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# Cryptocurrency Mania –

Bitcoin is everything you don’t understand about money combined with everything you don’t understand about computers.

John Oliver

## Issues to be addressed in this research paper

Bitcoin (in the following, BTC), the mother of all cryptocurrencies, has been through a most dramatic journey since it was first launched as a digital currency in early 2009 by Satoshi Nakamoto, although that name is apparently a pseudonym. Nobody knows who the real brain(s) behind BTC is (are).

Before going any further, allow me to make a couple of points. First and foremost, despite it being portrayed as a digital currency, BTC is not a currency. Currencies are issued by sovereigns and this is not. BTC is software – a digital phenomenon which has captured the world. Secondly, let me briefly explain why most digital currencies are called cryptocurrencies. In short, digital currencies use a technology called cryptography, which is the science of making and breaking codes. As you will understand in a moment, the science of breaking codes is an integral part of the technology behind digital currencies, hence the name.

In the following, I will take a closer look at the whole concept behind cryptocurrencies. If you think I spend too much time on BTC and not enough on the other cryptocurrencies, you should know that my hands have been forced. There is quite simply so much more readily available information on BTC that I didn’t have much of a choice. On that point, I should add that BTC’s market capitalisation is more than twice that of the next 999 cryptocurrencies size-wise (Exhibit 1). No wonder the focus is first and foremost on BTC. Having said that, you can assume that most of what I say in the following will apply to virtually all cryptocurrencies.

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BTC traded through $1,000 in February 2017 and through$10,000 in December of the same year. After a challenging 2018 where it lost two-thirds of its value, it almost doubled in value in 2019 and more than quadrupled in 2020, where it finished the year a tad below $29,000. In early 2021, the journey has been no less spectacular. After peaking at almost$42,000 on the 8th January, BTC suddenly became subject to some hefty profit taking. “A healthy and much needed correction”, some said. “The bursting of a bubble”, others called it (Exhibit 2). As I write these lines, BTC trades around $31,500. The extraordinary performance in 2020 resulted in BTC being by far the best performing mainstream asset last year (Exhibit 3). As you can see, no mainstream asset class came even close to the 300%+ that BTC delivered to its faithful investors. As the year progressed, and as most cryptocurrencies continued their almost inexplicable rise, some noteworthy, institutional investors came out in favour. Take for example the CEO of BlackRock (the world’s largest asset manager), Larry Fink, who made a couple of remarkable statements. In an interview with bitcoin.com (see here) he asked himself the question: Can it evolve into a global market? Possibly. Certainly by evidence of the imagination of so many who want to learn it or are interested in it. To me, it’s a very telling sign. He then went on to say something even more remarkable which underlines why we all need to take this phenomenon seriously: Having a digital currency makes the need for the U.S. dollar to be less relevant. ## Why cryptocurrencies? BTC was invented in the immediate aftermath of the Global Financial Crisis, and that is probably no coincidence. Investors came out of the crisis, looking for (a) uncorrelated returns and (b) a solid store of value. Nakamoto designed BTC to offer both. Despite early investors in BTC and other cryptocurrencies having made a fortune, and despite the aggregate market capitalisation of the 18.6 million BTC outstanding now being approx.$600Bn – i.e. you can no longer argue it is a fringe asset class that is hard to take seriously – the whole cryptocurrency concept is still poorly understood, though.

As a recent paper issued by the CFA Institute (Cryptoassets – the guide to Bitcoin, Blockchain, and Cryptocurrency for Investment Professionals) states: “… few people even understand what crypto really is or why it might matter. Is it an alternative currency? A technology? A venture capital investment? A specious bubble?”. Given these rather basic questions, let me try and explain why BTC was born in the first place.

As you’ll be aware, transferring money between two economic agents takes time if it involves two different banks, and the reason is simple. Bank A does not have access to Bank B’s customer database, i.e. all sorts of security checks must be performed before the transaction can take place. The crypto concept is the answer to that problem.

Nakamoto wanted to solve the problem by creating a single database that anyone could access at any point in time. The database (or ledger as Nakamoto called it) should not be controlled by anyone, be it bank, government or otherwise. Although simple in concept, implementing such an architecture was extraordinarily complex, and a new technology had to be developed. That technology is called “blockchain” and is the brain behind most cryptocurrencies today.

