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THROUGH THE HYPE
Senior Investment Analyst
Feb 18, 2021
In our view, understanding bitcoin creates a foundation upon which to understand the rest of the cryptocurrency environment. While different cryptocurrencies have varying characteristics, the first thing to know is that bitcoin is a decentralised currency, but unlike traditional currencies, it isn’t backed by any government. Invented as a new way to transfer value over the internet without intermediaries like banks, bitcoin is backed by a decentralised ledger database and limited supply.
Bitcoin uses peer-to-peer technology, via an open network, to create an unalterable record of which account owns how many bitcoins. Unlike banks with different systems, bitcoin is a single, global ledger system, synchronised across the internet, where any participant can view the ledger at any time.
Bitcoin’s rules are set out in its source code, which, although freely available, is only understandable to software engineers. By having a distributed ledger, no single entity or group is able to alter the ledger. Today, over 40 000 computers around the world independently verify every bitcoin transaction. So, in effect, bitcoin is a way to transact.
Blockchain technology is what underpins bitcoin and while bitcoin’s source code remains static, people are continually inventing new use cases for blockchain technology. Eventually, we expect blockchain technology to underpin all global banking and financial transactions. The blockchain facilitates high-speed, low-cost, round-the-clock settlement of transactions. You can send bitcoin anywhere in about 10 minutes, while it takes days to transfer normal money internationally.
Perhaps the best way to think about it is as a form of digital gold. Bitcoin shares some key characteristics with gold: it’s untraceable, almost infinitely divisible, rare and not controlled by governments. Like gold, bitcoin pays no dividends or interest, nor do you earn interest on your holdings.
Where it differs is that there is a clear, finite number of bitcoins that will ever come into existence: 21 million. After that, no more can be created. Currently, around 18.6 million bitcoins have been ‘mined’, or 89% of the eventual total. Unlike gold, which has a 5 000-year history as a store of value and a medium of exchange, bitcoin has 12 years of history, during which prices have fluctuated widely.
New bitcoins are created through ‘mining’ when someone completes a successful authentication of a ‘block’ of valid new transactions. In plain English, this means that the people (computers) who work to keep the distributed ledger system running and trustworthy earn a small transaction fee (paid in bitcoin) for verifying a block, in much the same way that the bank charges you when you transact in normal currency. As the number of coins mined increases, so the rewards for doing so decline. The reward halves every 210 000 blocks, or about every four years. This means that the final bitcoin will likely only be mined around 2140.
We know that the number of bitcoins in circulation will grow at a slower rate than that of ordinary US dollars, for example, so theoretically, the US dollar value of bitcoins should rise over time. On top of that, just like gold that’s buried and lost, a material portion of all the bitcoins mined to date has been lost. More than 20% of the bitcoins in existence have sat unmoved in a single address for over five years. We thus estimate that 5-10% of all bitcoins have been lost. People who own bitcoins directly via bitcoin.com have no recourse if they lose a password. Trading platforms do offer the ability to retrieve passwords, but then they hold the bitcoins.
A key step on the road to wider investability of bitcoin and other cryptocurrencies will be price stability, which has not been evident to date. In our view, before the bitcoin price stabilises, there will need to be a few more greed-and-fear cycles. Right now, bitcoin is more a vehicle for speculation than a currency for transacting. If you buy something with bitcoin, the person you pay has little idea what that will be worth the next day. In our view, this instability limits its viability as a day-to-day currency.
With any limited commodity, human ingenuity finds substitutes when prices rise or supply can’t fulfil the demand. Think back to the days when whale blubber was a key source of light. In the same way, many new cryptocurrencies have emerged over the years, from Ethereum, (which is a contract verification system that establishes ownership guarantees) to Ripple (which processes transactions far quicker than bitcoin, but has less security for storing value) and Bitcoin Cash. Nobody knows for sure which cryptocurrencies will last, but we suspect that only a few of the around 7 000 currently active crypto-assets will truly survive and flourish.
With governments worldwide printing money at record rates, and most countries experiencing high debt levels, the attraction of cryptocurrencies as an alternative investment is becoming clearer. There are only three ways for governments to get out of debt unless they can grow well ahead of long-term gross domestic product trends: austerity, which doesn’t last in democracies as voters simply vote for different rules; default, which is generally a last resort; and inflation, which has historically been the standard option (think Reichsmarks or Zimbabwean dollars). Future normal currency inflation would be positive for bitcoin’s price.
Key from a societal perspective is that bitcoin is not a productive asset. When money is invested in equities for example, it funds productive assets that should create value over time. Like gold, bitcoin generates no interest and simply sits there. This means that bitcoin investments reduce the amount of productive capital in the world.
We should not, however, dismiss cryptocurrencies as an asset class. The history is too short to form proper conclusions around bitcoin’s role in diversifying a portfolio, the way gold offers diversification through generally being negatively correlated with stock prices. If they were to become an asset class on their own, and if they made up, say, 1% of the standard multi-asset portfolio, then cryptocurrencies could move towards a market capitalisation of over US$1.5 trillion, above their current ~US$1.1 trillion. Such a situation might justify a bitcoin price of around US$65 000 in future.
We’re seeing greater institutional interest in bitcoin each year, a sign that the tech is growing up and gaining wider acceptance. Among the concerns is whether the rules in the source code are truly unbreakable. For most people, it’s far easier to trust a physical bar of gold that you can hold than a piece of computer code that you can’t. But remember that most gold is held via exchange-traded funds, so investors rely on computers to record their investments anyway. The wide distribution of the ledger is the real security.
Governments can’t control bitcoin’s distributed ledger, which can make them nervous if things get too large. The risk of government intervention rises as the absolute size of the markets increases. We agree with legendary investor Ray Dalio’s view that if cryptocurrencies get too big, then governments will get involved.
There are many coin exchanges around the world, but Luno is the largest in South Africa. It is owned by Naspers, which provides a degree of comfort to participants. Globally, Coinbase is widely regarded as the best platform on which to trade your cryptocurrencies. Generally, the global prices are better than those in South Africa, and the fees are lower. Trading costs are usually a ~1.5% deposit fee and another 1.5% to get back into normal cash. Although trading fees are low, they’re typically hidden by a ~0.5% bid/offer spread.
The South African government has no rules against owning or trading in cryptocurrencies. Note, however, that profits made in this regard are subject to taxation just like if you were trading shares.
We maintain our long-held view that valuing cryptocurrencies is fraught with danger. One could value bitcoin relative to gold, relative to the velocity of money, or by using Metcalfe’s Law (which states that a network’s value is proportional to the square of the number of its users), the cost of new production (about US$7 000 per bitcoin) or the ratio of new coins to existing stock. What is clear is that none of these methodologies are academically defensible the way traditional methods to value stocks and bonds are, and the only way you’ll make money from holding bitcoins is if you can find someone else to buy them from you at a higher price than you paid.
For more information, readers can view the CFA Institute’s 64-page paper on the subject.
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