Counsel Views – Episode 12: Stu Morrow
Host: Stu Morrow: Chief Investment Strategist, RBC PH&N Investment Counsel
This episode of Counsel Views features a special webcast with Stu in which he insightfully and incisively decrypts one of the most fascinating and confounding – not to mention contentious – new assets to arrive on the financial scene in decades: cryptoassets.
Since the introduction of bitcoin by the mysterious entity known only as Satoshi Nakamoto, cryptocurrencies and cryptoassets have been both praised and condemned while they have soared, plunged and soared again in value. Stu provides the context needed to understand and appreciate these exciting digital entities, as well as providing insight on the underlying technology upon which they function (blockchain), their place in portfolio management and investing, and what might lie ahead.
Hello, and welcome to the RBC PH&N Investment Counsel Webcast, Decrypting Crypto Assets. I’m Stu Morrow, Chief Investment Strategist at RBC PH&N Investment Counsel. Thank you for spending some time with me today.
Bitcoin is a potentially transformative technology whose impacts may extend beyond its use as an investment. For its most ardent advocates, a belief that Bitcoin will change society is close to an article of faith. Conversely, there are many decided nonbelievers who view the current enthusiasm for Bitcoin as a speculative phenomenon. The financial world is starkly divided on this issue.
Please note that RBC Wealth Management does not currently provide any recommendations or solutions related to Bitcoin or other cryptocurrency assets. The following is our effort to summarize and clarify the many questions about what Bitcoin is and how it may be relevant to investors today, and is for information purposes only. In our view, any investment in Bitcoin should be considered speculative and volatile, meaning that investors should be prepared to lose all of their investment.
In the future, we’ll follow up with additional teachings about Bitcoin and other cryptoassets for those of you who are interested.
Let’s get going with what the agenda will be for today.
So there’s a lot to get through. I’ll make sure to touch on each one of these points as I move through the presentation. So let’s get started.
I think sometimes it makes sense to start from the beginning. In order to make sense of where we are and where we may be going. And being a medium of exchange is the quintessential function that defines money. And that’s what we’re talking about, the evolution of money. Looking at the timeline here (on this slide) of the history of different types of money, is the monetary media that really survived the longest was really the one that had a very reliable mechanism for restricting its supply growth. Money with a restricted supply growth is often referred to as hard money. And in each of the forms of money here on this slide served as a good medium of exchange for a period of time at which it is considered to be hard money to the available population, but it stopped when it lost that property. Usually as supply increased and it became less scarce. It’s an important thing to talk about, scarcity.
So here’s a slide consisting of two tables. The first table at the top compares and contrasts the characteristics of money across fiat currency, gold, and Bitcoin or cryptocurrency. You can see here that the fine characteristics of money along the left side, they’re not uniformly present with both gold and Bitcoin. And there’s still some questions about Bitcoin being instantly recognizable and acceptable. First of all, not many goods and services today are quoted and priced in Bitcoin or other cryptocurrency. So the digital currency is really not a universally accepted unit of accounting just yet. In fact, the price of cryptocurrency is quoted, and often in fiat currencies, usually in the U.S. dollar. So ultimately, crypto’s no different from other stuff that is priced off the dollar and stands at the opposite side of money in a transaction.
Intrinsic value is sort of the last question mark there for cryptocurrencies and Bitcoin. And we left that as a question mark, and here’s why. Some might argue that there is intrinsic value and the ability to process transactions. Think of Western Union, SWIFT, and those types of companies that are intrinsically valuable in their own right.
Of course, Bitcoin’s intrinsic value makes up a small portion of its actual value. But some might agree that it has no intrinsic value actually.
On the other side of it, the argument around intrinsic value is in the energy used. The energy expended in this cryptocurrency mining, which we’ll talk about in a bit, used to create new coins and newly minted coins, and that almost certainly sets a baseline value for some people when we talk about intrinsic value.
As functions of money in the bottom table, clearly it’s still early days for Bitcoin and cryptocurrency. And compared to fiat currency as a unit of account and medium of exchange, are still ways to go. I’ve left store value also as a question mark for now as it’s not quite clear if it’s indeed going to hold up entirely. And keep in mind that for something to be of store value it has to have three things. One, it has to be liquid, it has to be universally accepted, and hopefully have a stable value.
Gold fits most of those criteria, although its price can vary, of course, widely with different fiat currencies.
This is kind of a funny cartoon with a really clear message that’s we’re usually, as human beings, quite resistant to adopting new technologies, and it really does illustrate a lot of the resistance we have to what we’re talking about today. Right? Blockchain technology, Bitcoin. Of course, this sort of behaviour didn’t run its course through the Stone Ages.
If we think back to the early days of the internet in the 1990s it was a pretty hard-to-explain concept to most people. Even though it’s really commonplace now to think of electronic mail and being able to surf endless amounts of information without using an encyclopedia, at the time that was quite foreign. And when the dot-com era commenced in the early 1990s, companies weren’t quite sure what to make of the internet, only that it did represent something big and a big opportunity.
