As I start to write this, I should say I am genuinely unclear on what to think of bitcoin investing at this point and its path going forward. I am not a cryptocurrency expert, but I do think I need to form an opinion to guide my own actions.
I do think that cryptocurrencies are in a very early innings and there are many more stories to come. But the key question is how will this opening act end – will it end with bitcoin at the top, or will it signal a slow decay of bitcoin over time.
Here are the arguments:
Case for Investing In Bitcoin in the long term: This year we have seen a phenomenal rise of bitcoin prices. The adoption started with companies like Microstrategy and Tesla investing in BTC, and then with Paypal, eBay and Tesla agreeing to use bitcoin as a medium of exchange. Arguments for investing in bitcoin are:
- Current adoption is minimal and with increased adoption of institutional investors, companies and even central banks there is a lot of price upside to be had
- Adoption is increasing as is seen from increased number of transactions (e.g., from Coinbase S-1), increased number of retail investors / corporations / institutional investors are increasing – its impressive to see Fidelity, Renaissance Technologies, Square, Stan Druckenmiller, Paul Tudor Jones, Ray Dalio, Elon Musk, Mark Cuban flock to it.
- As people increasingly hold their position, this drives the price higher as the liquid pool of bitcoin available for trading is limited driving the price higher
- If any of the central banks (e.g., Swiss) buy Bitcoin then the pricing will increase higher
- This open decentralized digital protocol is the “new internet” and the possibilities are immense and includes its ability to conduct cross border transactions and other financial transactions – it is too important to “sit this one out”
- It is a very trustworthy, strong, and robust protocol – there is $1T sitting at the table protected by cryptography, with everyone planning attacks on it for the past 12 years – but no-one has been able to get to that $1T.
- Momentum is with crypto – its price rise has validated its business case and given it legitimacy
- There aren’t many gold like investment available and Bitcoin is one of them. It is a store of value and a good hedge against currency debasement and inflation given only a limited amount of bitcoins can be created especially in the time when central banks are printing a lot of currency
- Blockchain may provide a transparency into transactions that can enable auditing, and isolating nefarious transactions – which may drive its adoption
- Bitcoin is becoming increasingly American and that will resist any government actions against it
- Bitcoin has been adopted by the retail masses, by millennials and by everyone who wants to opt out of an unfair system – any attempts to disenfranchise this segment might lead to civil protests.
- Increasingly hash rates are in the USA, which is starting to capture higher market share
- Although a lot of hash rate is in China – it does not mean that the Chinese government owns the
- Bitcoin regulation is going to become more mainstream and that will drive increased adoption. E.g., appointment of Gary Gensler might make the crypto currencies more mainstream (as he has said these instruments drive “financial inclusion”). However, one should also note that Gary Gensler has also been outspoken about criminality of transactions and shady practices around some exchanges (such as Binance or Bitfinex) which do not have counterparties.
Case for not investing in Bitcoin in the long term: Few arguments in this space are:
- While it is a tail risk, US could ban (or regulate down) bitcoin (like India and Turkey) due to multiple reasons:
- Bitcoin takes away the control of monetary policy from Fed – it is disintermediating governments from financing themselves
- Bitcoin is controlled to a large extent by China, Russia and Iran – and is taking away the monetary power from the US, by generating and diverting flow of US dollars to these countries which are looking to avoid sanctions; they can invoke national security
- A large portion of Bitcoin might be used for illegal activities and money laundering; they can also go after it due to ESG impact.
- Governments need to control their monopoly on currency and taxation; taxation by inflation can monetize the debt – but bitcoin prevents the inflation.
- It is easy to shut down bitcoin network which may be very vulnerable. For the cost of $7B, someone (e.g., China) can create empty nodes which get continuously rejected – but are unable to prevent the processing going forward, effectively shuts down the bitcoin network.
- As people have continuously talked about the Thucydides trap, it is more and more likely that there may be some adversarial action against China
- If that happens, $7B is too small to fire a salvo rendering the Bitcoin blockchain ineffective
- Competition will rise, which might drive the value down. Countries will come up with their own digital currencies (CBDCs), which will severely limit the adoption / utility of bitcoin. Since the way bitcoin works is static, other cryptocurrencies might evolve to become better and that might drive out adoption.
- Institutional adoption may be limited due to two reasons – unproven ability to diversify and high liquidity.
- It is an extremely volatile and speculative instrument. Its claim of being a store of value seems counter intuitive when the price fluctuates from $5K to $65K in less than a year.