Blockchain is also called “distributed ledger”, meaning that it is public. Anyone can download a copy, i.e. records are publicly available to view but not to edit. Complicated measures are in place to protect it from being tampered with. In fact, the BTC ledger has never been hacked, although BTC has been stolen from people’s computers from time to time, so the architecture is not fault free. That said, the underlying blockchain technology has proven a fortress (see for example this story), which is causing many banks and other organisations to use it for other purposes.

Critics of cryptocurrencies often ask the simple question: How can you be sure a BTC transaction is bona fide? When dealing in old-fashioned, analog currencies, at least you know the currency in question has been issued by a (supposedly) reputable central bank, and the transaction in question is controlled by a regulated bank. None of that is the case with BTC, where the oversight is left with the participants. Everybody keeps an eye on everybody else.

In principle, all a thief would need to do to steal somebody else’s BTC would be to post a message on the computer network (let’s call that somebody else Hugo as we’ll return to him more than once in the following). Now, if our thief posts the following message: “Hugo agrees to pay me every single BTC in his possession”, in principle, all Hugo’s BTC will be passed over to the thief. Likewise with double-spending – a technical term for spending more BTC than you actually have which, in principle, is quite easy to do. Nakamoto established very powerful measures to ensure those sorts of things can never happen.

Take for example double-spending. That is only possible if the participant in question makes up at least 51% of the mining power of BTC (more on mining and miners later). At $600Bn in market capitalisation already, hardly anyone in the world is wealthy enough to test the system. Even if somebody does, other security measures will kick in. One example of that is the computing power required, which is truly astronomical. As people with knowledge of the software behind BTC say, a 51% attack is a suicidal proposition, financially. Precisely how the blockchain technology works is beyond the scope of this paper, but I encourage readers who are interested in learning about it to read the aforementioned CFA Institute paper (see Supporting Literature later). ## How a BTC transaction works All BTC transactions are executed in the BTC network – a network of computers that run identical copies of the BTC database. If Hugo wants to sell, say, 10 BTC to somebody else, he sends a message to the BTC computer network that this is what he wants to do. After the network has verified that Hugo has at least 10 of them, the proposed transaction is placed in a so-called waiting room and is then mingled with all the other transactions that are in the waiting room at that time. BTC transactions can either take place peer-to-peer (as in the example just mentioned) or on a cryptocurrency exchange. Most individuals do their BTC transactions on an exchange. The BTC miners will enter the frame next. Miners are computers that are scattered around the world. They aggregate all transactions that have been validated and propose them for settlement. A group of validated transactions is called a block, hence the term blockchain. All the computers in the BTC network compete to settle the next block. The competition is about finding the solution to a mathematical puzzle, and the computer that finds that solution first is entitled to settle the block and will earn a reward. At present, that reward is 6.25 newly minted BTC with the reward being cut in half for every 210,000 blocks mined. The last halving took place on the 11th May 2020. The reward will continue to halve every 210,000 blocks, or about every four years, until 2140. At that point, all 21 million BTC will have been mined. Nakamoto deliberately made the mining process complex and time-consuming – another part of the comprehensive safety features that has made tampering impossible (so far). At present, another block is mined every ten minutes. This rather lengthy transaction time makes it very safe but less suitable for over-the-counter transactions. Imagine the queue behind Hugo at the local supermarket, and the outcry, if it takes ten minutes for him to pay for his two sandwiches. ## Is BTC digital gold or rat poison? I find it much easier to establish what BTC isn’t than what it actually is. As I have already suggested, I happen to disagree with all those who think it is another currency. Currencies are issued by sovereigns, and the management of them form a critical part of most countries’ economic policy programme. In my opinion, central banks are very unlikely to give up their monopoly on issuing currency any time soon. Think about it the following way: if all digital ‘currencies’ are issued privately, central banks will lose a critically important policy tool. They simply won’t allow that to happen. The fact that governments have not clamped down on cryptocurrencies yet is a hint to investors. Maybe they aren’t overly concerned. You can be sure that any new technology/payment form that would threaten governments’ monetary sovereignty would be outlawed immediately. Governments will not tolerate anything that could undermine their monopoly on printing money. So, if it isn’t a currency, what is it? According to Warren Buffet, it is rat poison squared (see here). According to other analysts, it is digital gold; i.e. opinions could not be more divided. If it is indeed digital gold, the price could go much higher. ARK Invest has calculated that for every 10% of global gold holdings that are converted to BTC, the market capitalisation of BTC will increase by almost$1Tn (Exhibit 4). If ARK’s calculations are accurate, the price of BTC could go a lot higher, as more and more investors see BTC as a viable alternative to gold. This could also explain why gold hasn’t done better during the current crisis.