Investor interest, as we all know, was quite big in the material at the time. But questions still remained, which were how do you monetize applications for the markets that don’t yet exist. Will there be one dominant player? Will there be one killer app? Or will there be thousands? And a lot of those same questions and the same resistance to blockchain technology are very similar to what we saw on the internet in the 1990s.
So just some background. Something to keep in mind as we talk through the presentation is to have a balanced, open mind when it comes to this new technology. We do have a natural behavioural bias towards being dismissive and I just want us to keep an open mind as we kind of go through this.
So let’s dig into blockchain technology before covering off some basics around Bitcoin itself.
It’s important to get an understanding of blockchain technology in order to understand the mechanics of Bitcoin and other cryptoassets, actually. So we’ll begin with a briefing on the purpose of this technology. We’ll talk about the economic advantages, the disadvantages, and we’ll also do a really brief illustration as to how the process is actually working to add transactions to a blockchain.
So blockchain technology also goes by the name sometimes of digital ledger technology. And it was designed to digitize the financial system. So think of wire transfers, peer-to-peer, business-to-business, doing it with ease and without anyone in between.
And the philosophy behind blockchain technology is built around this 100% verification and zero percent trust type of mentality which came about and was sort of executed post the great financial crisis of 2008 and the Libor scandals which followed where there were entities that deleted or hid transactions.
People lost trust with third parties. They wanted a distributed ledger system instead. Trillions of dollars of debt were abolished and transferred to the government via quantitative easing (QE), which you know. But at the end of the day, the creators of this blockchain and the philosophy really took issue with the fact that someone or some entities decided that this was the way it was going to be. And this sort of removed the accountability from a financial system that they wanted to be in place.
And blockchains make all transactions public. Right? It’s an important thing to remember. Its purpose and point of being is it removes intermediaries. It’s decentralized. But in order to be decentralized, you need to do a few things.
You need a reliable way to verify that transactions are actually real. You have to create a way to time stamp transactions. You need to ensure that nothing can ever be deleted from the record and build the sort of trustless system, and it can’t be any central authority which will limit the risk of corruption to the database.
So that’s sort of the background and purpose. I’ll talk about now, the economic advantages and then the disadvantages for blockchain technology.
So the first economic advantage really has to do with settlement. And blockchains, such as the Bitcoin blockchain, provide a massive improvement over existing settlement paradigms. Operating a relatively low-cost 24/7/365 type of market. And consider this. On April 12th of 2020, someone on the Bitcoin blockchain transferred [audio gap] 500 bitcoins, worth about U.S. $1.1 billion at the time, in one single transaction that settled in ten minutes for the processing fee of $0.68.
Now it’s pretty remarkable because we all know what banking wires would require. This usually only happens during banking hours. It takes one to two days to settle and have transaction fees ranging from 1% to 8%.
So the efficiency gains are real. Of course, they don’t translate into everyday purchases like buying coffee with crypto. There’s lots of things to consider like tax. There’s price volatility. The user experience. The delay in transaction processing time today would make those sort of everyday transactions sort of impossible, i.e. there’s a scalability issue with the Bitcoin blockchain.
But that being said, I also want to point out that cryptocurrencies are being adopted even more rapidly in emerging markets than in developed markets.
So outside of developed markets like Canada, the U.S., and the UK, countries with the highest cryptocurrency adoption, the highest trading volume and largest mining activity are mostly in emerging markets.
Also, central banks see digital currencies as a way of addressing inefficiencies in the payment system in emerging markets where bank penetration is much lower than it is in developed markets.
So their use in small-scale trading and remittance transfers from workers abroad to home are really sort of at the heart of what’s going on in some of the emerging markets. Central bank digital currencies, which we’ll probably allude to later on, but could also facilitate getting social transfers to the poor and improve transparency to large, informal economies in some emerging markets.
So very positive economic growth considerations for some blockchain technology with emerging markets.
The second economic advantage I want to talk about is this idea of creating a scarcity in property rights in a digital world. Because the underlying blockchain database is available to everyone, it’s distributed without being controlled by anyone. It’s decentralized. Cryptoassets can provide ownership guarantees that were previously nonexistent in the digital world.
So the idea of cryptography behind this, the secured math behind the database in blockchain, makes sure you have ownership of digital property rights without any intermediary verifying ownership for you. So you can verify the Bitcoins that you own. You don’t need someone to do that for you. It’s sort of rare in a digital world.
The third economic advantage we’ll talk about is this idea of digital contracts. Smart contracts. It’s sort of the—I think the long-term opportunity when it comes to blockchain technology. It revolves around this third economic advantage which is this idea of cryptoasset-powered blockchains allowing users to effectively program money with certain rules and conditions as you would program any software. And the sort of idea of “digital smart contracts” can be created, reviewed, enforced easily, instantaneously with virtually no cost.
So for single transactions between two parties, programmable money can give the payer and payee a vastly greater range of parameters used when exchanging value. It also enables a huge array of different valuables to be exchanged, far more than conventional money. So things like time, contracts, expertise, goods and services can all be traded.
The potential applications for self-validating transactions using the smart contracts is practically limitless. And I think this is sort of the long-term view of where we’re going with blockchain technology. Quite exciting stuff.
