This article was written in response to a question by 21-year-old student Cherine, who wanted to know whether it was safe to invest in cryptocurrencies. Will the price of Bitcoin hit US$1 million ($1.3 million) this decade? It is possible. We say this not because we are believers in the world’s foremost cryptocurrency, but because Bitcoin is a purely speculative asset. It generates no earnings or cash flow — therefore, there is no maths behind its valuation. In other words, Bitcoin has no underlying value. Its price is what the next person is willing to pay, driven by sentiment. Therefore there is no limit as to how high it can go, US$1 million or any other number, really, or how low, even zero.
Not surprisingly, there is significant controversy surrounding Bitcoin. And, we suspect, this is part of its appeal and why prices have surged in the last few months. Controversy keeps it in media headlines and attracts ever-growing attention — whether it is Elon Musk tweeting Tesla’s US$1.5 billion purchase of bitcoins or Warren Buffett calling it a “mirage” that he will never own.
What is Bitcoin? Depending on whom you ask, the answer could be a crypto- or digital currency, an asset class, a commodity or a software program. We like the software definition best — it is a piece of opensource software (computer program) made up of a set of digital protocol (rules).
In the earliest history of money, the medium of exchange was typically a commodity of some intrinsic value — anything that meets the five key criteria of relative scarcity, portability, easily recognisable, divisible and fungible (one unit is the same as the other) — including cocoa beans, sea shells, salt, tea and precious metals such as copper, silver and gold.
As economies grew and demand for money expanded, commodity money was gradually replaced by paper money, but which was still backed by some underlying commodity such as silk, silver and, the most popular, gold. That was until 1971, when US President Richard Nixon suspended the convertibility of the US dollar (at a fixed exchange rate) to gold. By 1973, the Bretton Woods Agreement had collapsed, allowing major currencies, previously pegged to the US dollar (and, indirectly, gold), to float freely. This means the value of fiat money is now based mostly on trust. Trust that the issuing government will honour its value and trust that the government will not debase this value through massive increases in money supply.
There are growing worries today, however, that governments will keep the money-printing machines running on overtime to monetise massive fiscal spending and pay off record levels of public debt. Historically, we have seen periods of hyperinflation that resulted in extreme hardships for the people when this happened: for example, in 1923 Germany and, more recently, in Zimbabwe and Venezuela.
Let’s face it. Democracy is mostly populist politics. It is hard to inflict pain and discipline. It is way easier to keep the good times rolling, by kicking the can down the road. One might even go as far as to propose that the US dollar will inevitably fail as a store of value. Never, possibly, likely or certainly?
While gold has no yield, the US dollar does. In Chart 1, we adjusted the price of gold to compensate for this rising value of holding the US dollar over time. In nominal terms, the US dollar has debased by 94% since 1973. After adjusting for the yield on cash, however, the value decline is only 47%. In other words, the debasement of the US dollar over time is real — but far smaller than many gold bulls would claim. And, indeed, only since 2001. Or is it?
We think this “debasement” in value is in fact reflective of the “price” of holding cash because of its liquidity vis-à-vis gold. Put another way, it is equivalent to the transaction cost of gold if it is to be used as a currency. This is similar to the liquidity premium for listed stocks, and why private assets get a big step-up in valuations upon going public.
Perhaps it is not surprising, then, that Bitcoin was born in the aftermath of the global financial crisis, when uncontrolled excesses by Wall Street banks led to the collapse of the US property market and sparked the Great Recession, the deepest global recession since the 1930s Great Depression.
Millions lost their jobs and homes. Millennials were hit particularly hard, entering the workforce smack in the middle of the unemployment crisis, many saddled with student debts. According to a 2018 report by the US Federal Reserve Bank of St Louis, millennials born in the 1980s are at greatest risk of becoming a lost generation for wealth accumulation. This explains, in part, why the young generations, millennials and Gen Zers — also the most tech-savvy — are the most ardent believers in Bitcoin and cryptocurrencies.
The subsequent bailouts of financial institutions and expansive monetary stimulus — notably with limited fallout for highly paid bankers, many of whom continue to earn fat bonuses — further eroded the people’s faith and trust in banks, central banks, governments, the value of government-issued fiat money and the entire fiat financial system.
Bitcoin is the promise of a technological utopia — the democratisation of the global financial system that is, thus far, dominated by profit-hungry banks and perceived to be heavily biased against the average person. Bitcoin is accessible to anyone with an internet connection and everyone is equal and anonymous within the network. There is no censorship and no government control.
Bitcoin was created in 2009 by a person or persons going by the pseudonym Satoshi Nakamoto — whose original intention was the creation of an innovative currency, an alternative payment system that is completely autonomous from any banking system or government. As Nakamoto wrote, “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”
Simplistically, this is how it works: Each Bitcoin transaction is added to a distributed ledger — which is basically a list of its entire history of transactions (blocks that make up the blockchain) — that is publicly available and transparent to all. Its code can be viewed by anyone so inclined. It is not controlled by any centralised institution, but operated and maintained anonymously by hundreds of thousands of independent computers (nodes) around the world.
