Yes, Bitcoin Is Still The Investment Of The Decade

“Bitcoin isn’t the bubble, it’s the pin”

Four months ago, I published a controversial article titled, “Why Bitcoin is the Investment of the Decade”. Perhaps my most successful call to date, as Bitcoin has since returned ~300+% at the early December peak. While it is gratifying to see that the number of tulip comparisons has slowed considerably, I think there are still a fair bit of clarifications and misconceptions floating around which need to be corrected – hence this note.

Bitcoin – a tool borne of broken markets

Today’s monetary system is drastically different from what it was a decade ago. Thanks to the advent of financialization and hyper-loose monetary policy, the invisible foundation upon which our financial system is built is tearing at the seams.

The fact is, Bitcoin isn’t the only thing that has gone parabolic today. The VIX, a gauge for volatility, is a great case in point. Take a look at implied volatility – now in its historic 0.5th percentile (!).

What’s really happened to vol? Everyone has their theories but the prevailing one goes as follows – central bank printing presses have created a “backstop” in today’s markets, incentivizing flows into riskier assets, which in turn drives vol down even lower. Rinse and repeat. Years of printing has thus lulled markets into a false sense of complacency and created the self-reinforcing low-vol equilibrium illustrated below.

Per Citi:

“Long periods of one-way markets breed survivor biases. The fund manager with lots of beta outperforms, the cautious fund manager underperforms. Either the latter gets on the bandwagon or soon enough outflows from the fund will ensue. Over time, fewer and fewer “critics of the regime” are left standing.”

As the chart below illustrates, all this has resulted in a very interesting phenomenon where buyers are compensated disproportionately for taking on risk. If you thought Bitcoin had the best risk-adjusted return over the last decade… think again.

Here’s my point – markets today are broken. Markets used to function as a mechanism for price discovery. Not anymore. Today’s business cycle is micromanaged by state agencies the world over to the point where volatility has essentially disappeared. This is important because the cost of money – the single most important driver for capital allocation decisions has now been artificially depressed by central banks, breaking the price discovery mechanism as we used to know it.

Enter Bitcoin – the first ever decentralized, non state-controlled currency of the modern era. The Bitcoin phenomenon is not entirely new. State-derived prices lead to natural outgrowths of a state-controlled system – much like liquor in the ’20s and potatoes in the mid-90s. These outgrowths are simply a reflection of pressures suppressed by state controlled pricing mechanisms – much like today’s.

Meanwhile, the same forces which have depressed the cost of capital today have also led to some mind-boggling developments in our present day financial system. For all the criticism of cryptocurrencies today, fiat based monetary systems have been over-financialized to the extent that ~$400tn of financial instruments float around today, on 4-5x leverage. Now, if Bitcoin is a bubble at a ~$270bn market cap, what do you call $400tn of financial instruments (~4-5x GDP) backed by assets with diminishing real value?

Could Bitcoin thus fit into a portfolio as a “chaos hedge” tool? I think so. At $270b, Bitcoin is already ~0.3% of all money in circulation – a reflection perhaps of its nature as an outgrowth of the over financialized fiat system we have to deal with today.

Misconception #1 – Governments Can “Ban” Bitcoin

Perhaps the biggest source of fear, uncertainty, and doubt (FUD) out there today is that governments can somehow “ban” cryptocurrencies. This could not be further from the truth.

In addition to the cryptocurrency itself, there are four key players within the ecosystem that the government can target – the developers, the users, the nodes (arbiters) and the miners. To bring down Bitcoin, the path of least resistance would thus be for governments to target the perceived weakest link.

(Source: CLSA)

In my view, the most bulletproof point in the ecosystem is the network of nodes. To understand why, here’s an illustration of the distributed ledger Bitcoin runs on i.e. the blockchain.

(Source: Stifel)

What the diagrams above show are the following key properties of blockchain:

  • Distributed – Group of replicated logs/databases
  • Shared – All nodes hold all transactions
  • Pseudonymous – Parties identified with public key
  • Resilience – Failure of one or more nodes do not affect the whole
  • Tamper-proof – Consensus based mechanism

To ban Bitcoin entirely, governments would have to destroy copies on each and every node holding the Bitcoin ledger around the world. If even one copy survives, so does Bitcoin. Even a coordinated attack by governments around the world would stand no chance of accomplishing this feat.

The users are perhaps the weakest point here and will be a key focus of regulatory efforts. The best way governments can attempt to regulate Bitcoin users is through the fiat-Bitcoin interface, i.e., exchanges. As exchanges are merely companies, they are subject to the same regulations as any other exchange operating in the country. This could range from KYC/AML compliance to draconian taxes on users through the exchange.