So some of the economic disadvantages. And you sort of hear these advantages quite often but what are some of the disadvantages?
And here there’s this idea of redundancy. So as we’ll show when we walk through how a blockchain transaction actually goes down -s having to record every transaction with every member of a network is very costly with only the purpose of removing an intermediary.
So the most efficient payment processing systems are all centralized for a good reason. Right? It’s cheaper to keep a central record than to keep several distributed records and have to worry about updating them all in sync.
So redundancy is an issue. Scaling. Scalability. There’s a clear trade-off between scale and decentralization. The Bitcoin blockchain can process about seven transactions per second compared to over 50,000 per second for Visa.
The common ledger approach to blockchain means that the ledger grows exponentially faster than the number of network members.
Computational power and storage become very immense over time, having a very decentralized database that you have to keep updating.
There are potential fixes in the works for this, the scalability problem. Lightning network, larger block sizes, for instance. But they’re not today and they’re not for certain.
Regulatory compliance. I think it goes without saying that operating in a regulatory heavy environment (banking, law) is complicated, to say the least. Be very difficult to see a world in which regulatory compliance doesn’t play a role in blockchain technology, in the future of Bitcoin and cryptoassets as well.
Irreversibility. So an interesting part of the blockchain technology is if we think about things like payments, contracts, or databases today that are operated with intermediaries. Human or software errors can be easily reversed by appealing to the intermediary. But once a block has been confirmed and new blocks are being attached to it, it’s only possible to reverse any of the transactions by marshaling basically 51% of the processing power of the network. So it’s almost impossible. And the easiest way to think about this irreversibility is, what happens on the blockchain stays on the blockchain.
Everybody joining the Bitcoin network de facto agrees to this existing consensus rule. So important to note.
The last thing I’ll talk about is security. So security is entirely reliant upon the expenditure of processing power, energy on verification of transactions and this concept of proof of work which I’ll talk about.
So for the Bitcoin blockchain, for instance, to be secure. Verifiers spend huge amounts of processing power and have to be compensated with a currency of course. We’ll talk about Bitcoin itself. And it really is to align the interest of both the network—the health of the network - and the longevity of the network. But security comes at a cost, and we’ll talk about that too. Expenditure of energy is something that is a bit of a headwind for Bitcoin and blockchain today.
So those are economic advantages and disadvantages. Let’s talk a bit how a transaction actually goes down in the next couple of slides.
So on this slide, at the top, there’s a common definition of what the Bitcoin blockchain is. I bulleted each of the key concepts behind blockchain technology just below it. So these are kind of critical to understanding what the blockchain technology is, how it can be trusted, and what purpose it serves.
So in terms of the slide’s topic= so distributed- so any computer in the world can access the Bitcoin blockchain. Very transparent. Cryptography is the secure. The science behind the communication. Every transaction on the blockchain must be cryptographically verified. Transactions are not added one at a time; they’re added in blocks. They’re chained together, hence blockchain. It’s an automated system based on the math behind the protocol which, since its existence, has actually proven to be completely secure.
So (again, what I said on the last slide); whereas what happens on the blockchain stays on the blockchain, you can only add transactions in an append-only format; you can never delete or remove transactions from a blockchain.
Proof of work is kind of an interesting one that we’ll talk about on the next slide, but it’s really about how the distributed computers on the network agree on which group of transactions will be appended to the blockchain next.
So computers are miners. We’ll use this term intermittently. They basically compete to solve a very complex cryptographic puzzle that will allow them to add a block of transactions to a blockchain, which I’ll cover in more detail on the next slide. And while there are other various forms of verification out there - there’s proof of stake, for example- no mechanism today has yet to be as reliable itself as—in terms of a security- as it’s a proof of work that the Bitcoin and blockchain uses. There are more advanced cryptocurrency protocols using a mix of different consensus and validation mechanisms, but the technology is still in its infancy and it requires, still, substantial vetting before it can be considered reliable.
let’s show a simple illustration, a basic overview really, of how a Bitcoin blockchain transaction is completed in about five steps. There are more intricate concepts behind the cryptography and the flow of transaction processing, but this should really give you a very high-level overview. And I’ve overlaid three of the blockchain functions on a previous slide, so you can sort of visualize where they come into play here. So you start with step one. Every transaction is sent to a transparent queue that is sitting there waiting for approval to be added to the chain, which occurs, the blockchain, about every 10 minutes there’s a new block added. Computer miners - (This is an automated fashion. No one’s sort of typing in anymore and doing this activity themselves.) - they get to pick which transactions to include in the next block that will be added to the blockchain. In the case of Bitcoin’s blockchain, miners will look at the ledger to make sure of three things: one, the money being sent is actually there; two, it’s being sent by the rightful owner; and three, it’s not being double spent.