For the effort of processing, verifying and adding each additional block of transactions to the blockchain — the process involves solving complex mathematical problems that requires massive computing power and energy consumption — the nodes are rewarded with a certain number of bitcoins. The world calls this “bitcoin mining”. This reward (new bitcoins created) is programmed to halve for every 210,000 blocks mined and will drop to zero when the total number of bitcoins in circulation hits 21 million, a figure fixed at its launch.
Bitcoin meets the five key characteristics as a medium of exchange. While it may have started life as a currency, however, Bitcoin has thus far very limited use as one — except for illegal transactions such as paying blackmail ransom and purchase of drugs.
Based on current architecture, Bitcoin is not useful for everyday transactional use. For one, processing time is slow, just about five per second. By comparison, current Visa-Mastercard networks process more than 5,000 transactions per second and have a capacity for many times this number. It takes about 10 minutes currently for one block of transactions to be verified.
Just imagine standing in line at the checkout and waiting for at least 10 minutes — this time delay can vary widely, sometimes even up to days, depending on network congestion — to complete a transaction. Bigger-value transfers usually require more than one confirmation — most wallets require three, though six is standard for most transactions to be considered secure — which is to say the total time required will be in multiples of 10 minutes. You could jump the queue by paying higher transaction fees. By comparison, credit card payments take a few seconds to complete and cash is, of course, instantaneous.
In addition to the scalability problem, extreme price volatility is yet another reason that Bitcoin is not widely — and quite probably will never be — adopted as a means of payment. We reckon few merchants would want to accept Bitcoin and risk making a big loss immediately afterwards. At the same time, owners of Bitcoin must surely be reluctant to spend it, not if they think prices are going to go higher tomorrow.
We have established that Bitcoin is not an investment asset (like stocks or bonds) since it has no yield. Even fiat currency, cash, generates an interest income on deposits with banks. It is a poor medium of exchange and store of value. Which brings us to the obvious conclusion — Bitcoin is a speculative asset. Prices are determined by demand and supply. Since supply is limited, rising demand pushes its price higher and higher (see Chart 2).
Investing in Bitcoin is most similar to investing in paintings (but minus the aesthetics) and gold. There is no intrinsic value. What drives prices is the perception of value — underpinned by scarcity.
Paintings are a lot more valuable after the artist is dead. The supply of gold is relatively limited. And there will ever only be 21 million bitcoins. Here’s the thing, though: The potential to create new cryptocurrencies is unlimited, which means supply is infinite.
In fact, thousands of cryptocurrencies have been created since Bitcoin. Bitcoin itself has split, or “forked”, many times to create spinoffs of entirely new cryptocurrencies, the biggest of which are Bitcoin Cash and Bitcoin Gold. In other words, Bitcoin may be the premier cryptocurrency today, but there is no guarantee it will not be replaced by another more popular cryptocurrency — one that is already in existence, such as ether, or that has yet to be created — tomorrow.
If it is not already clear by now, we will never gamble on Bitcoin, just like we would not invest in a stock with no underlying fundamentals. Still, we are quite confident that the technology behind Bitcoin, blockchain, will be a key building block in the digital future.
The benefits of a decentralised, distributed ledger — the transparency and accountability, its immutability and, therefore, security and integrity of the data, ease of accessibility and inclusiveness as well as the efficiency and cost savings from disintermediation — are real. We have no doubt that blockchain technology will continue to evolve and improve, creating more and more innovative applications.
We have only just begun to scratch the surface of smart contracts; as well as, for example, the use of blockchain to track provenance for goods, commodities and intellectual property in real time; for cross-border payments and money transfers; and for secure sharing of data and record management and so on.
We could envision blockchain as a means for central banks and governments to earn back the broken trust of the people. For instance, a central bank digital currency (CBDC) can merge the best of blockchain technology — including convenience, ease of use, speed, low cost, security, transparency and accountability — with the backing, price stability and regulatory protections of an official platform. CBDC will be legal tender that must be accepted by all, including for payment of taxes. Unlike the anonymity of the distributed ledger of cryptocurrencies, it will be centralised (or distributed among a group of participants, such as banks), regulated and managed by the central bank.
We are doubtful that any single cryptocurrency without a central authority can really be widely accepted as a global currency. Aside from the transactional limitations, which are solvable, complete anonymity will only serve to enable illegal activities and embolden criminals. In addition, the reason Bitcoin is such a good speculative asset — its uncontrolled price volatility — is also the reason it makes a poor currency and medium of exchange.
It may be well and good to buy some bitcoins for speculative gains. But would we really entrust with it our entire life savings? The Bitcoin network may be incorruptible, but the exchanges and digital wallet providers can — and have been — hacked. Stolen bitcoins are lost forever. For that matter, so are forgotten private keys (passwords). There will be no recourse at all, since it belongs to no one and no one is responsible.
Furthermore, central bank policies may have their flaws but they have, on balance, done more good than harm, especially in crises. Case in point: All the emergency measures at the height of the Covid-19 pandemic panic, we believe, prevented what could have been a catastrophic collapse of capital markets and havoc.
