An Introduction to Cryptocurrency and Bitcoin
You cannot turn on a television, open a newspaper, or attend a social gathering without hearing about Bitcoin or cryptocurrency these days. What was an arcane concept a few years ago, is now gaining wider acceptance. Sandy Cove Advisors is certainly spending a lot of time getting smarter on the topic as it may have future investment implications for our clients. We thought it would be a good idea to delve into the subject with a few articles on the topic starting with this introductory piece.
Bitcoin made its debut in 2009 and has grown exponentially since. For example, in early 2017, Bitcoin was valued at a little over $1,000 per coin. As of April 2021, it has jumped to above $54,000 per coin. Cryptocurrency, and more broadly, blockchain technology have continued to gain popularity over the past decade. In fact, long-established Massachusetts Mutual Life Insurance Co. (MassMutual) purchased $100 million in Bitcoin for its general investment fund, an unprecedented move.1 We have seen J.P. Morgan, Goldman Sachs, Fidelity, and Deutsche Bank get more involved with Bitcoin as well, creating even more market acceptance.
Many investors are finding this new asset/currency to be an appealing alternative or an addition to portfolios based in traditional markets like bond and stocks. Let’s review the basic tenets around this new technology to develop a good foundation. It will be on that foundation that we will continue to learn where this nascent industry of blockchain can take us and why it’s important to understand the concept and application. This article will be the first in a series exploring cryptocurrencies, so look for more information in future Perspectives publications.
Blockchain: What Is It?
Blockchain is described as an incorruptible digital ledger of economic transactions. It can be used to record financial transactions or virtually anything with value. It works as a digital ledger keeping record of all transactions taking place across a peer-to-peer network in real-time. It can be thought of as digital gold or digital currency since it is not and never will be tangible (like dollars or gold). These peer-to-peer transactions occur over the internet in an open market, decentralized network. Thus, two people on the other side of the world with only two cell phones can exchange Bitcoin for a goods or services without involving a bank or a government institution. And they can do so securely.
How Does Blockchain Work?
Imagine the blockchain as a book of records with a countless number of pages. Each page in this book is referred to as a block that can be programmed to record virtually anything. The pages (blocks) are then created one after the other and chained together simultaneously, creating a chain of blocks referred to as the blockchain.
The various blockchain records are maintained on a large network of networks, meaning no single person or entity has control over the records' history. Every time new information is accessed and updated, the changes made are verified and recorded before being encrypted and sealed off completely, unable to be edited again. This time-stamped, append-only log today has over 680,000 blocks of data with a new block being added every 10 minutes. They are all secured by digital signatures, or cryptography, making them safe from adversaries.
Blockchain Use During COVID-19
Blockchain technology has been around for more than a decade, but in light of the recent pandemic, some experts believe it could be making its way into more mainstream uses. From virus testing to tracing vaccine distribution, blockchain technology may be the answer the pharmaceutical industry needs to address safeguarding records and sharing information across multiple channels - as described in a recent article by Coin Journal.2
Beyond the healthcare industry, government agencies and nonprofits may begin turning toward blockchain technology because of its ability to offer data in a transparent and secure manner. Nonprofits, for instance, may be able to use it to give donors peace of mind in knowing their funds are being directed where they should, and not to a middle man or other shady location.
Most people today are interested in this new technology because they have seen the eye-popping returns and want to participate! As the chart below shows, there has been massive market appreciation of Bitcoin versus other asset classes.
While cryptocurrency has been compared by experts to buying a brick of gold (due in part to its high price per unit), it’s important to still do your due diligence before making any investments.
Now that we have a base of what cryptocurrency and Bitcoin are, let’s turn to how it can be applicable to our financial lives. We highlight one singular cryptocurrency, Bitcoin, because it has the most worldwide acceptance of all cryptos. Below is a market shares of all cryptocurrencies as of January 2021. As you can see from the pie chart below, Bitcoin dwarfs all other cryptos in the market today.
Sizing Bitcoin in the Current Market
It helps to put Bitcoin’s value in perspective relative to other major investment vehicles worldwide. Below is an approximate value of bonds, stocks and gold markets relative to size of Bitcoin. While smaller than markets that have been around hundreds of years, it’s still big enough now at over $1 trillion that it cannot easily be displaced.
Bitcoin as a Store of Value?