That takes you to step two. A miner then packages the transactions they’ve selected and reviewed it from the queue into a cryptographically secured data package known as a block, and each block can represent about 3,500 transactions or so today. Each block is mathematically linked to the most recent block which forms a chain. But before they broadcast their latest block to everyone else on the computer network (that’s decentralized, a distributed network) miners have to solve a cryptographic puzzle. The one that forces them to use a lot of electricity and energy in order to solve it. So think of a very complex math puzzle. The miner who solves it by step three, the miner who solves the problem first, gets to share their findings with the rest of the network where it’s then double-checked by other tens of thousands of computers in the network.
If the work was honest, that waiting miner with that block will get paid a combination of both transaction fees from the transactions they’ve selected to be included in the block, and a share of newly minted Bitcoin as well. If the work was not honest, (they were perhaps amended previous blocks or to the blockchain) [audio gap] wasted energy on trying to sort of go to the pass and change the It wouldn’t be very economically advantaged too, to spend money on a dishonest transaction. So there’s a bit of an alignment there between expenditure of energy and proof of work. So it’s quite interesting.
Takes us to step four. So once that’s done, the other sort of tens of thousands of computers, or these so called nodes on the system, they validate the transaction block. The miner of the node, or the computer that solved the cryptographic puzzle, gets the newly minted Bitcoin. The reward built into the network protocol.
And that brings you to step five. The block is then added to the existing blockchain and the transaction is then considered completed and irreversible once the next block is added on top of it, which would be in the next 10 minutes.
And that process continues on and on and on and has been happening since the Bitcoin blockchain has been in existence.
So that’s a ton of information. I know that it still goes a little bit over my head at times, so it does take some getting used to, the terminology, but that is a basic understanding of a flow of how a Bitcoin blockchain transaction will work.
So let’s now turn away from blockchain. Let’s focus a little bit more on Bitcoin itself. So rather than sort of holding an entire webinar on Bitcoin, (which we can do and which we’ll do more detail later) let’s go through not the nuts and bolts - but talk about three things. Let’s talk about the supply, which is an important thing to understand. Let’s talk about this concept of zero barriers to entry for cryptocurrencies and Bitcoin itself. And then we’ll talk about is this a Ponzi scheme or not? Which has been a typical question that we got.
So limited supplies equals scarcity. Bitcoin does differ from traditional currency which doesn’t have a theoretical cap on the amount of the currency that may be circulated to the public. The popular narrative of crypto promoters is that Bitcoin’s value is guaranteed because of its limited or finite supply. And this really does play well into the fear over central bank quantitative easing, Modern Monetary Theory, MMT, and the public trepidation really over what these monetary policies will bring to fiat money in the future.
And this vein (sort of the rise of cryptoassets, in a sense) echoes this anti-government/antiestablishment movement in society at large. Which may have started since the financial crisis. But nonetheless, the limited supply of Bitcoin (which is only 21 million will ever be created) does create a narrative of scarcity which is sort of rare in this environment of we’re talking about money and monetary medium. So important to understand.
But in the next slide, we’ll talk about the various ways that you could think about this new cryptoasset as having zero barriers to entry. So, today you may have noticed there’s literally thousands, over 5,000 cryptocurrencies out there. And by the way, there’s been a few thousand which have already sort of failed and gone to zero and been deleted from the record. So this isn’t accumulative. This is sort of net of what has already been abolished from the blockchain technologies.
But this idea that there is zero barriers to entry is actually no surprise, right, given the building blocks for blockchains are available to anyone with a computer. It’s via open source code. There’s no patents. There’s no secret technology. There’s no secret sauce. The value of Bitcoin, therefore, is what?
It is directly linked to a couple of things. One is the network size and the computing power used to secure the network. And the adoption of Bitcoin itself is, as a form of currency across the world in its various forms. But despite having zero barriers to entry, there is some sort of value to Bitcoin itself, which would be things like it is a well-known global brand. When you say Bitcoin, most people recognize what that is, that it is in and of itself something and it trades on exchanges and countries around the world.
I think it does have sort of a first-mover advantage as well (that could definitely be lost in time) as the dominant digital store of value to another cryptocurrency that has perhaps greater practical use or technological agility. Maybe that’s Ethereum. Maybe it’s something else. But it is also supported by a pretty robust and growing network of custodians, liquidity providers, institutional investors, and private investors. It’s integrated into hundreds of applications and it’s really coveted by millions of investors around the world.
The Bitcoin blockchain, to talk about value, is also secured by the largest network of computing power anywhere in the world. Larger than the most powerful supercomputer ever put into existence. The idea also too that this network is supported by an entire ecosystem of mining companies, chip manufacturers, and investors also does sort of give it some sort of longevity in that sense. Whereas any new cryptocurrency, the other 5,000-plus out there, really don’t have a lot of that. They don’t have the liquidity, the computer processing power, the security of the network. No clear regulatory structure. No global brand that Bitcoin has. And I like to think of this analogy like duplicating the software code that powers Facebook would be pretty relatively easy to do but recreating the network that makes it one of the most valuable companies in the world today would be extremely difficult to do.
Similarly, cryptoasset-powered blockchains are proprietary networks that are formed around nonproprietary software. So just another way to sort of think of that value as ‘what value does this have in a zero barrier-to-entry environment’?
