Stanislav Kozlovski walks us through the most important events for Bitcoin in the first quarter of 2021.
Gradually, then suddenly.
It is the way that Hemingway penned the process of going bankrupt: first comes a series of incremental steps which bring you closer to bankruptcy, until reality hits you and a sudden realization of what has occurred dawns upon you.
This process can be thought of as a universal one: it applies to many things in life, like achieving success, declining health or the once-in-a-lifetime emergence of a brand-new asset class.
Across the “gradually, then suddenly” spectrum, Bitcoin is inching closer and closer to the “suddenly” part—and this quarter is an immaculate example of that.
In this piece, we will provide a short overview of all the Bitcoin news in the first quarter of 2021. Let’s dig in.
Corporate Treasury Adoption
High-profile companies continued to accumulate bitcoin in their treasury, with Square buying $170 million worth of BTC and MicroStrategy performing the carry trade of the decade by taking out a $1.05 billion bond loan at 0% interest to buy bitcoin.
Morgan Stanley made an SEC filing that revealed they want 12 of their institutional funds to offer exposure to bitcoin and additionally announced they will offer their wealthy clients access to bitcoin funds as well.
Visa announced support for USD Coin to be used to settle transactions on its payment network. Admittingly on the Ethereum blockchain, this is a large step forward for the industry; it is not a stretch to imagine them extending support for lightning. CEO Al Kelly mentioned that they are working on enabling bitcoin purchases on Visa credentials.
Smaller banks around the world are also converging on bitcoin support, just not making the news. For example, a small private German bank, Donner & Reuschel, which has been in business for 223 years, is offering cryptocurrency buying and custody or Blue Ridge Bank which became the first US commercial bank to provide access to bitcoin at its ATMs, allowing people to purchase directly from them.
Meanwhile, over in the United States, the SEC is drowning in bitcoin ETF applications. A US-based bitcoin ETF seems imminent. There are six firms that have filed applications to the SEC proposing bitcoin ETFs that either track and hold the underlying asset directly or have more indirect exposure through funds which invest in bitcoin. As of writing, the firms who have applied are Fidelity, Goldman Sachs, NYDIG, SkyBridge Capital, Valkyrie and Cboe.
Just as we were all ready to take a break from 2020, this year proved to be just as dynamic.
It all started with the capitol riots and massive censorship of sitting president of the United States Donald Trump, where several high-profile internet platforms acted in a coordinated fashion to completely remove him from the mainstream internet, with some banks also announcing they would stop doing business with him. Regardless of your political views, this massively unprecedented event sent shocks throughout the world by exposing the scary power that these centralized platforms have. It only goes to show that a censorship-resistant and permissionless currency is desperately needed in a world which can erase even the most prominent figure in a matter of days.
Countries burdened with inflation and a failing currency saw their bitcoin interest skyrocket, with Google searches for bitcoin in Argentina reaching peak popularity (300 percent-plus growth) and a spike in Turkey, where their currency lost 15 percent purchasing power in a single day. Bitcoin seems to be heavily favored compared to gold in such burdened countries, consistently surpassing gold’s Google search volume in Venezuela and Nigeria.
As always, inflation numbers are unlikely to reflect what’s actually happening, as official numbers can rarely be trusted. The Federal Reserve’s chairman Jerome Powell asserts this belief as he publicly states that the real unemployment rate is closer to 10 percent compared to the officially stated one of 6.3 percent. If a government official cannot trust the publicly reported numbers, how can an average citizen?
History, this quarter including, has proven that countries cannot outright ban bitcoin; they can only temporarily ban their citizens from participating in the network. Some countries like Nigeria realized this inevitability and backtracked on their previous ban within a month after announcing it.
While noisy, this year did not bring any new content with relation to FUD, rather, it simply recycled old content that has long been debunked. Despite the unoriginal negative press, this quarter we saw many people write very eloquently and positively about bitcoin, in particular about itsenergyuse.
Some pro-bitcoin US politicians established key positions in the government, like Cynthia Lummis who joined the banking committee, Former TD Ameritrade Head of Digital Assets Sunayna Tuteja was named US Federal Reserve chief innovation officer and Gary Gesler, who has taught a blockchain course in MIT, is nominated for leading the SEC.
There was mixed news regulations-wise. As we started the year with the FinCEN proposal that had an unreasonably short comment period of 14 days over the holiday season, the onslaught of comments from the community made it so that they had to considerably extend it, with the new Biden administration significantly extending the comment period by some 75 days.
Further, Kentucky signed a bill into law that incentivizes bitcoin mining in the state by allowing for tax exemptions on property and electricity used in mining.
Miami, the hosting city of the Bitcoin 2021 Conference, proved to capture attention in the Bitcoin space with the prolific mayor Francis Suarez actively engaging with the industry through Twitter and in-person meetings with famous Bitcoin proponents like the Winklevoss twins. Suarez has also publicly pushed back on some of the negative comments from Janet Yellen and has said to be actively exploring investing part of the city’s treasury into bitcoin. He said that they are procuring a vendor to offer employees to get a percentage of their salary in bitcoin, allow Miami’s residents to pay for fees in bitcoin, potentially also allow taxes to be paid in bitcoin and rumours say they’re working on giving mining incentives to attract investment.
In a petty battle between Norwegian billionaires, Øystein Stray Spetalen was quick to reverse course after seeing the other Norwegian billionaire Kjell Inge Røkke’s company Seetee buy $58 million worth of bitcoin. In a conference in early March 2021, he expressed his negative views about bitcoin, but just a couple of weeks later, he realized he was wrong and bought some.
We’ve seen hugely respected names in the investment industry turn from skeptic to lukewarm, like Howard Marks who initially called bitcoin a pyramid scheme only to admit this year that he did not understand it. Ray Dalio has been trekking across the spectrum as well, most recently scheduled to speak at two crypto conferences: Texas A&M Bitcoin Conference inApril 2021 and Consensus in May 2021.
Bitcoin has the power to convert even the most faithful gold believers, like long-time gold bull Jeffrey Gundlach who turned neutral on his views on gold and the dollar, admitting bitcoin may be the better bet which is no surprise considering the Bank of Singapore implied the same thing in a research note.
Retail interest has been rekindled over the quarter as well, withmanyexchangesrecording all-time high traffic and bitcoin-related social media seeing parabolic growth:
In the same way that people never notice the “gradually” part of bankruptcy and are left struggling with solutions once the “suddenly” part hits, today’s market participants are scrambling to establish their position in this new Bitcoin world, be it as a service provider, investor or anything in-between.
While the flurry of news can certainly seem like we are in the “suddenly” part of the spectrum, it is worth taking a step back, observing the bigger picture and realizing we still have a long way to go.
Today, bitcoin’s market cap is roughly 10 percent of gold’s market cap, a five-time jump from where it was in May 2020 but still a far cry away from its first milestone of surpassing gold. Bitcoin’s market cap is still significantly less than the whole $1.9 trillion stimulus package that the United States printed out of thin air. Nevertheless, since 2020, there have been clear signs that bitcoin demand is growing incredibly fast, much faster than the market demand for gold, despite being worth only a small fraction of gold’s market cap.
My intuition tells me that we are still a fair amount of time away from jaw-dropping adoption. Money, after all, is humanity’s most valued asset, as the whole world readily trades its scarcest resource (time) for it. Bitcoin is a global permissionless network consisting of the soundest money the world has ever seen. Any quarter which truly embodies the “suddenly” part of the market penetration of this global asset will surely not be able to fit inside a single sub-3000-word piece.
This is a guest post by Stanislav Kozlovski. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc. or Bitcoin Magazine
A Short Introduction To What Influences Money Supply In The Modern Economy
It’s undeniable — the world runs on money. This thought is ingrained in all of us and we all understand it deeply. This is evident by the fact that we spend vast amount of hours every day in order to attain more of it.
In the Bitcoin space, we constantly see news, memes and critiques about how the central banks have printed absurd amounts of money yet again. The truth of the matter is that the monetary system does not work quite as simply as that — there are many more players involved that ultimately decide the net amount of new money creation in the world.
