A Look at Bitcoin and the Cryptoasset Space

a look at bitcoin and the cryptoasset space

Since 2017, when cryptocurrencies or cryptoassets like Bitcoin first had a major run-up,^[1] we have continued to receive questions around the appropriateness of buying cryptoassets like Bitcoin. Before continuing further, some definitions may be helpful. Cryptography can be defined as the process of using techniques to secure and protect communication, normally through solving codes or math-based puzzles. Cryptoassets, by extension, are digital assets which use cryptography to allow for the creation of these assets or to facilitate financial transactions.

Like the definitions, the history of this topic is also complex. As an overview, Bitcoin (BTC) is one of the first decentralized implementations of a concept called "cryptocurrency" first described in 1998 by Wei Dai on the Cypherpunks mailing list. This group discussed the idea of a new asset that uses cryptography to control the creation of new units of value and monitor transactions rather than a central authority such as the Federal Reserve. The first Bitcoin specification and proof of concept was published in 2009 in a cryptography mailing list by Satoshi Nakamoto (a pseudonym), who may be one person or a group of people. Satoshi left the project in late 2010 and remains in obscurity. The community has since grown exponentially with many developers working on Bitcoin and other projects. To help understand the motivation for creating a cryptocurrency, Cypherpunks valued cryptography as a way to avoid surveillance by governments and others to maintain privacy.^[2] ,^[3]

Along with the benefit of increased privacy, Bitcoin and other cryptocurrencies were meant to create a decentralized system. This decentralized system could cut out financial intermediaries and facilitate transactions directly between both commercial and individual parties. One benefit is that transactions would ideally be lower cost, and quicker, due to the elimination of non-essential steps and layers of fees. Time will tell if that will be the case, but as of today, there is still room for improvement. From an ideological standpoint, many supporters did not and do not trust financial institutions, central banks, or governments, especially in the aftermath of the Great Recession. Furthermore, throughout history, many fiat currencies (backed by government decree, not gold for example) have been depreciated or lost value. For that reason, they wanted to create a financial system that is not dependent on governments or centralized powers.

Cryptocurrencies, while decentralized, have no intrinsic value either, and only have value to the extent that people agree they have value. After all, these assets are entirely digital. Yet, one aspect that could drive value is scarcity. Bitcoin, for example, has a limit on the amount that can ever be created or “mined,”  where mining is essentially using computers to guess complex random numbers in exchange for Bitcoin. The limit to the Bitcoin supply is capped at 21 million units and as of today, over 18.6 million units have been mined. The 21-million-unit cap is not set to be reached until around the year 2140 for reference. If demand for Bitcoin increases, and supply stays constant, the price could increase. Government-backed currencies on the other hand have the resources of a country and the militaries that can justify value for the currency, though more money can always be printed.

Complicating matters, there is a part of the cryptocurrency ecosystem that many agree has value, and that is the blockchain. The simple explanation for the blockchain is that it is a decentralized transactional ledger. On the blockchain, participants around the world verify transactions that take place, and everybody maintains a copy of this ledger, making it decentralized.^[4] This blockchain technology could be useful in that it has potential to verify transactions, manage supply chains, and reduce compliance costs, among a litany of other uses. Several banks like JP Morgan have pursued projects that use the blockchain already. For example, JP Morgan has tested a private blockchain to track auto-dealer inventory.^[5] While there is widespread disagreement on the topic, many believe that a blockchain doesn’t need to use Bitcoin, as long as there is some financial incentive provided to maintain the ledger.^[6],^[7]

With the historical stage set, which parties have been the most vocal in the space about the benefits of Bitcoin and why? We question this because it is important to always understand incentives. One group that benefits are the tech savvy early adopters/creators who own Bitcoin. In fact, research by Bank of America shows that 95% of Bitcoin is controlled by just 2.4% of accounts! To compare, the Fed believes only 30.4% of household wealth in the U.S is controlled by the top 1% of Americans.^[8]  

There are some public figures that are visible in the news and are pointed to as authorities too. From a cynical standpoint, one example is MicroStrategy CEO, Michael Saylor whose company bought $475 million in Bitcoin from August to December 2020 (chart below) as MicroStrategy converted cash reserves into BTC, allegedly to hedge inflation. Of note, this is a company that has had revenue decline every year since 2014 so it could be a risky attempt to turn the business around.^[9] Most importantly, Saylor has a tarnished history. In 2000, MicroStrategy was accused of fraud by the Securities and Exchange Commission (SEC) for falsely reporting massive profits despite losing money. Ultimately they settled with the SEC. During the period of fraud, MicroStrategy’s “profit” was accompanied by a similar media frenzy, with the stock seeing an 80-fold increase in value over that time. Before the house of cards came down, they were lauded as a major success.^[10]

Another figure, Elon Musk, the CEO of Tesla, notably invested $1.5 billion in Bitcoin in January 2020 around a price of $35K per BTC but didn’t disclose the purchase until February. This led to an increase in BTC to a price over $50K.^[11] Due to lack of disclosure and his social media antics, there is potential that he may be investigated by the SEC. Some irony here is that Tesla aspires to be an environmentally friendly company, however, Bitcoin has been deemed by some as an environmental disaster based on the electricity consumption needed to mine Bitcoin. From a corporate standpoint, Bitcoin is volatile in price, so it may not be a great place to park funds if near term cash is needed.