So the other question we’ll talk about Bitcoin before we talk about some portfolio management applications or potential is, is this a Ponzi scheme? This is a common question people have. We’re talking about two difficult subjects here, technology and money, for all of us. And you combine them and it just sort of exponentially grows.
But I think what we’ve done is sort of laid out the traditional Ponzi scheme characteristics on this slide., My takeaway is I don’t think it’s a traditional Ponzi scheme like Madoff or Allen Stanford as two examples. Based on the typical characteristics of a Ponzi scheme, laid out here, it doesn’t appear to be one. It could be naturally a current Ponzi scheme, (which most academics would refer to as an asset bubble the greater full argument perhaps), which in academia is just really the same thing as an asset bubble. So traditional Ponzi scheme? No, for sort of the reasons outlined here. But could be sort of a naturally occurring (what is an) asset bubble itself.
So let’s talk about how Bitcoin might fit into a portfolio. So it’s important to highlight that in a relatively short period of time the narrative around Bitcoin has changed quite a bit. Look at the slide here in the early days, sort of the bottom left of the graph. Bitcoin has really promoted this narrative around this payment-enhancing technology, which then quickly moved to a currency, and then store of value, and then back to scarcity. And the more recent narrative about Bitcoin being perhaps considered digital gold, or a substitute or a complement for gold, has certainly been borne out of the fear of increasing easing global monetary policy, inflation fears.Certainly the fear factor around quantitative easing, increasing government deficits, government debt loads and, therefore, runaway inflation. That all builds into the scarcity narrative. That has sort of helped propel Bitcoin (amongst other things) into the future.
So with it having a scarcity value with a limited coin supply which we’ve talked about, you can see how there’s appeal here in holding this as a hedge of sorts against inflation. That’s not entirely the story though, however. But certainly the drivers behind price swings in Bitcoin are more plentiful than simply inflation fears alone.
And on the next slide, we’ll talk about which asset class this belongs in, because I think that’s an important part of when we think about our portfolios. When we think about this in the future, where does it belong? What is this? So what is it? A currency? Is it commodity? A bit of both? It’s kind of weird to say, but after more than a decade of being in existence (Bitcoin) there is probably finally some consensus as to what it is.
Most hardcore Bitcoiners out there, they liken it to digital gold. It’s a safe haven asset whose primary use case is holding. And even people who aren’t so into it, more or less accept that narrative today. Barely a day goes by where we don’t hear of some legendary investor opining on TV or social media saying something like, we believe in Bitcoin and it’s an emerging store of value which, like gold, can play an important role in a diversified portfolio, et cetera, et cetera. No one talks about, however, it’s not used in day-to-day transaction or how it’s too slow or too volatile to be useful as a currency. That all may be true, but those are sort of all talking points.
By and large, the sort of hold-on-to narrative has become the norm today. Which sort of makes it more this sort of commodity than a currency. Most people scoff at the idea that something so volatile could be considered a haven. After all, it’s had numerous drawdowns of 50% or more, including the more recent bear market which we’ve seen the currency or the commodity enter into.
On the other hand, you have to give it some credit. So it’s a nearly $1 trillion asset, which has basically been memed into existence despite being backed by nothing. When someone jumps in and says (you know sort of) I’m wrong, that Bitcoin is backed by electricity and math. That may not be true, right? Bitcoin’s network is secured by electricity and math, yes. Being secured is not the same as being backed. And you’re not entitled to redeem Bitcoin for anything in reality. So as per the slide here, the traditional definitions, I’ve put it more in the commodity camp than the currency camp. Certainly the demand/supply functions of Bitcoin resemble a very fixed supply, variable demand pricing model which we’ll talk about at another time perhaps.
Before we talk about how it may fit in to a portfolio, I think it’s important to talk about what influences the price of Bitcoin. As in the case of all other commodities, supply and demand drive Bitcoin prices. So to understand why Bitcoin prices move today and how they could behave in the future, any analysis really has to start looking at the underlying supply/demand conditions for this commodity.
And so for starters, it’s worth noting Bitcoin supply is capped. We’ve talked about that, the 21 million. It’s designed to become increasingly constrained over time. Also by construction, the cost of Bitcoin mining features prominently in price discovery, particularly energy. A quick look at the dramatic price increases we’ve seen in the past few years quickly points to that supply/demand imbalance that I’ve mentioned a few times. While Bitcoin supply is extremely transparent (we know that it’s based into the protocol, the math behind what’s happening on a blockchain), the demand can be rather opaque. So, therefore, what are people using Bitcoin for today as proxies? What are the demand drivers, for instance?
And you think of a couple of things; could be a measure of utility, activity levels on the network, as a medium of exchange. Could be used as a proxy to estimate demand,-one part of demand. Store of value, that’s a difficult one to proxy, though. You could look into blockchain signals that show how larger holders of Bitcoin have been doing. More buying than selling recently relative to smaller accounts. So, as a store of value, one can say that larger account holders are accumulating rather than selling. So watching on-chain behaviours is another way of people to proxy the store of value demand.