Here’s the thing most naysayers miss about this point though – exchanges can be decentralized too.

Remember when China banned local exchanges back in September? Here’s what happened – volumes in over-the-counter (OTC) exchanges such as LocalBitcoins surged almost threefold to offset the volume lost from local exchanges.

In Bangladesh, where the government outright bans Bitcoin (per Wikipedia – “anybody caught using the virtual currency could be jailed under the country’s strict anti-money laundering laws”), we see the same trend in its OTC/P2P exchanges. Bitcoin remains alive and well.

(Source: Cryptocompare)

For now, though, most exchanges are centralized and users may thus be subject to taxation. The recent court order for Coinbase to hand over records of its biggest customers is a great example of this. As things stand, taxing Bitcoin users is very feasible at the point of convertibility.

The pseudonymous nature of Bitcoin transactions aside, it is far too onerous to track Bitcoin usage by the general public. If a Bitcoin holder cashes out via an OTC/P2P transaction, for instance, the chances of the taxman decrypting a pseudonymous transaction like that would be slim to none.

For instance, an attempt by Cornell researchers to de-anonymize Bitcoin transactions over a specific time frame between Mar. and Oct. 2013, yielded the following:

(Source: arxiv.org)

Outside of single entity and large volume transactions, the network was virtually impenetrable. One way they pinpointed the source of large, single entity and community related transactions was by connecting the respective transactions to user activity through web scraping. Yet, notice that a very significant set of transactions remain untraceable. Now, multiply this manifold to a national or global scale and you get a very complex conundrum indeed.

Also, consider the political capital at risk if governments attempted draconian taxes. In this regard, Bitcoin’s market cap is a new source of power in its fight against drastic regulation.

There are also two more incentives for governments to lay off draconian taxes long term – privacy coins and capital flows. On the first point, altcoins such as Monero and ZCash are, unlike Bitcoin, completely anonymous, and would be a nightmare to trace. On the latter, a draconian domestic tax on Bitcoin would simply incentivize capital flow into countries with relatively lax tax policies for convertibility.

Here’s a brief summary of how Bitcoin is treated from a tax perspective in developed countries around the world. Note that most opt for capital gains treatment instead of income i.e. the lower of the two.

Country

Tax Treatment

US

Property/ Capital Gains

EU

Currency/ Capital Gains

UK

Foreign currency/ Capital Gains

Germany

Private money/ Capital Gains within one year

Japan

Asset-like “Payment method”/ Capital Gains

Australia

Barter arrangements

(Source: Bitcoin Wiki)

Misconception #2 – Transaction Fees Hinder Bitcoin Adoption

As a Bitcoin user myself, I completely get this point. It is incredibly painful to transact with Bitcoin right now. Here’s how bad things are:

Cryptocurrency

Transaction Fee (USD)

Bitcoin

41.66

Ethereum

0.72

Bitcoin Cash

0.3

Litecoin

0.60

Monero

9.81

(Source: BitInfoCharts)

Yes, it really does cost $42, on average, to transact using Bitcoin. A far cry from the old days when you could do it for $0.01 or fractions of a cent.

(Source: BitInfoCharts)

But perhaps we’re setting too high a bar for Bitcoin. No, paying $42 per transaction does not make sense as a fiat replacement. But as an alternative remittance service, it still makes a whole lot of sense. Remitting money from a G20 costs as much as 6% to the US to as much as 17% to South Africa. On a $2,000 remittance, for instance, that’s a huge $120 to $340 range (3-8x Bitcoin) in addition to piles of cumbersome documentation.

(Source: World Bank)

As I’ve stated in my prior article, I don’t believe Bitcoin will be the fiat disruptor. That doesn’t mean it can’t be.

In its current form, Bitcoin is a relatively inefficient medium of exchange and is certainly not feasible for day to day transactions. But the second layer potentially changes this.

If you’ve followed the Bitcoin story, you’ve probably heard of “Lightning”. Here’s how it works – instead of settling each and every transaction on the blockchain, multiple parties can set up dedicated “micropayment channels”, and report only the net settlement transactions to the network. Sort of a clearing mechanism if you will. The net effect is that transactions on the blockchain go down, and utilization drops along with mining costs and fees.

(Source: CCN)

Now, Lightning has been in the works for some time, and justifiably so. Applying Lightning to retail transactions is exponentially complex. The problem Lightning attempts to solve is combinatorial i.e. the permutations increase exponentially with scale. For a given set of users “n” for instance, there are n!/(k!(n-k)!) combinations of k members to account for.

