Commentaries

PMC Weekly Review – September 28, 2018

A Macro View: The Institutionalization of Bitcoin

When most investors are asked what they know about Bitcoin, their typical response includes references to money laundering, magical internet money, or a form of currency that is used by criminals. Although all of these may have been largely correct at one point in Bitcoin’s history, today’s environment has changed significantly. And going forward, Bitcoin may serve a much broader purpose and be recognized as a legitimate asset class for institutional and retail investors alike.

Most investors’ knowledge of Bitcoin is limited to mainstream media news articles covering crypto exchange hacks or wildly optimistic price predictions. Given the revolutionary technology that Bitcoin brought into existence, it is easy to understand why investors are excited and have such varying opinions.

To begin to comprehend Bitcoin, we need to understand the fundamental technology upon which it is built. In its simplest terms, Bitcoin is an internet protocol that governs how value is communicated over a communications channel. Before jumping into this new internet protocol, let’s briefly review another one that we have more experience with: email. Email is based on Simple Mail Transfer Protocol (SMTP), a widely used internet protocol that governs how email messages are sent and received, ensuring that our messages are sent to the correct destination and observable by only the desired recipient. Much like SMTP, Bitcoin is a protocol that allows us to interact with others around the world by transferring value, in a matter of minutes, to anyone who has a Bitcoin wallet! This is accomplished by network participants (Bitcoin miners) maintaining an up-to-date ledger of every historical and ongoing transition. This ledger is maintained on thousands of computers throughout the world, and to date, has never been hacked or compromised. This highly secure network creates a building block upon which participants can store value, send, and receive transactions. Just as SMTP and other internet protocols have built a foundation for the countless numbers of applications that we use today, Bitcoin is new protocol that enables a new way for people to interact, and a foundation for which new types of application can be built. The network is still in its infancy: How it will be adopted, used, and built upon remains to be seen.

Despite Bitcoin’s obscure past, it continues to grow in acceptance, as governments begin to introduce new regulations and institutions pivot to include it in their business model. One such example that may become particularly important in the acceptance and use of Bitcoin is the upcoming launch of Intercontinental Exchange’s (ICE) Bitcoin trading platform, Bakkt. ICE owns the New York Stock Exchange (and other global exchanges), but Bakkt will be its first federally regulated Bitcoin exchange, and its expected launch in November will make Bitcoin accessible to all institutional investors, most of whom have remained on the sidelines.

Regardless of an investor’s opinion of Bitcoin, history has shown that it can potentially provide diversification to a larger portfolio of traditional assets, as it is largely uncorrelated with these assets. Studies show that adding a 1% to 5% allocation of Bitcoin to a portfolio can help reduce its overall volatility and potentially improve its risk-adjusted return. Only time will tell how quickly institutional money managers will allocate to this new asset class once Bakkt launches in November, but if Bitcoin’s history is any sign of its future, it is likely to be an exciting ride!

Scott, Keller     
Portfolio Manager

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