PMC Weekly Review - November 17, 2017

A Macro View – Bitcoin: A currency, store of value, or simply a fad?

Technological innovations such as the blockchain, Bitcoin, and other cryptocurrencies have taken the world by storm. PR Newswire recently reported that total cryptocurrency market value increased to $200 billion in November, up from around $40 billion at the beginning of the year. Bitcoin, the largest cryptocurrency by market capitalization, is up more than 600% this year, with a market capitalization of approximately $130 billion. Note that Bitcoin exists only in digital form and was created in the aftermath of the Financial Crisis of 2007-2008 in response to the decision made by many central banks to expand their balance sheets by printing new money.

There are four main beliefs that make Bitcoin attractive to users and investors. Bitcoin offers the promise of lower transaction fees than traditional channels run by financial institutions; it is operated by a decentralized authority and therefore is out of the reach of governments; it cannot be counterfeited; and it cannot be devalued, since its supply is finite—only 21 million coins will ever be released, or “mined” (there were approximately 16,679,838 Bitcoins in circulation as of the end of last week).

It is not all hype, though, and Bitcoin’s climb has not been steady. Rather, it has been marred by weekly volatility as high as 20% and has been the subject of criticism from the likes of Warren Buffet and J.P. Morgan’s Jamie Dimon. In fact, Bitcoin’s survival risks are great indeed, as is the case for any new financial instrument. Its success relies heavily on its wide adoption across individual buyers, retailers, and private and public institutions. However, its disruption potential is great as well. Being able to quickly transfer money by paying only a fraction of the fees currently charged by banks is particularly important to emerging world populations receiving billions of remittances per year. It is in these countries where the adoption of Bitcoin is occurring at a much faster pace than in the developed world. Given its fixed supply, Bitcoin cannot be devalued, and in this sense it can be seen as a store of value, just like gold. In fact, Bitcoin mining activity has increased dramatically in Venezuela, a country that has faced massive hyperinflation in recent years. According to Horizon Kinetics, a well-respected firm in the value-investing world, purchasing Bitcoin is the equivalent of short selling the world’s currencies. Given that fiat currencies devalue, its view is that Bitcoin will be more valuable merely by staying still. 

Increased interest from both individual and institutional investors has fueled demand for cryptocurrencies, resulting in flamboyant returns. That interest also has caught the attention of many governments and regulatory bodies which, acknowledging cryptocurrencies’ disruption potential, have taken the first steps towards regulating them and, in a sense, tacitly accepting them. Investment manager Fidelity Investments is already mining digital currencies, and its employees can use Bitcoin in the company’s cafeteria. In addition, it recently announced plans to start tracking the digital currencies for its clients. New York-based money manager VanEck announced that it intends to offer cryptocurrency indices, and the Chicago Mercantile Exchange’s decision to launch Bitcoin futures in the fourth quarter of 2017 will enable investors to gain exposure to Bitcoin without actually owning it. In addition, the creation of a futures market has the potential to increase cryptocurrencies’ adoption as a form of payment by retail companies, like Walmart and Amazon, by mitigating certain hazards inherent to cryptocurrencies, such as counterparty, liquidity, and regulatory risks.

Given the disruption potential and the fact that Bitcoin is not correlated to any investable asset classes, Horizon Kinetics goes so far as to suggest that its clients add a small Bitcoin exposure to their portfolios. After running several success rate scenarios, it estimates the return potential of a Bitcoin investment could be as high as 1,000 fold. Investing just 25 basis points, or $250 of a $100,000 portfolio, could potentially produce a return of $250,000. Only time will tell what is in store for Bitcoin, but in the meantime, its asymmetric risk/return potential will most likely continue to attract investors looking to generate high returns that are probably correlated to nothing. 

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