And there’s another measure of speculation. I found a simple Google Search Trends, which does have pretty good correlation, not necessarily implying causation. But there is definitely instance of estimating a percentage of the speculative part of Bitcoin prices by using a simple search like Google Search Trends is kind of interesting.
Let’s talk about it from a portfolio context, sort of the easy math, which we’ll talk about why this isn’t so easy. But if we look at this slide (looking at historical returns), we start off on the left-hand side charts. We show two hypothetical portfolios here. First is a traditional balanced portfolio made up of about 60% equities and 40% bonds. And the second is the same traditional balanced portfolio with a 2.5% of Bitcoin sort of taken out from both stocks and bonds. And clearly, if you look at the annualized returns between, the difference between the portfolio with and without Bitcoin, the 5%, there is quite a difference in terms of absolute relative returns relative to the portfolios given even a small amount of Bitcoin added in there.
And consequently, if we look at the other side of that chart and we look at annualized standard deviation, which is a measure of risk, we can see that the Bitcoin portfolio, the traditional portfolio with 5% Bitcoin, does have a little bit more risk, but not incrementally so relative to its return.
And if you look at the right chart (and it’s called a Sharpe ratio, which is really just a measure of excess returns over risk, so it’s kind of return per unit of risk that you get), you could see how even that 5% of Bitcoin really did add something great to the portfolio and did improve the relative performance in terms of excess return.
So that’s great news for investors, but there’s one problem with this, of course. These are historical returns and risk measures. And when you buy something today, you obviously don’t buy the past returns, so you buy the forward returns. And when we build and manage portfolios, we look at historical measures of return, risk, and also the correlation, the covariance between different assets in a portfolio and how they may react at different points in a cycle, as well as forward return and forward risk expectations. And given Bitcoin’s limited trading history and really volatile return profile, over a very short period of time, it’s very difficult to come up with any reasonable forward-looking expected returns and risks for Bitcoin at the moment. So that process may evolve over time, but for now, it’s not a part of our investment process.
In the next three slides, I’m going to highlight really about Bitcoin volatility. Which you’ve heard about, you’ve read about, you maybe have experienced yourself, so this might not be news. But here on this slide, we’re showing the difference in daily volatility between Bitcoin (which is the blue line), the 10-year U.S. Treasury bonds (in the green line), and U.S. stocks (in the sort of dark-blue or black line) back to 2015.
And you could certainly take away from a number of things, but the obvious thing is sort of the magnitude of difference in terms of daily volatility. A higher number means price swings are more dramatic than a lower number. It’s important to keep in mind that the ride to very extraordinary returns has really not been a smooth one.
And this is another way of showing that sort of less-than-smooth ride. On this chart, we show from 2012 the historical drawdown, or price declines in Bitcoin, from an all-time high price. If you go back to the first half of this chart (kind of look at the drawdown experience from 2013 to 2016), it was certainly a very tough period for someone who bought Bitcoin in around the 2013 period in the last quarter. Similarly, after reaching a peak all-time high price in 2017, that drawdown experience continued for another two years before recovering a gain in 2020.
So the takeaway, again, is if you look at this, the ride to extraordinary gains has not been a smooth one, but certainly, if you’re buying Bitcoin anywhere near this sort of high time, has led to these long drawdown periods which take perhaps a few quarters or years to resolve themselves, which may not always happen. I mean there’s no guarantee that something sort of continues on its upward trajectory in any asset class.
And the last one to consider is the performance of Bitcoin (in a gold colour) relative to the performance of the U.S. dollar or cash. And gold itself and U.S. stocks over the COVID-19 market sell-off period that we went through in 2020. And while part of the Bitcoin narrative has been that its portfolio diversification through uncorrelated returns with traditional markets that certainly wasn’t the case during a major market selloff like we saw in 2020. And instead of acting as a store of value, or digital gold in a sense, Bitcoin declined some 53%, from March to February, a very short time. But nonetheless, we have to talk about it. Versus U.S. stocks which were down 34%; Canadian a little bit less. You know, gold has held about flat and cash was, of course, king for a very short period of time.
And the takeaway from this is Bitcoin certainly has become part of a risky asset framework and it shouldn’t be considered a safe haven asset, certainly during periods of heightened market volatility as we’ve seen in the past. The future may be different, of course, but if we’re looking at the past, that’s what we would say. Yes, it did rally back from this and so did stocks as well, but during periods of market selloff, it’s important to consider this in a portfolio context.
So let’s talk about some of the risks. Before we get into a specific risk, let’s talk about the risk of putting money into Bitcoin today despite the correction that we’ve seen happen in the last few months.
So this chart looks at asset bubbles of the last 50 years or so and they’re annualized price changes over time. And what stands out for me here is the sort of steep rise of Bitcoin since 2015 as noted by the black line on the chart. And the price appreciation has certainly been steeper than any other period of market bubbles in the past. So I’m not saying that it’s a market bubble, but we’re going to compare it to periods of market euphoria or certain amounts of market greed over fear.
And this chart only goes up to December 2020, and has since corrected for Bitcoin, of course. But ultimately, it’s head and shoulders above where previous market bubbles were. And again, not to say this is a bubble or it’s popped or whatever, but rather, a good reality check to think about compared to past periods of market greed and fear.