This system impacts our lives greatly — from things like interest rates on our savings accounts, mortgages, inflation and asset prices to global problems like the growing wealth inequality gap. Despite the significance, few understand how this system works. We are not taught about it in school.
In this piece, we will examine credit in depth. After the article, you will better understand why it is the cornerstone of our modern economy and how it is the main driver of money creation and be able to inspect the tools that central banks use to control credit.
To understand how money is made, we first need to understand how it’s spent.
We all know what a transaction is — the spending of money for something else , be it a service, a good, an asset or whatever else.
The economy is the sum of all of the transactions in all of its markets.
The economy is the sum of all the transactions in all of its markets.
With that, we can say that money is the basis of each transaction and therefore the basis of the economy.
In order to facilitate a transaction, a person has to spend their hard-earned money for something. Deceptively simple, a transaction is the critical building block of the whole worldwide economic machine.
Because the economy is the sum of all of the transactions and a transaction is driven by a person willing to spend money in exchange for something, we can say that the economy is driven by the spending of people.
The key observation here is that this spent money becomes another person’s gained money.
Think about it — every dollar you earn is a dollar somebody else spent. One person’s spending is another person’s income.
One person’s spending is another person’s income.
This is the basis of an exchange. Everything we do professionally is always building/giving something that gets exchanged for money.
Money is a human invention which has a long, long history. All sorts of things have served as money before — barter, shells, gold coins — and it has continued to change its definition to become things like paper money, digital money and bitcoin.
Disregarding the past and the future, let’s focus on money as what it is most conventionally thought of as nowadays: dollar bills.
This is what people imagine money as, even if in a digital form.
But that’s not entirely correct. Most of what people call money nowadays is actually credit — a sort of temporary money that must eventually be returned to the lender (typically a bank).
Most money nowadays is actually credit.
That’s right. Most money in the economy is actually temporary in its nature.
Note: That number is a lower bound, as it is hard to identify what part of the $19 trillion in M2 money supply is credit and what is not.
Credit is the biggest, most important and most volatile part of the economy. It is the act of borrowing money which you promise to repay in the future.
There are two terms to describe this interplay of borrowing: credit and debt.
Once credit is created, it is turned into debt.
credit(Middle French for belief, trust) — the act of a borrower taking a loan from a lender.
debt— the money owed (i.e., the liability) of the borrower once he has taken out credit.
Credit is what enables an upward spiral of spending in our economy.
If you’ve earned $100,000 and you take a $10,000 credit, you can suddenly spend $110,000! Because one person’s spending is another person’s income, this means that another person just earned $110,000! Imagine that they also take credit, and so the cycle continues.
Credit is what enables an upwards spiral of spending in our economy.
This fact is fundamental to everything else.
If you continue the spiral long enough, you can see how it translates into more and more spending, and therefore, more and more income!
The more credit is taken, the more money appears in the system. Since credit is typically used for spending, the more credit is taken the more incomes in the system rise. Through that lens, taking credit can be seen as a good thing.
But also, the more credit that is taken, the more debt that is created .
Tying this back to the 1:4.2 ratio, you can imagine how far along we’ve continued the cycle of credit creation.
You may be asking yourself: “Where does this magic credit come from, then?”
Fractional Reserve Banking
Look no further than our banking system for some credit!
This form of banking is called fractional reserve banking — it states that banks are allowed to lend out a fraction of the money they have in deposits from other people.
This is where we open Pandora’s box — money that’s lent by banks is created out of thin air. If Alice deposits dollars in a bank and the bank lends out part of them to Bob, both Alice and Bob have money in the bank — the sum of which is greater than what was initially deposited.
In other word — banks don’t physically have all of the money they’re giving you when you’re taking credit. The money they’re giving you when you take a credit is digital and freshly created.
Note that banks cannot print new physical money, they can only create new digital money — after all, they’re just updated entries in their databases.
In the end, banks are also not free to create as much digital money as they want — there are constraints.
They have a reserve requirement — a minimum percentage of the money they’ve loaned out that they’re legally required to hold in reserves. This is typically 10 percent.
A bank’s reserve requirement is the bottleneck that dictates how much loans they can give out.
For every $1 that a bank has in reserves, it could have given out close to $9 more in credit. That’s why it’s called fractional reserve — it’s reserving only a fraction of the actual money it’s “giving” to people.
On to some examples: If you deposit $1,000 to a bank, it has the ability to loan out $900 of that. This is literal creation of money, because in your eyes, you still have $1,000 in the bank, and in the eyes of the borrower, they have $900 in the bank — but only $1,000 was ever deposited. The result of that is that the bank has people with $1,900 in aggregate deposits in it, but actually has $1,000 worth of “real” money.
Here is a visualization of the system at play:
The example above illustrated part of the journey of a bank deposit. This is how banks make money off of deposits — they lend them out for interest not once, but continually as this new money cycles throughout the system.
Looking at it from a systemic level, we can say that when loans are given out, money is created. When loans are paid, money disappears.
Think of it like a balloon which can be inflated up to a point and deflated. In that sense, money created out of credit can be thought of as temporary, as it will eventually be returned back to the bank.
When loans are given out, new money is created in the system.
When loans are paid back, money disappears from the system.
That’s quite the mind bender for some. It takes a while to have this sink in and realize how it works.
Note On Reserve Requirements
This crisis brought change to a lot of things and fractional reserve requirements was one of them. It was abolished in the U.S. in March 2020. This is not unprecedented — a lot of other countries do not have a reserve requirement (Australia, UK, Canada), a lot of others have miniscule requirements (Europe : 1 percent) and the U.S. was moving toward an “Ample-Reserves Regime” regardless.
Even without a reserve requirement, banks are not free to print as much money as possible. They are still constrained, this time by the so-called capital requirements. In the U.S., capital requirements denote that an adequately capitalized institution must have a capital-to-risk-weighted assets ratio of at least 4 percent — i.e., a bank must have at least 4 percent in capital (common stock, disclosed reserves, retained earnings) out of the worth of all its assets. (Credit typically constitutes around 75 percent of a bank’s assets.)
In that sense, a bank’s reserves (i.e., money it has in its Federal Reserve account) are part of its capital, since it is a disclosed reserve.
The difference is that this disclosed reserve is no longer a single bottleneck on how much they can lend out — it is only a part of it now.
Regardless of specific regulations, the fractional reserve example should give you a good sense of how new money enters the economy through credit. Whether there is a reserve requirement or not is just the limit on how much credit can be created.
Controversy Around Fractional Reserve Requirements
With the recent abolishment of the fractional reserve requirement, there is currently a lot of outdated/mixed information online.
Further, if one takes the time to dive into the economic literature of the past century, they will be surprised to see that economists have cycled through numerous theories about the way private banks create money, all of which has been based on theoretical models.
There seems to be a fair bit of dispute over how this system works and it is frankly shocking to learn that much of modern banking policy, regulation and reforms are based on theory, not fact.
Empirical data seems to support that banks have the ability to create money out of thin air, which nevertheless does not dispute the fact that the money they can create is bounded by the regulatory (capital/reserve) requirements banks are faced with. The only difference is that they are not necessarily required to lower their reserves once a loan is given out.
Takeaways So Far
The economy is the sum of all of the transactions in all of its markets
Credit helps boost growth in an economy
Most money nowadays is actually credit
When a loan is given out, new money is created in the system
Banks’ reserve requirements were the bottleneck for credit creation for a long time but most recently, that system has given way to a more complex and vague mechanism of ample reserves
Summary So Far
We have learned about the importance of a transaction and the fact that transactions are the single building block of an economy. We explained what credit is and how it helps boost transactions’ value (spending), which in turn boosts income.
We explained how the reserve requirement works in a fractional reserve banking system and learned that, to this day, economists have not settled on a theory which dictates how money is created.
Okay, then, who dictates how much new money is created?
Central banks are generally in charge of creating money.
In the U.S., the Federal Reserve’s official goal is to conduct monetary policy such that the country achieves sustainable long-term growth. In other words, it wants to control money printing in a way that is conducive to growth.
Said newly-created money can either be physical in the form of bills (i.e., U.S. dollar bills) or digital, in the form of numbers in a database.