China is among the world’s most advanced in terms of embracing rapid technological changes and the digitally enabled economy. Not surprisingly, it is the first major country to launch a CBDC. The digital renminbi is managed privately by the People’s Bank of China under a centralised system with so-called “controllable anonymity”. That means the central bank can trace identities behind the transactions.
Its primary aim is to replace cash — and clamp down on corruption, money laundering, terrorist financing and other illegal activities — improve payment efficiency, onboard millions of unbanked and reduce systemic risks by complementing private payment networks (such as Alipay and WeChat Pay) with an official digital payments platform.
We think China’s longer-term ambition is to internationalise the renminbi, gradually bypass the use of the US dollar and existing cross-border payment systems (such as SWIFT) in international trade and transactions and, ultimately, challenge the greenback as the world’s reserve currency. The digital renminbi will surely spur other countries to catch up with their own CBDC. And if CBDC can earn back the trust of the people, it will surely undermine the case for private cryptocurrencies.
We believe Bitcoin (like other cryptocurrencies) will remain a speculative asset — a “digital gold”, but less. Why? Gold has a long history as a strategic asset, to hedge against inflation and preservation of value and as a safe haven, especially in times of heightened economic and political uncertainty. On the other hand, Bitcoin is driven by speculations for capital gains and too much liquidity. So, when equity markets fall sharply, it too is likely to fall and by more, given that it has absolutely no intrinsic value. Therefore, it is not a good hedging instrument in a diversified portfolio.
The ultimate bet — borrow to buy bitcoins, secured against bitcoins
When the price of money (interest rates) is nearly free, it will inevitably create excesses in pockets of the capital markets and asset prices. We see that in the trading mania surrounding the GameStop short squeeze as well as frenzied price rallies that appear detached from underlying fundamentals, including for virtually bankrupt companies and blank-cheque companies, SPACs (special-purpose acquisition companies).
Therefore, the meteoric rise in Bitcoin should come as no surprise. Its price rally is driven purely by market sentiment and speculations on the back of excessive liquidity, not only by retail investors but, increasingly, corporates and managed funds.
Case in point: Tesla made a huge splash in the media last month, announcing that it had purchased US$1.5 billion ($2 billion) worth of bitcoin. The company is sitting on a big pile of cash exceeding US$20 billion, after raising US$12 billion from the market in 2020, capitalising on its surging (overvalued) share price. That is practically free money. The purchase further stoked the Bitcoin mania, pushing prices higher still — and, we reckon, rising paper profits gives the market more reasons to also chase up share prices for Tesla.
Indeed, this is exactly what is driving the rally in MicroStrategy’s share price since it first announced investments in Bitcoin in August 2020 (see chart). The share price of the software company — now one of the world’s single-largest holders of bitcoin, sometimes called “whales” — is rising eerily in lockstep with the Bitcoin rally.
It is one thing for companies to speculate on Bitcoin with excess cash in hand — MicroStrategy is now raising money from debt issuances to fund its speculative bet, after exhausting most of its cash for this purpose in 3Q2020. Incidentally, the cash for its initial bet was raised, primarily, from the savings from retrenching staff last year. This is a sure sign companies are getting reckless with cheap borrowings.
MicroStrategy’s founder and CEO Michael Saylor, a loud (and recent) proponent for Bitcoin in social media, has a colourful background. MicroStrategy’s share price soared through 1999 and early 2000 before collapsing spectacularly after the US Securities and Exchange Commission charged him (and two other top management) for accounting fraud, artificially inflating the company’s revenue and profits when it was actually loss-making. The case was eventually settled with hefty penalties without admission of wrongdoing.
This game of inflating paper profits and ramping up valuations is certainly not new, though the vehicles of choice may be different. Take, for instance, locally listed Fintec Global’s record profits in the financial year ended March 2020 and 1HFY2021, which were 11 and 19 times greater than total sales in the respective periods, thanks to fair value gains in its investment portfolio. According to numerous articles in The Edge Malaysia, the company sits at the centre of a complex web of small listed companies, most of which are in the red but have nevertheless recorded eye-popping share price gains over a short period.
For sure, there is a group of Bitcoin enthusiasts who truly believe it is the future global currency and “digital gold” in a world where central banks’ unprecedented policies will eventually create runaway inflation and debase fiat money.
But there are many more who are simply profiting from the current mania by perpetuating the myth and pumping up valuations for their own gains. For these investors, Bitcoin is a speculative punt. Nothing more, nothing less.
The Global Portfolio recouped partial lost ground last week, rebounding 3.3% compared with the MSCI World Net Return Index’s 1.9% gain. Total portfolio value now stands at 57.5% since inception. Over the same period, the benchmark index is up a lower 42.4%. The top gainers for the week were Ericsson (+9%), Singapore Airlines (+8.4%) and Geely Automobile Holdings (+6.4%). Only two stocks in the Global Portfolio ended lower, Rio Tinto (-1.9%) and Okta (-0.1%).
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