So let’s talk about additional risks here. I won’t go into all of these, of course, but there’s certainly more prevalent risks here today with Bitcoin that we’re experiencing. Two things to address is one that doesn’t get much coverage, is this idea of concentration of ownership which is a real risk to the current narrative either as a payment vehicle or as an investment. About somewhere between 90% to 95% of Bitcoin today is controlled between 2% to 3% of all the accounts. And one of the main challenges that Bitcoin faces to gain mainstream adoption going forward is this high concentration ownership ratio. So the distribution is heavily skewed towards the largest Bitcoin accounts on the blockchain. If we compare this to the Fed data that suggests that the top 1% of Americans control 30% of all household wealth. That seems a little bit more distributed compared to Bitcoin. The fact that such a small percentage of accounts hold most Bitcoin in circulation makes it sort of less than a practical use as a mechanism for payments or perhaps even an investment vehicle.
On the other hand, actually, this limited breadth of ownership could, in theory, push the price higher in a sense that there’s one more person to sort of still buy in, that this distributed breadth still has a ways to go is one argument or another way to think about that.
I mean the other risk to think about is this idea of sort of systemic risk given unregulated markets. And I think at the date of this, when we’re talking here today, this—at one point Bitcoin and cryptoassets were close to a $3 trillion market. We’re about U.S. 1 trillion now at the time of speaking.
But there’s additional undisclosed leverage in the system that likely still has the eyes of financial regulators but does have a certain degree of systemic risk attached to that today. So that’s something that we’re monitoring. I think certainly as adoption grows and institutional investors and individual investors become potentially more exposed here, this takes on a greater degree of systemic risk that we as portfolio managers and strategists continue to think about.
And the last risk here on this slide is ESG, environmental, social, and governance, and sort of deserves its own sort of whole webinar but we’ll talk about in the slide. So in contrast to the relatively low carbon intensity of central bank, digital currencies, or fiat, ESG-minded investors like ourselves, we pay close attention to the environmental costs associated with cryptocurrency mining, Bitcoin mining.
We’ve covered off in the discussion about blockchain already, the reliance on these specialized computers that race to solve very complex equations that make quintillions of attempts of a second to verify transactions through “cryptomining” makes the whole process very energy intensive.
Researchers at the Cambridge University estimated a few years ago that mining Bitcoin, the most popular blockchain-based currency today, uses more electricity than entire countries such as Argentina. And these are estimates, of course, but on this slide here we’ve provided various estimates for equivalent energy footprints or carbon footprints for various Bitcoin transactions. Certainly something that does need to be kept in mind.
Perhaps the most environmentally concerning developments, of course, when it all comes to Bitcoin, is where most of the networks hashing power or computing power sits. Most mining pools suggest about three-quarters of Bitcoin global mining occurs in China; unconfirmed reporting of mixed renewable/nonrenewable energy sources used there. So there’s certainly a degree of the Bitcoin story that has suffered recently as the environmental impact of mining has become more mainstream.
And the way I see it today, is for sustainable higher Bitcoin prices itself, the network will need to do a couple of things. But one, I think ensure that the message around energy consumption efficiency is better understood. Proper follow-up studies to perhaps like the Cambridge University Institute study needs to be done and likely needs to be proved out with definitive studies that the network has been or will run off of cleaner energy sources versus nonrenewable energy sources.
The optimist in me believes that if Bitcoin does have staying power, that the innovation in energy consumption and green energy will come and that’s certainly something that there are companies out there today that are looking to take advantage of today.
The last slide, which I kind of put up here as a number of reasons, but I think it’s important to point out there are many unknown future cases for Bitcoin blockchain and cryptoassets that certainly I can’t come up with. But I think the first two are kind of ones that will put a couple checks in my year-end to-do list, but I think there’s certainly like more to do around U.S.-based exchange rated funds with Bitcoin and other cryptoassets similar to what we have already seen in numerous issues here in Canada.
There is certainly a paper that will be coming out from the Boston Fed and MIT on a Fedcoin, or a central bank digital currency, that may or may not have an impact on the Bitcoin ecosystem itself but will be something to look at.
And the longer-term issues of the sort of mainstream adoption may be a ways off or people getting paid in material numbers of the population in Bitcoin from their employers. It’s happening now in pockets but certainly not mainstream.
Green energy innovations. There’s certainly a lot of that going on in terms of putting more efficient energy, storage capacity, exploration on-site doing cryptomining along an oil-and-gas field, capturing flare gas for example. Companies like that exist today that are doing some great work. Those innovations may actually just accelerate our push away from fossil fuels and non-renewables. Perhaps Bitcoin blockchain can be used as the accelerant to converting the world to where we have to get to. So that could be a possibility for sure.
And, of course, there’s a bunch of tangential cases that we can’t define yet, ways that we would have thought about the internet. And thought about applications of the internet in the early 1990s would probably seem kind of ridiculous to some of us today. We may not have even thought of the applications we’re using today back then, so I won’t even go there.