Physical Money Creation
In regards to dollar bills in the U.S., it is the Department of the Treasury that literally prints those. The Federal Reserve decides how much should be printed in accordance with physical money demand — it then orders the Treasury to print that amount of dollars. This newly-minted money is then transferred to the Fed’s 28 cash offices and from there it is distributed to all the banks.
Actual paper money is decreasingly negligibly — it is only 11 percent of the total money supply. ($1.75 trillion out of $15,333 trillion, as of the end of 2019).
That’s right — most money in the world is digital. The way digital money is created is much more nuanced and less directly controlled by the Fed.
Let us dive deeper to understand how the rest 89 percent of the U.S.’s money supply is created.
Digital Money Creation
If you remember, we mentioned that credit is money that is loaned into existence. Since it is the private banks that loan money to the broad public, we can say that they possess the power to create money digitally.
If most money in the world is digital, then it must be the private banks that create most of the money supply in the world.
That’s exactly how it is — the vast amount of new money is created via credit issuance from private banks. This is contrary to popular belief and media headlines, which claim that central banks print massive amounts of money.
New money is created via credit issuance from private banks.
That being said, it is still up to the central banks to control this in accordance to their monetary policy.
Central Banks’ Role
Central banks still have great influence in how much money is created, they just control it indirectly by incentivizing the private banks appropriately and tweaking the money supply.
The Federal Reserve has three main ways of controlling the new money creation rate:
Federal funds rate
Let us go over them:
Capital requirements inherently limit how much credit a bank can give. Previously it was the reserve requirement that would be the bottleneck, but as we mentioned, banks are now only limited by their capital requirements.
If the Fed wanted to decrease the amount of credit in the system, it would increase the capital requirements of banks, thus further shrinking the amount of credit they are allowed to give out with their current capital.
Conversely, if it wanted to increase the amount of credit in the system, the Fed could lower the capital requirements to allow banks to lend out more with what capital they currently have.
Of course, allowing banks to lend out as much as possible does not guarantee that loans will be made. After all, you need to incentivize the public to take out more loans as well.
Federal Funds Rate
If you’ve ever read financial media, you would have surely seen headlines like “Fed Lowers Interest Rate.”
The interest rate commonly mentioned is in fact the federal funds rate, a fundamental interest rate to our economy that serves as a benchmark and influences all other rates. To best understand how it works, we need to first understand where it is used.
Private banks, along with a myriad of other institutions, trade with one another every day at the so-called overnight repo market.
overnight — short-term, typically for the duration of a day (hence, over the night)
repo (short for repurchase agreement) — a secured loan where one party sells securities to another and agrees to repurchase them at a higher price. In the overnight market, the securities most commonly sold are U.S. treasuries.
reverse repo — a short-term secured loan where one party buys securities from another and agrees to sell them at a higher price. It is the other side of the repo trade. For the bank selling a security and later repurchasing it, is it a repo. For the bank buying that security and later selling it at a higher price, it is a reverse repo.
The overnight market has many participants besides banks, but its main purpose is to help banks balance out their reserves after a day of operations.
It exhibits some of the lowest interest rates out of the whole economy, partly because the loans on it are so short.
Banks need reserves for a variety of reasons — in order to meet intraday payment needs, regulatory constraints (e.g., capital requirements), internal risk management constraints and more.
In any given day, a bank can give out more loans that it is comfortable with in the short-term — it settles this on the next day via the overnight market. An example:
Institutions have reason to lend money out in the overnight market as it is one of the safest investments out there. Banks with excess reserves similarly have an incentive to lend that money out in order to earn interest on it.
This interest is known as the overnight rate and it is mandated by the federal funds rate (FRR).
At the start of any business day, banks with excess reserves lend out their money to other banks in an overnight loan. Said loan is typically paid at the start of the next business day after that (hence, overnight). These loans are collateralized with U.S. treasuries.
The overnight rate of these repo agreements is very important to the process of new money creation because it is heavily tied to the interest that banks will offer their customers.
A high overnight rate means that banks will offer higher rates to their customers (otherwise they could only lend out in the overnight market which is safer). The higher the rate, the less demand there will be for loans, the less new money will be created.
Conversely, a lower overnight rate translates into lower interest for customers, thereby increasing demand for loans and driving new money creation.
So how does the Fed control this market?
Back in the fractional reserve days, when there was a reserve requirement, the main driver for controlling these rates were the so-calledopen market operations.
open market operation — the central bank buying or selling securities to the open market in order to implement monetary policy. This can either be pure transactions (buy/sell) or repurchase agreements (repo/reverse repo).
When the Fed wants to lower interest rates, it prints its own money and uses it to purchase securities from banks. Since the Fed can create as much money as it wants, it can be an endless buyer.
By purchasing securities with newly-printed money, the Fed injects new liquidity into the banking system. Because banks then find themselves with extra cash, there is less demand for loans and therefore the interest rates on loans fall in order to meet demand.
Vice versa, when the Fed wants to raise interest rates, it sells securities to banks, gobbling up cash (reserves) from the banking system, therefore increasing demand for loans. Due to the limited supply of cash, the interest rates rise because banks are ready to pay higher for it.
Nowadays, in the ample reserves regime, open market operations have a lesser effect. This is because of the large quantity of reserve — small changes in the supply no longer influence rates that much.
Rather than doing massive open market operations, the Fed started using other tools to bound the federal funds rate.
First, it introduced a new rule in which it pays banks interest on excess reserves they store in their account at the Fed. This is known as the IOER rate.
IOER (interest on excess reserves) rate — interest that the Fed pays member banks on the excess reserves they have in their account at the Fed.
If the Fed wants to raise interest rates, it can increase the IOER rate that it offers. With that, banks would only lend out money to other banks if it earns them more than parking their money at the Fed.
The problem is that the overnight market has participants which are not banks, therefore they’re not allowed accounts at the Fed and cannot benefit from IOER.
These non bank institutions could still lend out for less than the IOER, so the Fed solved this by doing open market operations in the form of offering institutions repurchase agreements at the Fed’s desired rate — institutions buy securities from the Fed and sell them at a higher price. This is a reverse repurchase agreement from the point of view of the institution.
Since the Fed prints its own money, it can offer whatever high rate it desires in the reverse repos, giving non-bank institutions no incentive to offer loans for lower rates than that (they could sell to the Fed for a guaranteed higher return).
This rate is called ON RRP.
ON RRP (offering rate on overnight reverse repurchase agreements) — interest that the Fed pays institutions when they conduct a reverse repo with the Fed (when they buy securities from the Fed in order to sell it back at a higher price).
Raising both IOER and ON RRP increases the interest rate in the overnight market, because no participant has any reason to offer loans below that rate. They serve as the lower bound of the federal funds rate.
Conversely, lowering IOER and ON RRP stimulates a decrease in interest rates. Banks are incentivized to loan their money out to earn more from it and other institutions are incentivized to seek higher rates from their loans than what the Fed offers.
Both interactions increase the supply of loans which lowers the rates.
Finally, the Fed has another tool to help control rates called the discount rate. This is the rate that the Fed uses to give out loans to banks.
Taking a loan out from the Fed is considered an emergency move, since it means that no other institution wanted to lend the borrower money in the overnight market. As such, the Fed typically prices this discount rate a bit higher than its federal funds rate.Regardless, having the Fed offer loans to banks at a rate it controls gives the system an upper bound on the maximum interest rate. With this tool, the Fed can now very tightly control the interest rate on the overnight market.
As you can see, the Fed now controls both the lower- and upper-bound of the overnight rate, effectively pinning it to whatever range it desires.
Quantitative Easing (QE)
And now, the final tool in the Fed’s arsenal — the one we’ve heard all about — quantitative easing!
While it sounds complex, it is relatively simple in actuality — it is the process of the Fed buying assets from its member banks with newly-created money.
It is the same as an open market operation — the only difference is that quantitative easing is done at a much larger scale and is thus not considered a normal day-to-day operation like open market operations.
These new assets go on the Fed’s balance sheet — this is precisely what causes the Fed’s balance sheet to expand, as many media headlines note.
quantitative easing (QE) — the act of the central bank expanding its balance sheet by conducting large-scale open market operations funded by newly-created money. It is typically used for buying long-term (10 year to 30 year) U.S. treasuries from member banks.