More on Warren Buffett in a moment but, to begin with, allow me to point out that I don’t fully buy into the liquid gold argument. I deliberate say “fully”, as part of the story makes sense. Let me explain.

For BTC to replace gold over time, it must feature the attributes of a typical risk-off asset. As you can see in Exhibit 5, BTC’s correlation with various risk-on assets is on the rise, i.e. it is not behaving like a typical risk-off asset.

Furthermore, risk-off assets are not very volatile. The volatility of BTC, although declining over time, is in a league of its own when compared to most other asset classes (Exhibit 6). Also, as you can see in Exhibit 7, about 2,200 of the almost 3,300 daily drawdown observations since July 2010 fall in the range of -40% to -85%. I find it hard to categorise an asset with such volatility as a risk-off asset.

On the other hand, gold is increasingly viewed as an archaic asset class that Millennials don’t buy into the way baby boomers do. It is therefore not impossible that BTC, over time, will gradually replace gold but, for now, it is a risk-on asset.

As far as Warren Buffett is concerned, although I share some of his scepticism, I believe BTC (and other digital currencies) is only the foreplay to what will happen in the years to come. In an increasingly digitised economy, does it make sense to maintain the existing, analog, currency system? Absolutely not, and I remain convinced that it is only a question of time before the first sovereign, digital currency is rolled out. Before long, they’ll all have one, and digital currencies will become modus operandi.

## How to value cryptocurrencies

One of the first questions I am typically asked when the topic comes up is valuation. “Is there any value at all in BTC, or is it all hot air?”, I am often asked. And, until I dedicated some time to research the topic, I was probably in the hot air camp myself (if I even had an opinion).

You can indeed apply a few different valuation techniques, so let’s quickly run through them. The first one is based on Metcalfe’s law which states that the value of a telecommunications network is proportional to the square of the number of connected users of the system. Metcalfe’s law is often used to value social networks like Facebook and Twitter, and one can argue that the same approach can be applied here, given that daily activity is a proxy for interest in, and adoption of, a cryptocurrency.

Critics argue this approach is not appropriate as equal weights are given to each participant, which may be fine when it comes to social media but not applicable to the investment community, where large institutions have a much bigger impact on things than retail investors do. Anyway – let’s assume Metcalfe’s law is a fair proxy, so what does it tell us?

It tells us that BTC has been overvalued for much of the time since it was first launched in 2009, but that we have also experienced extended periods of undervaluation (Exhibit 8). You should note that the chart was produced last autumn when BTC traded below $20,000, so it is slightly outdated. However, it will give you a good sense of today’s price vs. intrinsic value. Metcalfe’s law also tells us that, when all 21 million BTC have been mined in 2140, the fair value is$74,000, meaning that the return over the next 120 years will be about 0.71% per annum based on a current value of $31,500 – not exactly mouthwatering. A second valuation approach is based on the monetary equation: MV = PQ. It is a model frequently used to value traditional, analog currencies and is based on the assumption that a currency’s value is a function of the size of the market is supports and of the velocity of money as it moves through that market (Exhibit 9). The CFA Institute paper goes through how that valuation approach can be applied (and I paraphrase): If we assume that, each year, 100 billion BTC transactions (Q) will take place at$100 each (P), then PQ = $10,000,000,000,000 (ten trillion dollars) per year, which is not entirely unrealistic given current trading activity. Furthermore, if we assume that BTC’s velocity is 5 (i.e. every BTC changes hands 5 times a year), then the value of BTC as per this valuation model is$2Tn ($10Tn divided by 5). If we divide that number with the fully diluted number of BTC – 21 million – you arrive at a valuation per BTC of$95,238, once they have all been mined. As we approach the fully diluted number of 21 million BTC well before 2140 (because of the halving principle), you can see that this valuation approach arrives at a much higher annualised return than suggested by Metcalfe’s law.

The biggest issue I have with this valuation approach is the velocity estimate. In practice, the velocity of money is all over the place. According to the Federal Reserve Bank, MZM velocity (a key measure of velocity in the US economy) has ranged between 0.9 and 3.5 over the past 30 years. Cryptoassets are likely to change hands more often than analog money, hence the higher estimate. How frequently, one can only speculate about.

