By now, most people have heard about bitcoin, and many investors would be able to correctly identify bitcoin as one of many “cryptocurrencies” that circulate today. A full description of bitcoin, the blockchain, and the universe of other crypto tokens is well beyond the scope of this article, but for a short primer I would recommend starting here: https://academy.binance.com/en/articles/what-is-bitcoin
In the early years, about a decade ago, it was easy to ignore bitcoin completely. Most investors had never heard the terms “bitcoin” or “blockchain” yet, and it was a reasonable and consensus view that bitcoin was basically “made up computer money” with no practical use whatsoever. And with a total market value of less than $1 billion, it just wasn’t on most investors’ radar screens.
But we’ve seen things have changed dramatically since then. Today, the universe of cryptocurrencies has grown to roughly $2 trillion in market value with bitcoin representing about 40% of that total. Bitcoin futures contracts now trade regularly on the Chicago Mercantile Exchange, some U.S. athletes and mayors are being paid in bitcoin, El Salvador has adopted bitcoin as its national currency, and it is estimated that 22% of the U.S. adult population, about 46 million people, now owns a least a small amount of bitcoin directly.
Are you among those 46 million people that considers themselves a “cryptocurrency investor?” If your answer to that question is an emphatic “No!”, you may be surprised to learn that you almost certainly own bitcoin already. Wait – how could this be true if you are strictly a traditional “stocks, bonds, and real estate” investor? The answer to that question speaks to both the explosion in crypto asset values over the last few years, and to how we see it is slowly becoming accepted as a legitimate asset class by a growing list of institutional investors.
The reason that most investors have some exposure to bitcoin (even if they don’t realize it) is that there are now 27 publicly traded corporations in the U.S. that hold bitcoin as a reserve asset on their balance sheets. For example, Tesla is the fourth largest company in the S&P 500 index, and it holds approximately 43,000 bitcoin on its balance sheet, worth about $1.7 billion. MicroStrategy, one of the larger components of the Russell 2000 index, holds nearly 125,000 bitcoin on its balance sheet, valued at around $5 billion. Any investor who holds a diversified basket of U.S. large or small stocks will likely hold one or more of these companies, and thus some exposure to bitcoin.
Granted, in terms of total exposure for stock investors, these crypto holdings represent very tiny fractions of the overall equity value of U.S. companies; but, since nearly all of us own at least a tiny sliver of cryptocurrencies in our portfolios already, it’s probably time to do a quick overview of today’s cryptocurrency market and how to think about it as a potential investment.
Key point #1: Bitcoin is both a token and a network.
For about eight years, from 2009-2017, bitcoin was the only cryptocurrency in existence. Initially, there was also only one “use case,” and that was payments. The value proposition for bitcoin was as a global, borderless, permissionless, internet-native currency that could be sent around the world in a few seconds, as easily as an email. That use case still exists today, although many newer cryptocurrencies are much faster and cheaper to send than bitcoin.
Today, you hear more references to bitcoin being a “store of value,” as it has grown more valuable and is not very practical for day-to-day spending, especially in the U.S., where bitcoin is not treated as a currency under the tax code. Instead, spending bitcoin is treated as a sale of property, requiring methodical record-keeping and the payment of tax on any net realized capital gains. We feel this is why very few people in the United States use bitcoin to buy their morning coffee or for other day-to-day purchases.
Note that bitcoin is both a “currency” and a payment system. Bitcoin, with a capital “B,” is often used to refer to the entire network, whereas “bitcoin” (little b) refers to the token itself. Operators running the Bitcoin protocol validate transactions and are rewarded for securing the network by earning bitcoin (called “mining”) by being the first to solve difficult cryptographic puzzles. The amount of bitcoin earned through this process declines predictably over time, which maintains scarcity and a low rate of inflation.
Metcalfe’s law suggests that a network’s value is proportional to the square of the number of “nodes” (or users). A network with 100 users is theoretically worth 4 times as much as one with 50 users (since 100^2 = 10,000 and 50^2 = 2,500). This is one reason why bitcoin has value; as the number of users has grown to more than 100 million worldwide, the value of the network (“Bitcoin”) has grown as well, which accrues to the native token of that network (“bitcoin”).
Key point #2: The real technological breakthrough was the invention of “digital scarcity.”
Before bitcoin, earlier versions of electronic cash suffered from the double-spend problem. How do you prevent someone from simply copying the same digital token and spending it as often as they like? Bitcoin cleverly solved this problem by using a combination of public and private keys, secured by modern cryptography, and by publishing all transactions on a blockchain (which is just a public ledger) for anyone to download and study. The total supply of bitcoin is also capped at 21 million, which is hard coded into the bitcoin protocol.
Key point #3: Bitcoin was the original, but there are now thousands of other cryptocurrencies.
Bitcoin was the first cryptocurrency, and with a market cap of about $700 billion, is still the largest. Ethereum, introduced in 2017, is the second largest, with a market capitalization of about $300 billion, but there are many thousands of individual crypto tokens that trade actively today. Ethereum, like bitcoin, is considered a general “base layer” or “layer 1” coin; other coins, sometimes referred to as “layer 2” coins, are built on top of base layer coins. Most of these have very specific use cases and are often intended to improve the speed or functionality of base layer networks.
Key Point #4: The vision among today’s crypto enthusiasts goes well beyond payments and stores of value.
Today, many leaders in the cryptocurrency industry imagine the wholesale re-creation of several industries, from finance to entertainment, as well as the invention of entirely new ones. They see the potential for dramatic gains in speed and efficiency, lowered transaction costs, and the elimination of “middlemen” everywhere. They describe a future world in which creative artists can connect directly with their audience and monetize their content, without the need for a centralized platform like Spotify, for example. Peering even deeper into the future, they envision the next iteration of the internet itself, sometimes referred to as “Web 3.0,” in which individual web users can regain control over their own data and identity, all powered by decentralized cryptographically secured tokens. Of course, whether any of this comes to pass is still an open question.
Conclusion
Because of this broader vision, it may be time to update our thinking, and even our language, when it comes to today’s cryptocurrency industry. In fact, the word “cryptocurrency” itself may no longer be an accurate description of these digital assets, since buying them is more akin to owning shares in a start-up company. The major difference is that investors can access these projects at a much earlier stage, rather than wait until equity shares are issued in a public offering. As with other forms of venture capital investing, this feature has the effect of amplifying the potential gains and losses on crypto investments.
Cryptocurrency remains a highly speculative and volatile asset class, with wild swings of 5% or more occurring frequently on very short timeframes. For investors within the normal range of risk tolerance, digital assets should probably be limited to a very small portion of your overall portfolio. Correlations with other risk assets, especially with U.S. large growth stocks, appear to have increased over time, but it’s too soon to say if this is a permanent condition. It’s also too early to know if digital assets will eventually join stocks, bonds, real estate, and commodities in standard investment portfolios. It will be fascinating to see where this all goes in the next several years.
Sources:
https://explodingtopics.com/blog/blockchain-stats
https://academy.binance.com/en/articles/what-is-bitcoin
Disclosures:
The opinions expressed herein are those of Elevate Wealth Advisory (“EWA”) and are subject to change without notice. EWA reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This should not be considered investment advice or an offer to sell any product. EWA is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about EWA, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.
The opinions expressed are those of Elevate’s Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed.
This is not a recommendation to buy or sell a particular security.
There is no guarantee of the future performance of any Elevate portfolio.
Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.
This material is not financial advice or an offer to sell any product.