The effect of this is that it injects new money into member banks’ reserves, boosting their capital and allowing them to loan out much more than they could have with respect to their capital requirements.
The more banks can loan out — the more they will, hence supply of loans increases. Demand falls since less banks need liquidity.
QE makes it so that interest rates fall.
Side Note: Quantitative Tightening
Each aforementioned tool is useful both for raising and lowering rates. Since QE can only lower rates, it has a counterpart named quantitative tightening (QT) which is the exact reverse — the act of the central bank shrinking its balance sheet by selling off assets which results in raising interest rates.
The interesting part is that QT is the only tool we’ve mentioned that has never before been done at scale. As there have not been many practical applications of it, we have to turn our attention to experiments.
The Fed has experimented with QT throughout 2018 and 2019 when it sold off some assets in its balance sheet but it had to abruptly end it pretty shortly after, once it noticed a slowing down economy.
In this long piece, we learned a ton about how money is created in the world, how transactions power our economy (one person’s spending is another’s income) and the fundamental importance of credit on boosting economic growth and new money creation.
We covered how, contrary to popular belief, the Fed does not outright print money and distribute it to the world. The way money creation works is much more complex, vague and indirect. Further, it is not immediately obvious that money creation is bad, as credit has its benefits to an economy.
We learned that credit issuance is the mother of new money creation and therefore interest rates are fundamental to it.
We briefly touched on some of the money creations mechanisms at play — fractional reserve banking, the ample reserves regime, the overnight market and the way the central bank uses its tools to interact with these mechanisms in order to control the interest rate, namely capital requirements, open market operations, IOER, ON RRP, the discount rate and quantitative easing.
All Takeaways And Summarized Bullet Points
The economy is the sum of all of the transactions in all of its markets
Credit helps boost growth in an economy
When a loan is given out, new money is created in the system
Most money nowadays is actually credit
Banks’ reserve requirements were the bottleneck for credit creation for a long time but most recently, that system has given way to a more complex and vague mechanism
The vast amount of new money creation is done through credit issuance from private banks
The interest rate that the broad public gets on loans is largely determined by the overnight repo market’s interest rates
The overnight repo market’s interest rates are tightly controlled by the federal funds rate
The Federal Reserve controls the federal funds rate via multiple tools, lower-bounding it via IOER/ON RRP, upper-bounding it by the discount rate and tweaking supply/demand of loans via QE
Because the interest rate influences the demand for loans, it influences the rate of new money creation. The Fed therefore influences the rate of new money creation.
Next time you see a large M2 number, know that it is not the Fed that printed $18 trillion of M2, but rather it might be that the Fed gave the private banks money such that they can lend out a lot more and increase the money supply.
While it’s easy to blame the central bank, the crux of the issue is that the whole system is inherently flawed. If the complexity and obscurity isn’t enough to prove it, the fact that we operated a banking system based on theoretical models which changed three times throughout the past century should be testament enough to prove that this system is not sound.
Why A Bitcoin Investment Is A Massively Underrated Opportunity In Today’s Macro Landscape
We live in interesting times. With the advances in technology and the proliferation of the internet — software is eating the world. Coming out of the Great Recession — the world had seen massive economic growth in what was close to an 11-year bull run largely dominated by U.S. tech equities.
We live in interesting times. With the advances in technology and the proliferation of the internet — software is eating the world. Coming out of the Great Recession — the world had seen massive economic growth in what was close to an 11-year bull run largely dominated by U.S. tech equities.
“There are decades where nothing happens; and there are weeks where decades happen.”
That is precisely what it felt like — COVID massively propelled all the aforementioned trends, and more, into overdrive. Data from McKinsey has shown that digital adoption has been driven forward five years in the span of eight weeks.
With all of the economic trends being accelerated, the first set of lockdowns which shut down many businesses across the world and an upcoming second set of lockdowns, many economists fear that we are dangerously close to a global depression.
In such unprecedented and uncertain times, the simple act of protecting your wealth can be challenging.
In this article, we are going to explore some of the options investors have in protecting and growing wealth, the many recent events that changed the dynamics of investing and make the case for an underdog asset with the potential to yield large asymmetric rewards.
Cash Is Trash
Why has money lost value?
In the old days, our monetary system had intrinsic value. It was directly linked to gold.
Post World War II, in 1944, the leading Western powers developed the Bretton Woods Agreement which formed a framework for global currency markets.
Every world currency was valued against the U.S. dollar, and the dollar, in turn, was convertible to gold at the fixed rate of $35 per ounce.
In the so-called gold standard, U.S. citizens could convert $35 at a bank for an ounce of gold. By 1976, this system had been completely abandoned — the tie between dollars and gold was cut entirely.
At that point, we firmly entered into the era of fiat money.
fiat (fi·at | ˈfē-ət) — an authoritative or arbitrary order : decree
fiat money — currency established as money by government regulation
Money was no longer backed by an inherently valuable asset (gold) — it was the trust of the government issuing it that stood behind the money and gave it value.
In an age where money is not tied to anything but the government backing it, said government is free to do whatever it pleases with it.
Such monetary policies are controlled by humans — meaning they are prone to greed and error. History has shown that this often leads to governments devaluing their currencies, most often through inflation.
Inflation is cruel, and complex. When the government introduces more money into the system, it eventually trickles down into the economy. At that point, the people who held cash lost part of their purchasing power.
From the perspective of a single person, this effect isn’t as obvious. If you had $1 at one point, you believed you had enough to buy one apple. But gradually, apple prices rise to $2 and you get left behind. This is because new money in the system does not spread evenly.
If you were to hold your dollar throughout the rise, you would have lost 50 percent of your purchasing power.
A peculiar thing can be observed in markets:
Denominated in gold, the S&P 500 had the same price in February 2007 as it did in November 2019, despite the respective nominal prices in dollars being $1,444 and $3,176.
If you were to sell a share of the S&P 500 in 2007 for $1,444 and held it until November 2019, you would not be able to buy the same share of the S&P anymore — only half. Conversely, if you were to sell a share of the S&P 500 for 2.12 ounces of gold at that time, in November 2019 you could have rebought that S&P share.
Again, if you were to hold your dollar throughout the rise, you would have lost 50 percent of your purchasing power.
While demand and market narrative certainly play a role, a driving cause is the increase of money in the system. For the S&P 500 to grow 100 percent and keep the same price in ounces of gold, it would mean that the price of gold must have risen at the same rate.
This shock put the central banks and governments in a dicey position — they were forced to provide monetary stimulus in order to both stabilize the markets and provide relief to the unemployed, low-income families and small businesses.
The world mostly followed — Australia and the Bank of England have both cut their rates down to a record low of 0.1 percent. Some others banks, like the European Central Bank and Bank of Japan, already had negative rates.
Technically, the Bank of England also dipped its toes into negative territory in May.
It seems like the whole world is a feather away from negative rates, a highly-debated and controversial topic.
When the Federal Reserve raises the federal funds rate, newly offered government securities (treasury bills and bonds, widely regarded as the safest investment) usually experience an increase in returns.
In other words, the risk-free rate of return goes up, making these investments more desirable.
Conversely, if rates fall — the risk-free rate decreases.
Additionally, interest rates have an inverse correlation to bond prices, so the more rates fall, the more expensive bonds become and therefore the less they yield.
Both of these incentivize income-oriented investors seeking higher returns to flock to riskier bets.
The current flurry of printing is not likely to stop anytime soon.
As of writing (just seven months after the last stimulus) the U.S. is currently negotiating a new package and Europe just hinted at a new package come December. After all, COVID is not over and winter is coming — we may be in for the largest infectious wave yet.
Back in March, the Fed was quick to assure us that it had an infinite amount of cash and that they were ready to do whatever it takes to ensure banks have enough capital.
For decades, part of the Fed’s job was to keep inflation at reasonable levels.
In August it changed its policy to instead prioritize maximum employment. They’re saying they will prioritize low unemployment rather than low inflation. This is a historic shift and profoundly consequential.
Consequential not only for the US.., but also for all of the other central banks in the world that largely follow the Fed. It opened the door for high future inflation throughout the world.
All signs are pointing to the fact that the Fed will act as a constant guardian against unemployment and, therefore, recessions.