A third valuation approach is based on stock vs. flows or, in other words, on the dynamics of the halving principle. BTC’s price tends to surge around the times of halving – in fact, both before and after (Exhibit 10a). This makes sense. If the supply is cut in half, particularly when demand is rising, a shortage may develop, which will cause the price to rise to incentivise holders to sell existing stock. According to Pantera Capital and its model, BTC should rise to c. $115,000 by August of this year, based on this dynamic (Exhibit 10b). Let me share one final valuation approach with you. BTC is increasingly viewed as a competitor to gold when investors look for a store of value. Currently, with the gold price hovering around$1,860 per ounce, the total global stock of gold amounts to c. $13Tn (197,576 tonnes of gold ever mined x 35,274 ounces per tonne x$1,860 per ounce). Therefore, on a fully diluted basis, should all gold investors decide to convert to BTC, the implied value of one BTC is about $619,000. Obviously, this will never happen. Much gold is used in jewellery and not as a store of value, and some investors will never switch from gold to BTC. On the other hand, one could also argue that proven gold reserves should be added to the nearly 200,000 tonnes already mined. Proven reserves add up to about 52,000 tonnes globally, which would raise the value of the total stock to$16.4Tn and the implied value of BTC to almost \$780,000 on a fully diluted basis.

As Millennials grow older and move into their prime savings years (their 40s and 50s), I do believe that cryptoassets stand a good chance of becoming the new gold to some investors. Even if only 10-20% of all gold is replaced with BTC eventually, there is significant upside from current levels.

## BTC in a portfolio context

The extraordinary performance of BTC, almost regardless of timeframe (Exhibit 11), has driven many investors to open their eyes to this new asset class. You should be aware that Ark Invest published the chart below in September 2020, i.e. the performance numbers below do not include the stellar performance in late 2020.

Whether BTC is a currency, a risk-off asset likely to increasingly replace gold as a store of value or simply a speculative risk-on asset, it comes with some attractive attributes that portfolio managers should not ignore. I assume BTC is a bona fide investment, and that there is nothing suspect going on in the corridors of the cryptoasset exchanges. Quite frankly, that is an assumption I am not entirely comfortable with at this stage (see later). Also, it is an uphill battle, psychologically, to recommend clients to invest in an asset that your regulator takes a very dim view on (see for example here).

Having said that, there are very obvious benefits associated with an investment in BTC. Before going into those, let me make a couple of observations. Firstly, when industry heavyweights like Larry Fink give their endorsement, a very significant barrier has been broken. Larry’s comments will most likely lead to a flood of other institutional investors beginning to take this investment opportunity seriously.

Secondly, in a world plagued by rising debt problems, we are fast approaching reckoning day when some of all that debt must be destroyed. The probability that central bankers will choose to inflate their way out of this problem is high, as the only alternative to that is default. There are no benign solutions to debt destruction. If central bankers choose to stay behind the curve in their battle against inflation, investors will desperately seek protection in lowly correlated assets, and this is where BTC fits in.

Now to the attributes. Adding BTC to a traditional portfolio has – or at least has had – a significant and asymmetric impact on both absolute and risk-adjusted returns. The authors of the CFA Institute paper found that adding 2.5% BTC to a traditional 60/40 portfolio did wonders. As you can see in Exhibit 12, the Sharpe ratio (a proxy for risk-adjusted returns) improves markedly once you include 2.5% BTC in the portfolio provided you rebalance the allocation to BTC quarterly.

In Exhibit 13, you can see the impact on risk-adjusted returns if you don’t rebalance. As is obvious, there are suddenly extended periods where BTC contributes negatively to risk-adjusted returns. Effectively, you are penalised for the extreme level of volatility in BTC during those periods where it goes through a meaningful correction.

The lesson is obvious. So long as volatility remains extraordinarily high, regular rebalancing is critical. If you don’t rebalance at regular intervals, you pay the price during those setbacks that have occurred quite frequently. If you do, a 2.5% allocation to BTC is not big enough to do major damage, yet big enough to affect the Sharpe ratio positively and in a meaningful way.

## The wider implications

Let’s assume you are even more cynical than me and steadily refuse to invest even a penny in BTC. You may lose an opportunity, but I am sure you’ll also have far fewer days where you feel the urge to have a(nother) aspirin. The cryptocurrency concept is so complex, and so full of pot holes, that I fully understand anyone who takes that view. Having said that, I still believe you’ll pass on an opportunity by taking such a stern view.

