How I Think About Bitcoin In Portfolios
It is a controversial asset class to say the least
As a previous portfolio manager of many years for various families and institutions, thinking about asset allocation and portfolio management is part of my DNA.
When Fig launched on September 25, we have received overwhelming amount of interest from various prospective customers, institutions, and investors. We are very thankful for our early supporters and are working non-stop on the next steps in our product roadmap to bring to you a suite of risk managed Bitcoin investment products.
One question that keeps arising is: why did you choose Bitcoin as the first asset for Fig's structured notes instead of stocks?
This is because I fundamentally believe Bitcoin would and should serve as a diversifying asset class in most investors’ portfolios. Let me explain why.
What I think Bitcoin is Not
It is helpful to begin with what I believe Bitcoin would NOT become.
I believe Bitcoin is not and will not be currency to be adopted by any country with strong sovereign power over its citizens. A country adopting Bitcoin as its currency will lose its sovereignty.1
Historically and until now, money and politics have rarely separated. In the eyes of a government, fiat currency is nothing but a means to influence the behaviour of its citizens within its military enforced sovereign soil. Taxes, currency base, distribution of fiat money, and recognition of legal tender are used to incentivize its citizen’s behaviour to influence the production of goods and services that the country’s elected leaders deem to be most important for the country’s survival. In the context of global trade, monetary system is used to influence production in areas that are valuable to other nations through trade.
Then What is Bitcoin?
If not a country’s currency, then what is Bitcoin? I think it is too binary to think that Bitcoin will either become a currency or not. That line of thinking does not take into account of its unique digital nature - it seems that most investors apply framework for evaluating gold to Bitcoin. Historically gold has served as an alternative money. But due to its lack of fluidity and arbitrary supply mechanic, its usefulness has been limited to an “inflation or chaos hedge”.
Bitcoin has several unique properties that makes it inherently different than gold, or any other asset in the world.
It is digitally scarce.2
It is an extremely fluid asset that can be transported to anywhere in the world without deterrence.3
It is a decentralized and censorship resistant ledger network that is theoretically more robust during times of stress.4
Bitcoin Use Cases
Given these unique attributes, Bitcoin is similar to gold but could play a more intimate role in the financial system. Like a fine wine, all it needs is time.5 I am looking at Bitcoin from a pragmatic lens in the context of investment portfolios. Below are some possible use cases of Bitcoin which I think are possible:
Bitcoin becomes a fluid collateral6 used by financial institutions in their borrowing and lending operations. Due to the Bitcoin ledger’s transparency and the fact that transactions cannot be deleted from the blockchain, using Bitcoin as collateral has its benefits of improved trust between counterparties. Because of its digital and transparent nature, one cannot rehypothecate Bitcoin. This significantly reduces risk of unintended leverage and makes the financial system safer. 7
It evolves into a parallel financial system that works in distress situations like wars and catastrophe. During times of hostility, financial systems are likely weaponized with unintended consequences. Bitcoin, without a centralized entity controlling the operations of the network, can operate even if nation states’ financial systems are either controlled or paralyzed. For example: sending units of value (Bitcoin) to family and friends in places of distress like Ukraine. Gold cannot serve this role.
It is a store of value. I know this sounds paradoxical. Money is nothing but a social contract with a set of expectations shared among a group of consenting participants. For example: my fellow Canadians and I expect the Canadian dollar to be worth a certain amount of goods and services with a minimal volatility in annual price fluctuation (i.e. 2%). Using the same train of thought, gold is worth a certain amount of goods and services with a moderate amount of price volatility. If enough consenting participants agree to participate in Bitcoin’s system, then they would agree that at its current state, Bitcoin is a unit of account that is worth approximately $28,000 USD worth of goods and services, with a +/- 46%8 annual fluctuation in price. This is benchmarking against a fiat currency. It is not impossible one day enough people will benchmark prices against Bitcoin only.
In the next few posts I will dive into details of each of the possible use cases. If any of the use cases come to fruition, there would be profound consequences which may change the way we look at the financial system that we are so used to for the past 80 years.9
(In)Conclusion
Go back to Fig’s founding story, I am grateful to have been born and be able to experience the world as it is today - full of changing dynamics and thought provoking shifts. Blockchain was a young industry back in 2013. Now, almost 10 years later I still believe it is still a young industry now. However, I firmly believe it is one of the most transformative technology in our lifetime. Bitcoin and blockchain presents a very unique role in which it attempts to separate money from “state” - whatever the definition of state10 is.
In that light, I view Bitcoin is an option on the changing geopolitical, and consequently financial, landscape and therefore should be part of most investors’ portfolio as part of their diversification strategy.