The low inflation rates of today can be explained with the fact that technology is such a massive deflationary force that it’s combating the inflation to reasonable rates.
If you expect an annual 2 percent inflation, which is what most governments target, then the value of your money is halved over 35 years due to the power of compounding.
It is arguable whether these numbers will continue to hold given the policy shift, the 2020 explosion in stimulus and likely continuation into 2021. There is also a separate argument to be made about whether the 2 percent inflation number is accurate at all and whether everybody experiences inflation the same way.
By all accounts, the last couple of decades have shown that holding cash yields no long-term benefits.
The only attractive use case for cash is to take advantage of short-term opportunities — something that is hard to time correctly and unlikely to be done by non-professionals.
If cash is trash, and all the facts are pointing that it’s going to continue to be so for the foreseeable future, then any astute investor would try to move their capital outside of cash and into assets.
In other words: don’t sit on cash!
Now that an investor is forced to preserve his wealth in assets, the question becomes which assets are the best to pick?
There are many and a lot can be written about the topic, but for purposes of brevity we will go over two very popular ones — stocks and bonds.
One very common and lucrative asset is company stock.
Economists love and hail shares because they are considered a productive asset — it is something that is working daily to increase its value.
Unfortunately, we are at a very wobbly place in the markets. There is an extremely wide dispersion of revenue multiples between the highest and lowest valuation stocks. The spread ranks in the ninety-third percentile since 1980.
A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a “crash” or a “bubble burst.”
Typically, a bubble is created by a surge in asset prices that is driven by exuberant market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset’s intrinsic value (the price does not align with the fundamentals of the asset).
This definition is not far off from what we’ve seen so far in 2020. There have certainly been some stocks that have exploded in growth, whose price has greatly exceeded their intrinsic value.
While these numbers certainly pale in comparison with Nikola’s astronomical bubble, it is worth remembering that P/S ratios are a worse indicator than P/E, because the companies are not even profitable yet.
Often, narrow rallies lead to large drawdowns as the handful of market leaders have a high chance of failing to generate enough fundamental earnings strength to justify the elevated valuations and investor crowding for long.
Historically, sharply narrowing breadth has signaled below-average S&P 500 returns as well as larger-than-average prospective drawdowns.
Regardless, some people are resourceful and are making use of the situation. A record number of companies are IPOing in 2020.
Robinhood, for example, gained 3 million customers from the January to May period and is predicted to have added at least 5 million year-to-date. This would be 50 percent user growth on top of its already-large 10 million user base.
Many people apparently found themselves day trading in their homes as a means to pass the time. That is reasonable, given the zero commissions on trades, the $1,200 government checks sent to people, the beefed up unemployment benefits, massive volatility in the stock market that is likely to attract people and the fact that other venues for gambling like sports betting were closed.
To best end this section, let us explore failing company Kodak, whose stock soared as much as 2,189 percent (!) in two days after the company announced it received a government loan to make drug ingredients to help with the pandemic.
Retail traders piled onto the stock in just a couple of days, driving it up.
Unfortunately, they got wiped out in record time as well.
It is hard to deny that retail investors have a role in some of these irrational rallies.
Such widespread speculation is likely to cause volatility in the market given that these speculators are quicker to enter and exit stocks than the average person.
It is theorized that these investors have an outsized impact because online brokerages like Robinhood are selling their order data in real-time to hedge funds like Citadel, which are leveraging high-frequency trading bots to front-run the retail investors, amplifying their impact on price in the process.
In any case, these extreme examples showcase that there is a decent amount of irrationality in the markets today, likely spread out to most stocks.
That being said, some people are realizing the ludicrousness in the market.
You know you’re in a weird market when CEOs publicly admit that their companies are overvalued.
We’ve concluded that the stock market is at unprecedented levels right now and therefore risky — it would be prudent for us to find something safer.
Bonds have traditionally been considered a safe bet — an incredibly popular portfolio allocation has been the so-called Classic 60/40 split — 60 percent in stocks and 40 percent in bonds, the idea being that the latter hedges your risk in stocks.
Remember that bond prices are inversely correlated to interest rates and the Fed recently announced that those are likely to stay at 0 percent until 2023. The result should be high bond prices and low yields from them.
Given that bonds (and stocks) are at historically high valuations, the future is understandably projecting underperformance in said assets.
Bond yields today are so low that small changes (e.g., inflation) could lead to losses.
When a company defaults, an auctioned sell-off of all its assets occurs. The proceeds go to the bond holders. Typically the norm has been to recoup close to 40 cents on each dollar invested in a bond that has defaulted.
Today some are seeing 1 to 4 cents recouped for every dollar — a 99 percent loss in some cases.
Debt issued by the owner of Men’s Wearhouse (August 3) traded for less than 2 cents on the dollar. When J.C. Penney Co. went bankrupt (May 15), an auction held for holders of default protection found the retailer’s lowest-priced debt was worth just 0.125 cents on the dollar.
It shouldn’t have been a surprise — people were calling these zombie companies out a long time ago:
Truth be told, the bond market has been rotting from the inside. The long-lasting repercussions of ultra-low interest rates enabling risky companies to sell bonds with fewer safeguards (covenants).
Before any hint of a downturn, there were concerns in the increase of borrower-friendly covenants of bonds. Money managers had tight deadlines with insufficient time to sift through reams of loan documentation and this allowed them to miss loopholes in fine prints.
Desperate to generate higher returns during a decade of rock-bottom interest rates, money managers bargained away legal protections, accepted ever-widening loopholes, and turned a blind eye to questionable earnings projections.
Creditors always do worse in economic downturns, but in previous downturns, they had more power to press companies into bankruptcy sooner in order to stem losses.
Essentially, the effect of this is that once corporations get to bankruptcy, they’ve exhausted their options for fixing their debt, often topping up even more to try and get them through the pandemic.
It is amazing to learn about the loopholes such companies jump through to sustain themselves. For instance, they can execute asset transfers, spinoffs, carve outs and other controversial moves as a result of allowances inserted into the fine print of loan documents whose reviewers often do not have enough time to understand, as we said earlier, e.g.:
Retailer J. Crew Group Inc transferred its intellectual property outside of creditors’ reach as part of a debt restructuring (prompting a legal fight with the lenders)
PetSmart Inc transferred part of its stake in online unit Chewy.com away from lenders as it struggled to turn around its brick-and-mortar business. Again prompting a legal fight, some dropped their litigation after reaching a deal
Most details buried in loan documents rarely come into play for companies with healthy balance sheets, but a turn in the credit cycle as we’re seeing now could leave businesses struggling to repay lenders and their private equity owners scrambling to protect their investments from creditors.
This lowering of interest rates also pushed investors toward riskier higher-yielding securities which allowed junk-rated firms to borrow more in order to help them survive the crisis. Funny enough, that increased demand has also lowered interest rates in the junk bond market.
The high demand has resulted in a massive increase of debt. The Net Debt-to-EBITDA ratios of companies is at a recent all time high.
The dynamic here is twofold — companies take on more debt and investors get a lower rate of return for the same (or greater) risk.
Respectively, because corporate America is overburdened with debt, companies will have to divert more cash to repay these obligations, which places a limit on the amount they can spend on growing, especially if profits are dwindling.
And because investors get a lower rate of return for arguably greater risk, they are incentivized to pursue other ways of protecting their wealth.
Risk Of A Recession
It’s easy to get lost in the day-to-day market swings and forget the big picture. Let me remind you that we are at our most leveraged and risky market in the last decade, coupled with numerous other unfavorable circumstances.
Many recession signals are flashing red nowadays and have been for awhile.
During the pandemic, we saw an all-time high record of unemployment filings. People were being fired left-and-right!
Prior to COVID-19, the U.S. had a record of 695,000 weekly unemployment filings, recorded in 1982. This year, it obliterated the record. The new record is now 6.8 million unemployment filings in a week.
Worse off, in the last 37 weeks since the start of the pandemic, weekly unemployment filings have not gone below this previous all-time high record.
This is perhaps why the U.S. had beefed up unemployment benefits with $600 extra per week. Funnily, some people were making more while unemployed than while holding a job. It is likely that this helped fuel consumer spending throughout the quarter. Unfortunately, this stimulus ended in August and a new one is not in sight yet.