Even if Lightning isn’t on the horizon anytime soon (rumor mill says end-2018), perhaps we are missing the bigger point here. The very fact that Bitcoin can accommodate second or third layer solutions like Lightning is a very exciting prospect. Fiat currencies are static and cannot be improved upon. Bitcoin can. As the first mover, Bitcoin enjoys the biggest mindshare and naturally attracts the strongest and most active developer base to build upon the existing layer.

Misconception #3 – Bitcoin Can be Hacked

The idea that Bitcoin is inefficient, inferior, unscalable, etc., essentially misses the key point behind Bitcoin in the first place – it is slow by design. By making certain tradeoffs in favor of security, Bitcoin has temporarily sacrificed economic scalability for social scalability.

Yes, it’s true that Bitcoin as a network has reached its limit and transaction fees are off the charts. Yet, the one thing that never seems to be acknowledged is its security. Bitcoin has been running for almost eight years now – the longest of any blockchain available. Yet, it has never been hacked. Today, the prize for a successful hack of the chain stands at ~$270bn – yet no one has been able to crack it.

The cryptography underlying Bitcoin – SHA256 is extremely secure (“SHA” refers to the hashing algorithm and “256” refers to the number of bits in the keys of this algorithm). SHA functions take a specific value, “hash” it, and produce an output. It’s a one-way process in the sense that reverse engineering the output back to the input is virtually impossible.

(Source: Stack Overflow)

There’s been some speculation that quantum computers can potentially crack SHA-256 in ten years or so. Possible? Yes, but it’s a very long shot. According to this paper, a sufficiently large quantum computer could indeed crack Bitcoin by 2027. But here’s the catch:

As with cracking the proof-of-work, the researchers assume quantum computers get big and fast relatively quickly, and even so, they fall slightly short: with a 10 GHz clock rate, around half a million qubits, and a low enough error rate of 10-1 could crack the signature in 30 minutes.

But that doesn’t mean Bitcoin is hackable.

Firstly, Bitcoin takes ~ten minutes to record a transaction on the blockchain. This leaves any quantum computer a ten-minute window to crack the algorithm if it fails then the transaction goes through and the attack fails. Note also, that this is very much a worst-case scenario.

The second, more important point is that Bitcoin is not a still target – it’s a moving one. Fixes have already been offered by the community and as the largest and oldest, Bitcoin will be one of the first to benefit. Quantum computing is thus likely to alter the design of cryptocurrencies, but it will not destroy the ecosystem.

Here’s the thing most people miss about Bitcoin’s security – it’s anti-fragile. As Nassim Taleb discusses in his book on anti-fragility, assets that do not depreciate are more likely to stick around the longer they are around. Bitcoin has weathered almost a decade of hack attacks, the most notable being the transaction malleability issue which brought down Mt. Gox. While a closer inspection point to the reality that Bitcoin itself has never really been “hacked”, these attacks only serve to make Bitcoin extremely resistant to hacking.

Misconception #4 – Altcoins Will Disrupt Bitcoin

For the purpose of this note, I will focus on the key altcoins out there today – Ethereum, Litecoin, Ripple, and Monero. Relative to Bitcoin, these coins are relatively young – Ethereum, its closest rival, is more than 4x younger. Bitcoin’s network security thus holds the longest proven track record as well as the network effect associated with being the first mover.

*As of July 2017

(Source: Cryptofundamental)

Bitcoin’s track record is what lends credence to the idea of it being “digital gold” i.e. a store of value. Some speculate that this theory comes straight out of the “Tinker Bell” theory of value – if enough people believe something is valuable, it is. But we’ve seen this before with disruptive forces such as Amazon (NASDAQ:AMZN). Like Amazon in its dotcom days, Bitcoin is in the process of building its footprint. Clearly, there is little to no demand for day-to-day cryptocurrency use today. But at some point, the world will want or need a mainstream cryptocurrency. When this day comes, bitcoin will be the obvious “first port of call”. That has value.

Bitcoin’s preeminent market position is important for a number of other key reasons including mindshare, anti-fragility, and developer activity. The latter is perhaps the most important out of these. As cryptocurrencies remain very much open source works in progress, attracting the best developer minds to build on top of existing layers is crucial. For all the hype about developments on the Ethereum platform, Bitcoin still benefits from far greater developer activity.

