain production. This is coupled with the previously covered demand dynamic, where there are a growing number of groups willing to hold the asset as a store of value. Supply pressures triggered by halving events combined with the aforementioned growing demand leads to a significant movement upwards for the price of Bitcoin. So far, the S2F model has proven to be incredibly accurate, as the chart above illustrates, and it predicts a Bitcoin price of $288k following the impact of the halving event of May 2020.
A common concern with the S2F model is the argument of Efficient Markets, and the idea of ‘no free lunch’. According to the Efficient Market Hypothesis, markets would discount future halving events, and Bitcoin’s price would accurately reflect this information. However, the S2F model does not explicitly consider risks, which may be simultaneously discounted by the market. It is critical to account for these risks and form a full picture of both tailwinds and headwinds for the asset. I will briefly address some of the more significant concerns surrounding Bitcoin and cryptocurrencies.
The main and most reasonable concern on Bitcoin is the imminent threat of government regulation, which I view as a significant risk. Governments and central banks will not wish to give up their control on local (and global) monetary policy if Bitcoin continues to grow exponentially, and may place restrictions or even complete bans on the asset. The Central Bank of Nigeria has already placed a ban on the use and exchange of Bitcoin by financial institutions and banks, and India looks soon to follow. It is yet unclear whether such bans will be effective at curtailing user growth, and these two cases will proof critical as an experiment — both countries’ Bitcoin market are amongst the top ten in the world, with Nigeria coming in second only behind the United States. Developed countries are looking to incorporate some sort of regulation too — in September 2020 the European Commission proposed the Markets in Crypto-Assets “MiCA” Regulation, which looks to establish a regulatory framework for crypto and digital assets by 2024. Incoming regulation may also not necessarily be negative. For example the state of Wyoming in the United States passed 13 Blockchain Laws in 2019, which included the recognition of digital assets as individual property. This is an important space to monitor on a continued basis if you own or are considering owning crypto assets.
The inherent volatility of Bitcoin and cryptocurrencies should also be a risk all investors consider in detail before gaining exposure to the asset. It is undeniable that Bitcoin is a highly volatile asset and may not be compatible with the investment objectives and constraints of many individual and professional investors. I see this as an important hurdle for continued adoption amongst institutional investors, and why I consider education and understanding to be an even more important prerequisite for crypto investing. Having said this, Bitcoin continues to produce greater risk-adjusted returns than any other asset, illustrated by its Sharpe Ratio below, which measures excess returns per unit of risk taken:
Because of Bitcoin’s superior Sharpe Ratio, a small allocation to the asset (say, 1%) with annual rebalancing is perhaps an appropriate approach for investors with little fondness of volatility.
Another challenge for Bitcoin is whether it can displace gold’s role in an investment portfolio — the two assets are certainly comparable due to their characteristics as inflation hedges and as significant diversifiers against more traditional investments. Some investors believe that gold is the superior asset for two main reasons. First, its track record — gold has been a reliable store of wealth for thousands of years (compared to Bitcoin’s 12-year history), and that is not likely to change any time soon. Second, gold’s value is also derived from its utility in jewellery, computers, and other technologies as a factor of production, whereas gold supporters quote Bitcoin has no similar utility. This latter point has been disproven earlier, as Bitcoin’s utility is driven by its growing network in the financial system. Furthermore, Bitcoin’s monetary properties are to a large extent superior to gold. It is perfectly divisible and portable, which is a significant issue with gold. Given the aforementioned supply dynamics of Bitcoin, it is also more scarce. Lastly, it has additional properties driven by its digital nature — it is verifiable via its underlying blockchain technology, it is decentralised, and it benefits from network effects. While I do not believe that gold’s position as a financial asset will ever go away (and in fact will also likely benefit from incoming inflation), I do believe it is foolish not to expect a superior and digitalised version of gold to become more dominant, in the same way that ecommerce is dominant over retail, and video games are dominant over tabletop games. For these reasons, Bitcoin is known as digital gold.
Some other stated ‘risks’ are also guided by misconceptions, for example the argument of Bitcoin’s carbon footprint and negative repercussions for the environment, which is not founded on evidence. An estimated 74% of Bitcoin mining’s energy consumption comes from renewable energy sources, as miners look for the cheapest forms of energy to run their operations. Some miners even use stranded gas that would otherwise go out as polluting gas emissions. Bitcoin mining is in fact a more sustainable and efficient alternative to the traditional banking system and gold mining, with dollar costs per Gigajoule of energy consumed being 40x and 10x more efficient respectively.
Having said all this, Bitcoin’s price has historically moved in line with the S2F framework, and there are many who are firm believers of the technology and its future major role in financial systems. In fact, Paul Tudor Jones has also quoted the intellectual capital and the “growing contingent of really smart and sophisticated people who believe in it…that are dedicated to seeing Bitcoin succeed” as an additional reason for a small allocation in the asset. While it is important to consider the risks and monitor how these progress over time, I am of the view that the value proposition of Bitcoin is too strong to reject under the current market environment of central bank influence.
I would like to conclude by saying that there is an incredible amount of content on this topic, and many different variables and details to consider. This is what makes the asset class such an interesting focus for financial markets. It is critical for investors to attempt to develop a sound understanding before buying, or neglecting, any asset, and I hope this note has helped someone gain even just a little piece of knowledge in the matter.
Thanks for reading!
 Satoshi Nakamoto, 2009. P2P Foundation, http://p2pfoundation.ning.com/forum/topics/bitcoin-open-source.
 Multipl, 2021. S&P 500 Earnings, https://www.multpl.com/s-p-500-earnings/table/by-year
 ARK Invest, 2020. https://ark-invest.com/articles/analyst-research/bitcoin-myths/
 CNBC Television, 2020. https://www.youtube.com/watch?v=SmH1avX_RVc&ab_channel=CNBCTelevision
DISCLAIMER: *The above is not investment advice and should not be taken as such. These are personal opinions and they do not reflect the view of my employer*.