Many Americans are living paycheck-to-paycheck. Report conducted before the pandemic by Bankrate concluded that:
Consumer debt continues to grow, too. The more indebted the average person is, the less likely they are to take on more. Rather, they’d be more reluctant to spend and instead save in order to pay back their dues.
Given that a major part of the economy is fueled by consumer spending (a lot of which is based on credit), a slowdown can be expected.
Above the immediate conspicuous concerns lie others that are better hidden. One of them is the fragility of the market — a subtle risk that is likely largely unaccounted for by many investors.
Fragility In Carry Trading
Oversimplified, a carry trade is essentially one where you make money if things do not change.
Carry trades first started in the currency markets but have spread more widely into the equity markets. A debt-financed corporate share buyback is a good example of an equity market carry trade — issue cheap debt and buy back your own equity at a higher yield.
There are both more direct ways we see carry trades take place (volatility trading in hedge funds) and more sophisticated ways. At their core, all of these trades are vulnerable to volatility.
Carry trading amplifies market fragility and hides unrevealed risk — such trades always increase both leverage and liquidity.
The growth in leverage makes the world more fragile, but increased liquidity temporarily hides this fragility.
As the amount of carry trading increases, it makes the system appear more stable than it is since there’s more liquidity in there and less volatility.
Carry trading is very vulnerable to volatility, though. Because carry traders are also very leveraged, their trades become extraordinarily sensitive. They cannot withstand a modest amount of losses.
This problem has got bigger over time. Because the market is made up of more carry trading and therefore is more sensitive to volatility, the Fed is forced to react to shorter-term market developments, almost babysitting the market.
Leveraged loan — a type of loan extended to a company/individual that already has considerable amounts of debt.
A large percentage of loans had gone to companies with a debt-to-earnings ratio of six to one. We call these “zombie firms” — unprofitable firms which stay solvent merely because they take advantage of low-cost borrowing. Such firms don’t make enough to cover their interest but survive by refinancing their debts.
Default rates on leveraged loans have not hit highs yet (just 4 percent, up from 1 percent a year ago), but are possible to follow. It is reasonable to assume that you cannot get a market dependent on easy, leveraged loans and expect all to be fine when you cut off the supply.
To add fuel to the fire, the U.S. is in shambles. It is arguably the most divided it’s ever been since the Civil War in the mid-19th century.
The foundation on which the immense wealth and power of the U.S. is built — the society — is fundamentally shifting.
The U.S. was unable to elect a president for more than five days. Even now that the media has reported that Biden has won, there have been massive accusations of voter fraud and fake news. This is only stirring up fire in an already-heated country.
It is very hard for a government to maintain good policies when under severe scrutiny from the opposite political party and supporters.
To top it off, hundreds of thousands of COVID-19 cases are coming in by the week there.
COVID-19’s Second Wave
As this article is being written, the second wave of COVID-19 is spreading throughout the world.
Europe is increasing measures and implementing lockdowns in some countries and the virus spread uncontrollably in the U.S. while it was busy with elections.
COVID-19 is set to cause a lot more capital to shift hands. As commercial real estate leases expire, many companies are set to not renew as they’ve moved to a fully remote culture after realizing the benefits. Combine this with people moving out of large cities and you can see low demand in the future.
Such low demand is likely to cause additional toil on the already-struggling local service businesses that are close to bankruptcy.
It is hard to refrain from investing when you’re seeing people make money easily by just putting it into the top-four tech companies, but history has rewarded the prudent and patient.
“Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone’s throwing money at is a formula for disaster.”
In all regards, many economists are pitching for a switch to alternative, “riskier” assets. Many such assets exist — foreign equities, private equities, inflation-linked bonds, emerging market assets and more.
We will now focus on the ultimate alternative asset of them all.
A Succinct Introduction To Bitcoin
Bitcoin is the first blockchain-based cryptocurrency. It was invented in 2008 by an individual or group known by the pseudonym Satoshi Nakamoto and was released as open-source software in 2009.
Bitcoin is a scarce global decentralized digital asset — a type of financial instrument backed by the internet. It is an open network in which anybody can participate. Most importantly, it has a disinflationary nature by having a fixed cap on supply.
Bitcoin falls into an entirely different category of goods, known as monetary goods, whose value is set game-theoretically. Each market participant values the good based on their appraisal of whether and how much other participants will value it. The origins of money serve as a good basis to understand this game-theoretic nature.
Through leveraging four fundamental technologies (peer-to-peer networks, digital signatures, distributed ledgers and proof-of-work consensus), Bitcoin enjoys the following qualities:
Durability : Being digitally replicated throughout the world, Bitcoin cannot degrade.
Portability : Bitcoin is transferable to anybody in the world like sending an email, WiFi connection or not. It can be stored in a flash drive or even as numbers in your head, allowing you to carry it wherever, undetected.
Fungibility : Each bitcoin is equal , unlike real estate or diamonds, for example.
Censorship-resistance: Due to the decentralized nature of the network and portability of bitcoin, it is hard for any corporation or state to truly prevent the owner of the good from using it, although they can disincentivize them.
Sound money — Money whose purchasing power is determined by markets, independent of governments and political parties. E.g., money backed by gold. (Note the Bretton Woods system did not qualify as sound money because the government had a fixed peg price for exchange).
It is truly borderless — a global monetary good accessible by all. It is a much-needed safe haven for third-world countries who cannot access reliable store of wealth, Bitcoin is finding use in said places.
In a world of negative real rates within developed markets, and a host of currency failures in emerging markets, what Bitcoin offers has utility.
In that way, it is a better store of wealth than gold.
The root problem with conventional currency is that a lot of trust is required to make it work.
The central bank must be trusted not to debase the currency, but history is full of breaches of such trust.
Banks must be trusted to hold our money and transfer it electronically, but history is full of examples where they lend it out in waves of credit bubbles with barely a fraction in reserve and end up insolvent.
Most people in the West rarely give any thought to this, because it mostly works, barring the occasional meltdown. Unfortunately, a large portion of the world perpetually suffers from having to place trust in such institutions.
Many countries are plagued by inflationary regimes or politicized and untrustworthy banking systems. See Lebanon for a recent example, where the nationally-regulated Ponzi scheme erupted and its currency lost more than 50 percent of its purchasing power.
Bitcoin was specifically designed as a countermeasure to “expansionary monetary policies” by central bankers (aka, wealth confiscation via inflation).
This is why Bitcoin was released after the Great Recession and its genesis block in the blockchain says “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
More than just a new monetary technology, Bitcoin is an entirely new economic paradigm: an uncompromisable base money protocol for a global, digital, non-state economy. It promises to mark the separation of money and state.
Bitcoin presents us with an opportunity to reinvent gold and rethink money for the digital future in a more globalized, internet-native way.
One common criticism of Bitcoin is that it is not perfect technology. Some go as far as to call it legacy. Over the years, many competitor cryptocurrencies have been created with the goal of dethroning Bitcoin through better, shinier features and improvements (e.g., greater privacy, increased efficiency in transactions, “fairer” governance models).
Unfortunately for them, these competitors lack the massive network effect of Bitcoin — they are very unlikely to be able to catch up.
The network effect for Bitcoin is wide. It encompasses:
The liquidity of its market (large investors will seek the most liquid market)
The number of people who own it (otherwise who’s to say it’s valuable?)
The community of developers maintaining and improving its software (critical, as we are talking about a software protocol)
Brand awareness (self-reinforcing, as would-be competitors to Bitcoin are always mentioned in the context of and compared to Bitcoin itself)
The network effect also attracts miners who help make the chain more secure, which is also a self-reinforcing loop that grows the network effect.
Large investors, even nation-states, will seek the most secure market.
Theoretically, an alternative cryptocurrency with the same network effect could outcompete Bitcoin — the problem for them is that such network effect is likely not attainable again.
The path-dependence in the invention of Bitcoin magnifies and underpins its network effect — it makes Bitcoin extremely hard to disrupt.
The launch, growth and organic adoption path of Bitcoin as a proof-of-work asset is non-repeatable. It’s trajectory was a sequence of idiosyncratic events that likely cannot ever be reproduced.