(Source: GITHUB)

But the key thing most people miss about the altcoins is this – Bitcoin derivatives notwithstanding, altcoins don’t compete with Bitcoin, they complement it.

If we were to broadly split cryptocurrency use cases into three buckets, it would be as 1) a medium of exchange, 2) means of network payment and 3) an application token.

(Source: CLSA)

The cryptocurrencies positioned in the medium of exchange space include Bitcoin, Litecoin, Dash, and Monero. Of these, Monero and Dash are focused on privacy i.e. anonymous transactions while Bitcoin and Litecoin are positioned for conventional value exchange. Litecoin decentralizes the mining process and makes faster, cheaper transactions. But, this doesn’t make it inherently more valuable than Bitcoin.

There are always tradeoffs in the world of cryptocurrencies and Litecoin sacrifices some degree of security in favor of speed. This makes it suitable for smaller transactions but higher value transactions are more suited for Bitcoin. To argue that Litecoin is superior to Bitcoin because of its speed misses the ideology behind Bitcoin in the first place. Bitcoin intentionally sacrifices performance and scalability in favor of bulletproof security. The first layer was never designed for day to day low-value retail transactions. These can instead occur on the second or third layers.

For the most part, it appears the market has rewarded Bitcoin’s value proposition. Despite the ongoing congestion on the Bitcoin network, Bitcoin continues to maintain its dominance over the rest of the cryptocurrency universe.

Valuing Bitcoin

Forget what you knew about valuing other asset classes; it probably doesn’t apply to Bitcoin. After all, Bitcoin is backed by neither cash flows nor the sovereign powers of governments. But it is backed something far more reliable – the laws of math, cryptography, and the critical mass of a two-sided network.

My first approach – network valuation yields a ~21k Q4 2018 price target using extremely conservative growth assumptions. Building on Fundstrat’s approach of tying Bitcoin prices to wallets and transaction volume (which explained ~94% of Bitcoin price movements), I assume the following QoQ growth assumptions for Q1 2018-Q4 2018:

Qtr1 (2018)

Qtr2 (2018)

Qtr3 (2018)

Qtr4 (2018)

Unique Addresses (Quarterly Avg)

20%

15%

10%

5%

$ Vol/ Avg # Addresses

60%

40%

20%

0%

(Source: Author Estimates)

Now, I’ve factored in some very conservative estimates to reflect high transaction fees dampening growth. But if I had assumed Q4 2017 growth rates continue into 2018, valuations would have flexed upward of $30k. A bull case could easily push this even higher to ~50k. Another interesting point to note – a very low bar i.e. a 20% contraction on both average wallet count and volume per address is required to maintain current valuations.

(Source: Author Estimates)

In addition to the gold disruptor angle (a ~20% share of gold used for investment and official reserves would result in 107% upside to ~30-40k), I find the “chaos hedge” angle compelling as well. Assuming Bitcoin at a $270bn market cap captures 0.5% of global broad money supply, this provides ~67% upside (valuation of ~25k).

USD

Target %

Valuation

Upside (%)

Global broad money supply

$90trn

0.5%

$450bn

~67%

Gold used in investment & official reserves

$2.8trn

20%

$560bn

~107%

(Source: Author Estimates)

And yes, for the same reasons I laid out here, I still think the Grayscale Bitcoin Investment Trust (OTCQX:GBTC) is a feasible way of owning Bitcoin without actually owning the underlying.

Is Bitcoin Still the Investment of the Decade?

I’m going to stick my neck out here and say yes. To be clear, there are four key misconceptions which I think should be corrected:

1) governments cannot “ban” bitcoin and regulatory crackdowns long term will be very, very difficult to enforce,

2) the Bitcoin network is slow and expensive at scale by design while maintaining second layer optionality, and thus transaction fees will not hinder Bitcoin adoption long term,

3) Bitcoin itself has not and will not be hacked by external agents, quantum equipped or not,

4) Altcoins do not exist to disrupt Bitcoin, instead, they work around Bitcoin and complement it.

The fact is that Bitcoin does not have to replace fiat to justify its valuation. Especially not in its current form.

Valuation-wise, Bitcoin is not priced as expensively as most would have you think. The only way Bitcoin can be kept from growing its value by Q4 2018 is if both network activity and wallets contract ~20%. If it simply maintains current growth rates, a 100% return is on the cards. A moderate bull case would thus easily justify a $50k valuation by Q4 2018.

Couple that with alt gold and “chaos hedge” optionality and all the ingredients for a huge run in 2018 are still in place.

Disclosure: I am/we are long BTC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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