Like gold, Bitcoin has a finite supply, so it’s considered a scarce asset. There will only ever be 21 million Bitcoins created. That number was coded into its existence. Today about 18.4 million coins have been mined and at the going rate they will all be mined by 2140. The last few million will be harder to mine as the blockchain grows and supplying cryptographic proof of work increases in computational intensity. If you have limited supply and greater global acceptance (demand), then laws of supply/demand hold true and the price should rise. That is the main case being made for Bitcoin today.
Also, like gold, Bitcoin has performed well during volatile market times like Brexit and most recently the bear market brought about by the pandemic. During February 2020, the S&P fell 34% and Bitcoin suffered a worse decline of 45%. However, Bitcoin recovered fully to pre-pandemic levels by May 10, 2020 while it took the S&P 500 another three months (August 16, 2020) to get back to pre-pandemic levels.
Bitcoin is still much more volatile than gold and the equity markets. The standard deviation (a measure of volatility) of gold is 15% today versus Bitcoin at 82%.
Bitcoin does offer a value benefit as a hedge against well-established currencies. If central banks are keen on creating monetary policy that devalues their currencies (like what the U.S. is doing today with massive stimulus & deficit spending) it may be prudent to keep some assets in a digital currency that is disconnected from central bank policy. We believe this dynamic is also driving the attraction to this alternative asset class at present.
Bitcoin as an Investment?
While stock and bonds will always be the mainstay of investment portfolios, the addition of digital currencies, like Bitcoin, may provide even further diversification. This is because Bitcoin has historically performed as an uncorrelated asset. The chart below shows that returns of Bitcoin versus U.S. equities only have a 27% correlation. While it may be considered an investment, it is not appropriate for everyone. Only those with a high-risk tolerance and a long time horizon would be candidates. Investing in any high-risk assets comes with the condition that it could become worthless so investors should size it appropriately (1-3% of total assets).3
BITCOIN versus TRADITIONAL INVESTMENTS
Source: Fidelity Digital Funds
Bitcoin as a Currency?
To be a currency, it needs to have five key attributes:
Thus, at first glance it seems to be a currency. It walks like a duck, and talks like a duck, etc. However, not all see it that way. Currently, the IRS deems Bitcoin as property and not currency. As such, any gains made holding Bitcoin are considered capital gains and taxed at the tax payer’s current capital gains rate. This makes it difficult to be a medium of exchange when you are constantly paying taxes on your currency!
In addition, we noted that Bitcoin’s price is extremely volatile, 4x more volatile than the S&P 500, making it difficult to use as a means of exchange. For example, if you are purchasing your new Tesla with Bitcoin and you have just enough to pay for the car, it should be a simple transaction. However, Bitcoin trades on cryptocurrency exchanges open 24 hours a day 7 days a week. If over the weekend, Bitcoin takes a dive (like a did a few weeks ago) when you are about to purchase your new vehicle, you could find yourself 20% short of the purchase price because the price of Bitcoin fell.
Today, Bitcoin is not legal tender and cannot be use to pay your taxes. It is also not widely accepted for goods/services (though we are seeing increasing vendors accepting it on a daily basis). Thus, it is hard to see it being a disruptor of existing global currencies, but it may be in addition to those currencies. As an example, engaging in a transaction using Bitcoin in Africa is much easier, faster, and sometimes, more trusted than a current government’s version of their currency which may be debased to the point of being nearly worthless.
Blockchain as the Great Democratizer: Google enabled millions of people to access information easily on the computer via their search engine. It may not sound noble, but it leveled the playing field for humanity to have the same access to information (no private schools or bus fare to public libraries are needed). In short, cryptocurrency can level an unfair advantage of having access to a third-party financial intermediary (bank, credit union, brokerage firm) for money movement or exchange. Removing the financial third-party enables billions of people to transact without the need for government enforced systems making trade and finance more accessible than ever before. Will we get to a point where we move away from the traditional trusting of an economic intermediary to the trusting of computer code and consensus? This radical shift is not one met with instant acceptance, we are in the middle (or the beginning) of this journey to determine Bitcoin’s merits/values, or not.
In summary, there are clearly growing opportunities for blockchain technology, which may benefit our lives financially as an investment or a hedge or in non-financial settings as well (supply chain management, digital identity, medical records). From just the financial aspect that most of this introduction discusses, we see a benefit to taking out the middle man and creating a decentralized network where peer-to-peer transactions can be fast, cheap, and global. It can provide economic freedom to the billion+ unbanked population of the world with just the use of a cell phone. That’s a powerful concept, but it’s not fully accepted practice yet.
We leave you with a working list of PROs and CONs regarding Bitcoin to help further frame the conversation. This list is not a complete list, but highlights some of the main benefits and concerns.