As Bitcoin opened the world’s eyes to digital scarce assets, any “New Bitcoin” attempting to launch today would face issues that Bitcoin did not — no miners/hash rate resulting in weak security early on (something attackers would take advantage of) and an even weaker incentive to attract investors.
Security is the number one requirement for any sound store of value system, after all.
Look no further than the “Bitcoin Cash” chain fork that proved to be a failure, only succeeding in being a real world example of the importance of Bitcoin’s path-dependent emergence.
Discovery of Absolute Scarcity
The invention of Bitcoin can be seen as a critical breakthrough — the one-time discovery of absolute scarcity — a totally unique monetary property never before achievable by mankind.
There is no other asset in the world that has absolute scarcity — gold is constantly mined, money is printed, stock certificates are issued, real estate is built, etc. The only other thing in the world that has absolute scarcity is time. In the same way that you cannot create more time, you cannot create more bitcoin.
Back in 2017, it was popular to believe that most cryptocurrencies had good governance due to the possibility of exit — if the user base disagreed with the direction of the project, they could simply fork it and build it in their desired direction.
While this acts as good insurance against a project going completely sideways, it is in a project’s best interest to have a minimum amount of disputes that cause splits. Such hard forks only shrink the backers of the project.
Bitcoin keeps its domain narrow — its users only need to believe in the idea of a sound, fast-settling global digital money system with finite supply.
By refusing to compromise on its key features, Bitcoin has remained the dominant cryptocurrency.
This rigidity of Bitcoin is a strength — it upholds a strong community, reduces protocol risk and maintains stable operations. It acts as a source of credibility, allowing people to feel safe allocating their savings in the technology for decades.
The investor community is growing as well. Less than 1 percent of bitcoin held for more than one year was traded when the price fell so abruptly (more than 60 percent) this March. An ever-growing chunk of strong believers (HODLers) is forming, as shown in this chart.
Lastly, digital assets have no shortage of talent. A massive brain drain is occurring from Wall Street to the digital asset industry.
Said volatility is a function of its nascency — yet unproven, a relatively small market cap, speculators chasing quick profits and little volume all result in that.
When Bitcoin reaches a market cap similar to gold, which is around $11 trillion, and therefore a similar demographic adopting it, it is logical for it to adopt similar volatility as well. To reach such a market cap though, a lot of upwards volatility is required — and with it comes downside volatility.
Regardless, such large drops like the one in March can be thought of as a feature, not a bug. Unlike the stock market, Bitcoin does not have circuit breakers (two of which we saw during the liquidity crunch). Without such intervention, actual price discovery can occur and the weak hands (speculators) get shaken off.
Even though Bitcoin dropped a massive amount during that time, it quickly and steadily climbed back up, reaching new highs recently.
As of this writing, it is worth $17,500.
The potential of Bitcoin is too large to easily comprehend, especially in unprecedented times like these.
While Bitcoin can grow beyond the addressable market of money, we will keep exploring that narrative for the scope of this post.
The main functions of money are
Store of Value (SoV) : to preserve wealth
Medium of Exchange (MoE): to barter
Unit of Account (UoA): to denote prices in it
No money starts by providing all three functions — each new species of money follows a distinct evolutionary path to acquire all three.
Note that the SoV phase has the best chance of happening and will likely see the steepest growth in price, but it is worth speculating what adoption as global money would look like too.
As we know that predicting prices in any specific time horizon is something even the most seasoned investors struggle with, we will abstain from it. Rather, we will focus on theoretical, long-term valuations.
Hundreds of Thousands — Store of Value Competitor
If we treat Bitcoin as a worthy competitor of gold, it has a lot of catching up to do.
Bitcoin is superior to gold in every way besides established history. It is logical to assume that as time passes and the Lindy effect takes hold, Bitcoin will continue eating up gold’s market share as a store of value.
If Bitcoin exists for 20 years, there will be near-universal confidence that it will be available forever, much as people believe the internet is a permanent feature of the modern world. Coincidentally, Bitcoin’s 12th birthday just passed!
We acknowledge that for Bitcoin to surpass gold’s market capitalization as a store of value, wealthy nation states will need to participate as well.
Regardless, it is enough to eat up 10 percent of gold’s cap ($1 trillion) in order to mark four-times growth as of today. Retail and institutional investors can easily prop up the price that much and we will later show that such adoption is growing at a promising rate.
Additionally, Bitcoin can also eat up some currencies that are used as a store of value. If we assume that Bitcoin has the chance to become the world’s global savings vehicle, it will eat up market share of the dollar, the Japanese yen and the Swiss franc since they are touted as safe haven assets.
In the context of 2020, gold’s $10 trillion market cap is likely to increase too.
After all, we have an overpriced stock market with overvalued risky bets and a $100 trillion bond market whose interest rates are decreasing and could go to negative yielding territory.
You need just 10 percent of the bond market money moving into BTC to move the needle and make it above gold.
Plotted against these assets, a multiple-trillion-dollar bitcoin valuation does not seem insurmountable. Especially with all of the massive money printing in the world, what’s a few trillion between friends?
Increasing inflation and increased interest from investors seeking stores of value will offer Bitcoin tailwind to reach such astounding market caps faster.
As a non-sovereign monetary good, it is also possible that at some stage in the future bitcoin will become global money (much like gold during the classical gold standard of the 19th century).
If Bitcoin in fact becomes global money and the whole world is using it, it makes sense to assume that it will only continue to gain in value as the world’s economy progresses. Deflation driven by technology, or newly-gained efficiency in producing materials/services, should make everything cheaper.
Because Bitcoin’s supply is fixed (absolute scarcity), we will essentially see the same service/product become cheaper over time.
For an oversimplified scenario, let’s compare the cost of gold and a brand new car in both 2010 and 2020:
“It has happened globally with such speed that even a market veteran like myself was left speechless,” Jones wrote. “We are witnessing the Great Monetary Inflation — an unprecedented expansion of every form of money unlike anything the developed world has ever seen.”
“The best profit-maximizing strategy is to own the fastest horse. If I am forced to forecast, my bet is it will be Bitcoin.”
He recently touted the asset again, citing the massive contingent of smart, sophisticated people in the community and comparing the investment to an early tech company like Apple or Amazon back in the days.
This sort of public adoption from a well-known and well-respected name is enough to open the eyes of many other hedge fund managers who may see the same qualities in the asset that Jones did.
But that didn’t seem enough. Most recently, we’ve had two other well-respected names in the investing space publicly share their interest in Bitcoin.
Most recently, a CIO from Blackrock (the world’s largest investment management company with over $7.4 trillion under management in 2019) mentioned on national television that he believes Bitcoin is here to stay. He noted that it is likely to take the place of gold to a large extent.
The promising thing is that, as more such institutions and respected people speak out, the likelier it is for additional institutions to take action because internal champions inside them are less likely to be dismissed and the career-risk (investing in an unestablished asset) for fund managers is reduced.
Grayscale is a company that offers public and private investment funds covering digital assets. Investors who are looking for Bitcoin exposure but do not want to have their own custody are turning to Grayscale to manage their assets.
They are in an unique position because they currently have the largest viable physical bitcoin product that fits into the legacy financial system — reasonably so, companies like Fidelity are trying to catch up.
Grayscale issues quarterly reports regarding the assets it manages and said reports are showing massive growth in the amount of Bitcoin investments its fund is receiving.
Q1 2019 : $41 million invested into their Grayscale Bitcoin Trust ($GBTC)
Q2 2020: $751 million (180 percent quarter-over-quarter growth)
Q3 2020 : $718 million (this is its fourth record-breaking quarter in a row)
Year-to-date investment into Grayscale has been over $2.4 billion (counting other assets like ether) — more than double its $1.2 billion cumulative inflow from 2013 to 2019.
Grayscale has consistently reported that interest in its funds are coming primarily (84 percent-plus) from institutions, most of them being hedge funds.
Estimates say that Grayscale is buying bitcoin at a rate of 150 percent the amount being mined daily. In other words, Grayscale is likely eating up all of the new supply in bitcoin and then some.
As of this writing, it holds over $9.1 billion in assets under management.