Despite these two examples, there are good reasons for some companies to acquire Bitcoin. For example, Square and PayPal bought BTC. This makes sense since they are payment providers. In this case, preparing for any potential shifts to using cryptocurrencies or other forms of electronic payments seems prudent.^[12],^[13] We have also seen increased adoption from university endowments and public foundations who may view Bitcoin as a new asset class similar to gold.

Whether we are dealing with an individual or an institution, in an unproven and speculative space, we want to be careful to not become a victim of charlatans, which can take different forms. In Ben Carlson’s A Short History of Financial Scams, he identifies two types of potential charlatans. In his book, “Type I charlatans” are “more or less sincere but wind up ruining their investors anyway because they take their ideas to the extreme or fail to account for their unintended consequences.” These individuals could be true believers in the hype but fail to acknowledge potential downside. One example could be an individual like Elon Musk, who seems intent on changing the world. Type IIs, however, are more concerning as they “blatantly set out to take people for all they’re worth” and use charm and persuasion to recruit their stooges. These Type II individuals could be figures like Bernie Madoff, early adopters that stand to gain, or by firms that collect a management fee regardless of how cryptocurrencies like Bitcoin perform. This may play into the Greater Fool Theory,^[14] where the reason for speculating is to buy and sell shortly afterward before an eventual collapse.

From TMG’s standpoint, we believe there is a difference between speculating and investing, and we prefer to be on the investing side of the spectrum. In our eyes, cryptocurrency is more of a speculative opportunity, and we want to be clear that we do not allocate to cryptoassets at present time.

In this environment, we would not be surprised if many people around the world are taking on risk that they really can’t afford, to try to get rich quickly. Strong market returns and government stimulus only add fuel to the fire. In a country like Venezuela,^[15] there may be some reasonable rationale to buying Bitcoin as many people are experiencing financial hardship and the local currency rapidly loses money. In that instance, buying Bitcoin may be a reasonable risk where the upside could be great, and the downside isn’t much worse than the current situation.

In the U.S. however, it isn’t quite the same situation with a more stable currency, but behavior may be similar. Looking at some data from Coinbase, a popular cryptocurrency exchange, low FICO (Fair, Isaac & Company) score users have been driving recent cryptoasset growth. In the study, 53% of Coinbase users have a FICO score under 650 (very poor to fair range according to Experian), compared to the overall score range of 300-850. These users have increased their balances by 340% between January 2020 and 2021.^[16] This is a demographic that maybe shouldn’t take on as much risk with higher debt loads, but yet has done so. This growth in demand is potentially driven by fear of missing out, as BTC grew from $5,400 on March 9, 2020 to above $55,000 as of March 17, 2021. The continued growth of BTC itself could be fueled by increased institutional adoption, speculation by retail investors, or as some have theorized, price manipulation by Tether.^[17] For many, the reason is not important as long as the price continues to rise.

Despite the cause of the increase, BTC is clearly not being used as a currency as originally intended since it is too volatile to be a store of value and too expensive to use for day-to-day purchases. Because of the volatility, Bitcoin has been rebranded as digital gold, since supply is meant to be finite. The finite supply of BTC could be a hedge on inflation, as the price of BTC could appreciate in U.S. dollar terms if government stimulus such as money printing continues. This potential inflation hedge continues to be one of the more compelling cases for value today. The thesis is yet to be proven, as Bitcoin has not seen an inflationary environment. In addition, as the chart below shows, stocks and bonds may continue to be some of the more appropriate investments to exceed inflation. Other noticed uses for this decentralized asset have been to send funds to other countries, for remittances to family, getting around government sanctions such as in North Korea or Iran, financing terrorism, or for payments in the drug trade.^[18] Because Bitcoin can’t be centrally controlled, it seems well within the realm of possibility that governments may not be receptive to an asset that is at odds with their need for control, or puts the nation’s security at risk. From a geopolitical risk standpoint, it may be worth considering that 65% of all ongoing mining has been taking place in China, due to low energy costs there.^[19]

At TMG we do not believe that our clients need to or should take on risks that aren’t necessary and are best served focusing on long-term retirement goals. In addition, until more regulations are in place or there is an easier and safer way to allocate funds (an SEC approve ETF for example), we will not set up cryptocurrency wallets/accounts (at Coinbase for example) for clients, or buy cryptocurrencies for them in a discretionary manner. We also need to avoid being influenced by parties that may be acting in a way that is at odds with our clients’ needs.  As a gentle warning for do-it-yourselfers, losing the password to your digital wallet where cryptoassets are stored, means that your funds will be lost forever.^[20] We, of course, welcome further discussion with you, especially if you want to learn more on this topic.

As always, we want to be a source where counsel can be found. This is a new frontier that requires due diligence and understanding before committing funds. Our team at TMG is here to continue building a thorough understanding of this new frontier, while helping you to find solutions that are right for your unique needs.

The Mather Group (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, please see the firm’s Form ADV on file at www.adviserinfo.sec.gov. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG's research and professional experience and are expressed as of the publishing date of this communication. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice nor is it intended to provide comprehensive tax advice or financial planning with respect to every aspect of a client's financial situation. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Before investing, consider your investment objectives. Past performance does not guarantee future results.