That said, passing on BTC is not the end of the opportunity set, and the reason is blockchain – the underlying technology. Blockchain is an emerging technology which will change the world as we know it. One major advantage is that it eliminates the need for third-party involvement (say, a bank) in a contractual arrangement between two economic agents. This opens for a brave new world without banks. Peer-to-peer lending may become the norm not so long from now where, today, it is still a fringe activity. Likewise, both checking and savings accounts can be decentralised.

I am therefore inclined to say that the most revolutionary part of the BTC ‘revolution’ is not the emergence of digital currencies per se but rather the underlying blockchain technology, which could change everything. All the damage online retailers have done to brick and mortar retailers may only be the first act in a digital show that will fundamentally change the world as we know it.

The ramifications are massive. Imagine how blockchain will affect the Internet of Things (IoT). Take for example a self-driving Uber vehicle with its own blockchain wallet. When the passenger enters the car, it doesn’t move until the passenger has paid for the journey with a cryptocurrency. When the car needs to re-fuel, it uses the same wallet to pay for the refill.

I could list dozens of such opportunities – the cryptocurrency concept is just one of many examples as to how the blockchain technology can be applied. Let me give you just one more example, cross-border payments, which is a major source of profits for most banks. When blockchain is up and running, there is no longer any need to get a bank involved in such transactions. Two economic agents can do it between themselves. I would therefore strongly urge you to invest in blockchain, even if you decide to pass on the cryptocurrency opportunity.

## The bottom line

The world’s first coins appeared around 600 B.C. in ancient Greece. Now, some 2,600 years later, the concept hasn’t changed much. The coins may be manufactured by some fancy machine these days, and volumes are more strictly regulated, but the coin itself is very similar. In a world which is being digitised very quickly, that won’t fly for long. We simply must convert to digital currencies in order to take full advantage of the digital age.

I don’t think BTC and the other digital currencies currently on offer will move into that space. Monetary authorities simply won’t allow that to happen. Having said that, this doesn’t imply that cryptocurrencies as an investment opportunity are doomed – not at all. Cryptocurrencies could gradually replace gold as a store of value, and demographics support that argument, or they could continue to trade as they do now – as a risk-on, only modestly correlated, esoteric asset class which increasingly carves out a slice of investment portfolios.

Should you decide to invest alongside all those other ‘converts’, I urge you to follow a simple rule set:

1. Never invest more than you can afford to lose. The crypto concept has not yet been proven beyond doubt.
2. From the outset, set a (modest) target allocation (say 2.5%) but do not invest it all on Day One. There is plenty of volatility in cryptocurrencies, and it would be foolish not to take advantage of that.
3. Once you have reached your planned allocation, rebalance regularly (at least quarterly). Don’t allow yourself to get carried away during good times as you’ll pay the price when the market corrects.

If you follow those simple rules, you’ll be exposed to a fascinating asset class without running the risk of being wiped out, if it all goes haywire. Certain types of investors are discouraged from investing in cryptocurrencies – by the regulator and by me – but if you tick a few suitability boxes, I can understand if you do it, even if I am reluctant to do it myself.

The key reasons I am reluctant? Although I buy into the concept in principle, the fact that a very high percentage of all BTC (more than 95%) is owned by less than 5% of all holders makes me uncomfortable. In my book, such an uneven distribution increases risks significantly. Adding to that, even if many of those I have spoken to will argue otherwise, I believe the BTC market is still a bit of a cowboy market with various illicit activities paid for with a cryptocurrency (e.g. drug dealing). All this needs to be sorted out before proper institutional investors are prepared to engage in this market in size. (See Christine Lagarde’s views on this topic here.)

Niels C. Jensen

22 January 2021

## Supporting literature:

Cryptoassets – The guide to Bitcoin, Blockchain, and Cryptocurrency for Investment Professionals
Matt Hougan & David Lawant, CFA Institute Research Foundation, 2021

Bitcoin – Ringing the Bell For a New Asset Class
Chris Burniske, ARK Invest, 2017

Bitcoin as an Investment
Yassine Elmandjra, ARK Invest, 2020

Why We Currently Don’t Buy Bitcoin – Or Any Other Cryptocurrency
James Smigiel, SEI, 2021

##### About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.