Most interestingly, JPMorgan has said that investors appear to prefer bitcoin over gold, with gold ETFs seeing modest outflows in October whereas bitcoin funds have increasing inflows.
Bitcoin Investment In The Corporate Balance Sheet
MicroStrategy was the first public company to invest in bitcoin as a way to diversify its corporate balance sheet. It invested a whopping $250 million into bitcoin, buying 21,454BTC in August 2020.
This is a significant investment — MicroStrategy, an established public company, invested close to 25 percent of its total assets in BTC as a way to protect against currency debasement. Not only that, it invested some $175 million extra after that in September.
“Those macro factors include, among other things, the economic and public health crisis precipitated by COVID-19, unprecedented government financial stimulus measures including quantitative easing adopted around the world, and global political and economic uncertainty,” CEO and Founder Michael Saylor has said. “We believe that, together, these and other factors may well have a significant depreciating effect on the long-term real value of fiat currencies and many other conventional asset types, including many of the assets traditionally held as part of corporate treasury operations.”
“We really felt we were on a $500M melting ice cube. Once the real yield on our treasury got to more than negative 10%, we realized that everything we are doing on P&L is irrelevant.”
A funny point is that not many companies can match MicroStrategy’s initial investment of 21,500 BTC. In fact, only 0.10 percent of all public companies (862) in the world can afford to do the same before the supply of bitcoin literally runs out. If 862 companies bought 21,500 BTC, they would collectively have about 18.5 million BTC, which is the current supply in circulation.
Many companies have been building up their balance sheets prior to COVID-19 in expectations of a recession. Once these companies with extra cash on their balance sheets see the benefits, they are likely to begin following suit.
It is only a matter of time until we see more companies come out with announcements on how much they’ve bought. Here are the balance sheets of three crypto-friendly companies as of their Q3 earnings reports:
Square: $2 billion (just $50 million invested in BTC)
Bitcoin adoption has also been taking off through the many intuitive, easy-to-use apps that allow for bitcoin purchases. Some examples are Coinbase, Robinhood, Revolut and Square’s Cash App.
Square is the only public company of the above for which we can take a look at the numbers. Cash App has been selling bitcoin for almost two and a half years now (since Q2 2018). Its sales in bitcoin have been growing at a rapid pace recently.
The recent percentage growth is beyond spectacular, especially when accounting for the amount of volume in sales.
Starting in the U.S., PayPal plans to expand this feature to select international markets in the first half of 2021 and also port it to Venmo.
It will additionally provide educational content for its user base.
It is great news to see that PayPal will eventually expose its 340 million user base to Bitcoin — another decision that will ultimately drive crypto to mainstream adoption.
While Bitcoin has been rapidly gaining exposure throughout the pandemic, it has also been strengthening itself.
Starting from inception in January 2009, about 50 new bitcoin were produced every 10 minutes from miners verifying a new block of transactions on the network, called the block reward.
Bitcoin’s deflationary nature comes from the fact that it’s programmed to decrease this block subsidy — an event called a halving.
Bitcoin has so far gone through three halvings, the latest of which occurred in May 2020, halving the block reward from 12.5 BTC to 6.25 BTC.
This causes a supply shock which has historically driven a bull market and a mania over the asset in the ensuing 18 months (as of writing, we are in month five). The mechanics are clearly described here.
This process greatly increases the stock-to-flow (S2F) ratio of Bitcoin.
Stock-to-flow ratio — The stock of a certain commodity compared to the rate of production. e.g estimates say gold has 200,000 tons above ground and 3,000 tons of annual new supply, putting its stock-to-flow ratio around 66
Today, this is in the upper fifties for bitcoin and it is projected to go over 100, surpassing gold’s S2F ration after Bitcoin’s fourth halving in 2024.
Nothing else guarantees the market waking up like some solid price action, cryptocurrency-style. As of starting this piece, the bitcoin price had rallied 70 percent upwards.
Bitcoin is setting records each day for its longest number of consecutive days spent over $10,000. It also recently beat its past all-time high record in both market cap (the previous figure was $334 billion) and in nominal coin price (the previous record was $19,783).
As we will discuss next, price action has a strong positive correlation with network security. The more the price rises, the more interest from miners and the more secure the network becomes. This, in turn, can attract more investors.
Despite the massive gain, the market cap of Bitcoin is still small compared to its potential. We expect further large gains in the long term.
Bitcoin’s security is tied to its hash rate — the measuring unit of the processing power of the Bitcoin network.
There is a strong network effect in Bitcoin that helps securitize the network:
The price of bitcoin rises
Mining becomes more profitable due to the increased price of bitcoin received from the mining reward for producing the next block
More miners join the network to compete for this increased reward and, in the process, contribute their electrical power — the hash rate goes up
Network security follows the hash rate’s growth as the increased amount of electricity spent creating blocks means more electricity is required for an attacker to override the previous blocks
With more network security comes more trust in the network’s ability to preserve the coins of the holders, leading to an increase in adoption
The cycle repeats as these new users, as well as increased trust in the network, lead to an increase in the overall use and subsequent price of the asset
Bitcoin’s hash rate is over seven-times larger than it was during the peak of its historic price climb to an all-time high in late 2017. We’re seeing resources being spent researching, developing and deploying mining hardware at a record pace.
Negative Network Effects
The Bitcoin ecosystem was long plagued by security vulnerabilities in external services, price volatility and a steep learning curve.
It’s fair to assume that the price has been affected by these factors, but it is only a matter of time until these issues are cleared up.
Conclusion — Bitcoin Investment
Bitcoin’s strengthening fundamentals paired with the recent world trends make investment in the asset a very attractive investment opportunity , one that is perhaps once in a lifetime.
It is the original, longest-lasting cryptocurrency with the highest levels of hash power, network effects, liquidity, market capitalization and the strongest community.
Bitcoin is the first truly global bubble whose size and scope is limited only by the desire of the world’s citizenry to protect their savings from the vagaries of government economic mismanagement.
After all, Bitcoin rose like a phoenix from the ashes of the 2008 global financial crisis, a crisis that was largely caused by mismanaged bank policies.
In a time where the whole system appears messed up, Bitcoin provides the average person with a solid way to “opt out,” hedging against all system risk and preserving their value in the purest way.
The recent months have greatly increased Bitcoin’s chances of success, with all of the following:
A deadly virus whose second wave is just unfolding
Political instability and civil unrest
Record amount of unemployment and business closures
Conventional assets being in an unattractive phase, seemingly not accounting for the extra risk — projected slow growth, companies and individuals overburdened with debt, stocks valued at high earning multiples
Unprecedented monetary politics and historical money supply expansion — high chance of inflation
Negative interest rates looming around the corner
Billionaires, institutions and corporate treasuries piling in on BTC
BTC fundamentals the strongest they’ve ever been (hash rate, supply, community)
2020 has massively amplified the case for Bitcoin.
While Bitcoin’s price has jumped sharply in the past weeks while writing this article, it is still early.
There still exists a small window of opportunity in which normal investors can benefit from the upcoming avalanche of money into the space.
The question comes down to this: Do you think that this asset’s value is accurately priced at about a $325 billion market with all the facts presented here, keeping in mind that it was at a $200 billion market cap before any of this happened?
Personally, I’m irrationally long. With the direction that the world is headed in, it seems as if there is a lot more room to grow.
It is only a matter of time until more of the world opens its eyes to the opportunity and more capital enters the bitcoin market, only a matter of time until regulations get further relaxed and a Bitcoin ETF gets launched in a developed economy.
We are in for a massive upwards spiral driven by hype and fear of missing out on the scarcity of BTC.
The decentralized and bottoms-up nature of Bitcoin is truly beautiful.
What is happening can be described as a retail revolution that is driven from the ground up — one where the normal retail investor can front-run institutions, get ahead of pension plans, family offices, bankers and corporate treasurers.
Owning bitcoin is one of the few asymmetric bets that people across the entire world can participate in. Much like a call option, an investor’s downside is limited to one x, while their potential upside is still 100 x or more.
Thanks for reading! I hope that this article presented a clear picture of the recent macroeconomic events and made a compelling case for what I believe is a once-in-a-lifetime investment opportunity.
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