My main take away after studying blockchain for close to 10 years is that it is important to question why is our status quo the way it is. Despite being labelled “scam” or “fugazi” for years11, it is perhaps prudent to not dismiss Bitcoin outright, but to study it from the perspective of an empircist rather than a rationalist. If nothing more, perhaps we can gain insight into the flaws and strengths of our existing financial system by studying a prospective new system that is designed to supplant it. It is not an asset with cashflow nor profitability. It is important to view Bitcoin from a macro lens in order to fully appreciate its potential.
Remember that none of the information presented in this letter or on the blog constitutes investment advice or solicitation of any kind. Views in this blog post are personal opinion of the author and do not reflect the view of Fig Investments. The author and Fig Investments are not your financial and investment advisors. Before investing money in any asset or investment product, you should conduct your independent due diligence. Please refer to Fig Investments' disclosures here.
Money and currency are terms often used interchangeably. Currency is money adopted by governments as legal tender. Usually governments have monopoly over the control of the currency system in a country. Adopting something like Bitcoin as currency is different than general recognizing Bitcoin as money, not unlike some portion of the population still take gold as money. To be considered money, Bitcoin needs to serve as a medium of exchange, a unit of account, and a store of value. I think the only factor missing is the store of value, which is dependent on time.
Bitcoin is subject to a consensus of all the Bitcoin miners and transaction validators. According to the consensus which is derived from the original Bitcoin whitepaper, there will only be 21 million Bitcoin in circulation. The amount of Bitcoin mined is can be predicted with precision at any given point in time. On the other hand, supply of gold can arbitrary go up or down due to various factors such as price, demand, and geological factors.
https://www.oreilly.com/library/view/mastering-bitcoin/9781491902639/ch08.html
If one is to take $100 million worth of gold to another country, one would need security, insurance, and customs will ask a lot of questions if not outright ban the export of gold. If one is to take $100 million worth of Bitcoin, on the other hand, one simply needs to memorize their cryptographic keys, or more colloquially, a set of seed phrases. As long as the the keys are memorized, or stored on physically or digitally, one will be able to transport Bitcoin to anywhere in the world.
Keep in mind modern banking system is nothing but a giant ledger that tracks balances. Despite that, this point is a bit controversial One is that Bitcoin is still a relatively young network - it is barely 15 years old. A claim like censorship resistance needs time to prove. Two is the hypothetical scenario in which a powerful agent such as nation state tries to take over the Bitcoin network, using brute methods such as buying Bitcoin outright or buying enough computing power of cripple the network’s consensus mechanism - the 51% attack. There are various game theory mechanics that is baked into Bitcoin’s network design which makes these kind of brute force attacks highly costly - so costly that it does not make economic sense to attack the network. See here for an excellent explanation: https://corporatefinanceinstitute.com/resources/cryptocurrency/what-is-a-51-attack/
For the more technical readers, I am referring to the Lindy Effect, which is a theoretical conjecture that the longer something stays alive the more valuable it becomes. See https://en.wikipedia.org/wiki/Lindy_effect
Collateral simply refers to an asset pledged by a borrower to a lender as security for a loan.
Under the hood of the financial markets are trillions of collateral being exchanged by banks around the world to and from each other to borrow and lend the US dollar for a variety of liquidity and hedging reasons. Many of these collateral are interest rate based securities such as mortgage backed securities, treasury bills, and asset backed securities. Many of the collateral pledged faces problems of rehypothecation (i.e. liens on the collateral) without centralized clearing and custody. Blockchain technology like Bitcoin solves this problem perfectly as location of a collateral (Bitcoin) is known and verifiable at any given point in time. Think of Bitcoin as a ledger system that tracks where and how Bitcoin is moved, without any party being able to “cheat” the system.
For the technical readers: this figure is derived from the current 1 year at the money call and put option implied volatility on Bitcoin. We can probably all agree Bitcoin value does not fall within normal distribution. But that is a topic for another day.
To fully appreciate an evolving and possibly new financial system that Bitcoin and blockchain may represent one day, one has to study history. I am referring to the establishment of the current economic and financial system laid out via the Bretton Woods system in 1944.
Throughout history we have seen the definition of state shifts and changes. The nation state concept as we know it today can be attributed to the Treaty of Westphalia in 1648, which is not so long ago in the grand scheme of things.
Is Bitcoin a zero interest rate phenomenon only to satiate the need to buy anything at whatever cost, or does it have actual intrinsic value masked under the guise of the flaws of a young asset class? I think this belongs into the unknown unknowns.