- regarding diversification, the ability of bitcoin to diversify is unproven given small sample sizes and high volatility
- Additional information around institutional adoption barrier is provided in this link.
- Bitcoin is far from decentralized as it is basically owned by a cabal – 2% of the accounts hold 95% of all the bitcoins, and countries like China, Russia and Iran have 90% of hash rate
- Not all transactions can actually be audited in blockchain as there are “level 2 transactions” which happen away from exchanges
- Quantum computing can not just crack into the wallets, but can solve the bitcoin cryptographic puzzles easily – driving. The counter argument will be that people running defense will adopt the same technology and will negate this threat.
- Bitcoin is not protected against cyber risk – while “cold storage” may work, it takes it out of circulation driving the utility of owning bitcoin for transactions lower. There are multiple dimensions where a hack can happen – it can happen in exchanges (Mt. Gox) or at hot storage. It may be a simplistic approach but if the US defense network can be hacked – exchanges could also be hacked.
- Ratings agencies might look at bitcoin holdings (vs. cash) within corporations unfavorably preventing additional corporation adopting it. E.g., if S&P decides that the bitcoin holding of Tesla and Microstrategy is inferior to holding cash, then that might prevent corporations from making a big purchase of bitcoin in lieu of holding cash
People may talk about how banning of bitcoin is very hard to do and cannot be done, it is relatively simple given the power that governments hold. It can be banned by through “outlawing” or by regulating down (e.g., through mark to market taxes or holding tax). Given US investors buy bitcoin through wire transfer – US could make bitcoin purchases impossible.
One cannot ignore the price actions that we are seeing. At this point Bitcoin has already touched closer to $65K all time high. So the question remains – where do we go from here in terms of pricing action? Is the adoption driving its overall risk higher?
In terms of price actions, there is no real inherent valuation of BTC. Yes a lot of energy has gone into making Bitcoin – but the real valuation is driven by adoption. Bitcoin is trying to displace Gold and it is true that JP Morgan has highlighted that there have been outflows from Gold ETFs into Bitcoin. So the first approach to thinking about pricing action is what portion of the gold portfolio can Bitcoin displace. Ray Dalio’s Bridgewater has done the analysis and have found the following answer (source: Bridgewater) –
From this we can say the price action of BTC is probably closer to $65K – although it could be much higher than this if the liquidity pool is smaller. The other approach to getting to the price of Bitcoin is looking at the halving schedules. A Bloomberg analyst has suggested prices in 2021 to be as high as $400K. There are even more outrageous claims and a wide variety of bitcoin models. However, the Bitcoin price model that appears to be relatively reasonable is the diminishing returns model from HC Burger.
This model might allow for a price of about $100K not before 2021 and then $150K by 2022 or so. However, it might be volatile.
So, overall, my view would be absent any central bank actions, the price of Bitcoin might continue to drive up. But there is a non-zero probability that due to a central bank action the prices might collapse.
One thing to note would be that if prices don’t rise too dramatically, the downside of central bank actions (e.g., voters might not support) might not be justified. Over the longer term, if the prices increase to a really high level the central bank may justify their actions of banning the cryptocurrency even in the face of voter backlash.
My view might be that the government might allow it to be $2T asset (e.g., $85K price or so), but they might be worried if it becomes a $5T asset.
So overall, in the light of this, I think this is still a Buy, until it reaches about $100-150K, which might happen in 2022 or 2025. I think at that point, it might be prudent to pull the trigger. While nothing may happen, the risk of loss may become higher, the returns might become diminishing in any case, and the overhang of regulatory action might remain.
To understand how long the party might be ongoing, I modeled a varying range of probability of outlawing by central bank. I ran three scenarios (one where the central bank outlaws bitcoin at $300K, $400K and $500K prices). Here is the expected value chart:
Based on this, there is going to be an end to the bitcoin party at some point. I will be starting to get a bit nervous around $100K or perhaps even earlier to some extent. Excess success of bitcoin might carry its own seeds of failure – and its still not clear to me if that excess success has already been achieved. Ethereum / Litecoin might actually be tokens that may not face that amount of regulatory scrutiny. Ethereum supply issues may be getting addressed through regularly scheduled burning of tokens.
So the punchline, Bitcoin still a Buy, however, with a price target of $80-100K may be achieved in 2021-24 timeframe. But may really make sense to sell at one of the peak points in light of regulatory scrutiny it might generate. If one wants to continue exposure to cryptos, perhaps selling bitcoin to ethereum at BTC prices of $80-100K might be most appropriate.
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