But this wraps up what I would say is our introductory webinar on blockchain technology as a subject matter now. I hope it’s provided you with some basic understanding of blockchain, Bitcoin, how to think about this as an investment, perhaps a speculative investment as we said in the beginning. We look forward to, of course, providing you with future updates to this and other relevant investment topics as we go through.
And I hope you and your family have a very safe and happy summer break, and we’ll talk to you soon. Bye for now.
This presentation was recorded on June 16, 2021.
This presentation references investment benchmarks. An investment benchmark is a standard for measuring and evaluating the performance of investments compared to markets in general. Benchmarks show the performance over time of a select group of securities. Below is further information in respect of the benchmarks referenced in this presentation:
Bloomberg Barclays US Aggregate: The Bloomberg Barclays US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market. In addition to investment grade corporate debt, the index tracks government debt, mortgage-backed securities (MBS) and asset-backed securities (ABS) to simulate the universe of investable bonds that meet certain criteria. In order to be included in the Agg, bonds must be of investment grade or higher, have an outstanding par value of at least $100 million and have at least one year until maturity.
MSCI EAFE: The MSCI EAFE Index is an equity index which captures large and mid-cap representation across 21 Developed Markets countries* around the world, excluding the US and Canada. With 844 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. (*) Developed Markets countries in the MSCI EAFE Index include: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
MVIS CryptoCompare Bitcoin Index: The MVIS CryptoCompare Bitcoin Index measures the performance of a digital assets portfolio which invests in Bitcoin, prices from selected exchanges. Factsheets and a guide to the index can be found on their website: https://www.mvis-indices.com/indices/digital-assets/mvis-cryptocompare-institutional-bitcoin(Open in new window)
S&P 500 Index: The S&P 500 Index includes 500 companies across many sectors of the U.S. economy. The index is weighted by market capitalization so bigger companies make up a larger proportion of the index than smaller companies. The index is designed to measure performance of the broad US economy through changes in the aggregate market value of the largest US companies.
S&P/TSX Composite: Comprises the majority of market capitalization for Canadian-based, Toronto Stock Exchange listed companies. It is a benchmark used to measure the price performance of the broad, Canadian, senior equity market. It was formerly known as the TSE 300 Composite Index.
XBT USD Currency: A Bloomberg CFIX rate fixings are designed as reference points for Cryptocurrencies. As used in this methodology, the term "fixings" refers only to such Cryptocurrency fixing rates and not to any other rate, calculation or other information that may be related to, or associated with, such fixings that are made available by Bloomberg. Based on pricing provided by the Bloomberg Generic Price (“BGN”) using Bloomberg’s well-known data, technology and distribution platforms, CFIX is made broadly available to the investment community with the objective of providing Cryptocurrency fixings that are reliable, representative, and transparent for the Cryptocurrency markets around the world. Pricing sources are trading platforms that facilitate buying and selling Cryptocurrencies online. Many Pricing Sources refer to themselves as "exchanges," which can give the misimpression that they are regulated or meet regulatory standards of a national securities exchange. Many of the U.S.-based digital Cryptocurrency trading platforms have elected to be state-regulated 'money-transmission services'. Traditionally, from an oversight perspective, these predominantly state-regulated payment services have not been subject to direct oversight by the SEC or the CFTC.
NKY Index: The Nikkei 225, or the Nikkei Stock Average, more commonly called the Nikkei or the Nikkei index, is a stock market index for the Tokyo Stock Exchange. It has been calculated daily by the Nihon Keizai Shimbun newspaper since 1950. It is a price-weighted index, operating in the Japanese Yen (JP¥), and its components are reviewed once a year. The Nikkei measures the performance of 225 large, publicly owned companies in Japan from a wide array of industry sectors.
NDX, the Nasdaq-100 is a stock market index made up of 102 equity securities issued by 100 of the largest non-financial companies listed on the NASDAQ stock market. It is a modified capitalization-weighted index.
SH COMP: Shanghai Stock Exchange - The Shanghai Stock Exchange is a stock exchange based in the city of Shanghai, China. It is one of the two stock exchanges operating independently in mainland China, the other being the Shenzhen Stock Exchange. The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990 with a base value of 100. Index trade volume on Q is scaled down by a factor of 1000.
NBI Index: The NASDAQ Biotechnology Index is a stock market index made up of securities of NASDAQ-listed companies classified according to the Industry Classification Benchmark as either the Biotechnology or the Pharmaceutical industry. A list of the 213 components of the index is published online.
XAU Currency: A symbol for the Philadelphia Gold and Silver Index, an index of precious metal mining company stocks that are traded on the Philadelphia Stock Exchange.
S5HOME: US housing (S&P Homebuilders Select Industry Index) - This index is comprised of stocks in the S&P Total Market Index that can be classified as being part of the GICS (Global Industry Classification Standard) homebuilding sub-industry.
NY FANG Index: An equal-dollar weighted index representing a segment of consumer discretionary and technology sectors, made up of highly-traded growth companies such as Facebook, Apple, Amazon, Netflix, and Alphabet’s Google.
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