WHAT IS MONEY
We think about money in terms of paper currency, coins, debit, and credit cards… anything that can act as a “medium of exchange” to purchase goods and services, settle debts, and meet financial obligations. Fiat money is government-issued currency that is not backed by a physical commodity but by the stability of the issuing government. With Fiat money, governments, through their central banks, have unhindered access to the printing press. Treasury can expand or contract money supply to stabilize employment, the economy’s growth trajectory and inflation.
Traditionally, we characterize money as something issued by governments, circulated through the commercial banking system, and fulfilling the following functions: acceptable to both parties as a medium of exchange, recognized as a store of value, easily divisible, and secure. At present, digitization has expanded the definition of money to include cryptocurrencies circulating via the Internet secured by blockchain ledgers.
THE EVOLUTION OF CRYPTOCURRENCIES
Before presenting an investment thesis for cryptocurrencies, and more broadly, alternative assets, I humbly offer caveat emptor! I have been a long-term skeptic on cryptocurrencies. Following the lead of Warren Buffet and Jamie Dimon, it was never clear to me how something like Bitcoin could become mainstream. Warren Buffett – and I am paraphrasing – could see no investment thesis that would support buying an asset that had no intrinsic purpose. Jamie Dimon, CEO of JP Morgan Chase Bank, questioned the value of a cryptocurrency priced in a Fiat currency (i.e. one Bitcoin = US $56,000).
For another perspective, suppose you enjoy a wonderful meal at a fancy restaurant in your hometown. It is the pièce de resistance… “as good as any top of the class restaurant in New York”! Catch the inference? People who live in New York and visit high end restaurants are not likely to suggest that the meal and service is as good as any restaurant in Belleville! If you have access to a stable Fiat currency (i.e. US dollars, Euros or Canadian dollars), what is the value in holding Bitcoin that does the same thing? If in fact, Bitcoin can even play that role.
The bull / bear debate on cryptocurrencies, of which Bitcoin is the patriarch, hinges on whether they become widely accepted as a medium of exchange. And there are challenges, not the least of which, is serious blowback from governments with limited access to Bitcoin transactions that makes it difficult to monitor criminal behavior and collect consumption-based tax revenue.
There are also system issues that limit Bitcoins’ scalability. To transition from a wannabe currency to an actual currency, systems need to execute millions of transactions every minute of every day. Bitcoin is nowhere near that level and upgrades are critical if cryptocurrencies are to combat the rise in payment processing competition from tech giants like Apple, PayPal, Square and Facebook.
That said, one cannot ignore Bitcoin’s value as an alternative asset, its’ speculative potential as a momentum trade and the value proposition as a potential hedge against inflation. We also need to recognize that Bitcoin is gaining traction among millennials.
Visa, Mastercard, Square and Pay Pal can accept payment in Bitcoin. You can get Bitcoin debit cards to pay bills at most terminals and through Bitcoin ATMs exchange the cryptocurrency for Dollars or Euros.
The Bitcoin story received another boost when Tesla exchanged US $1.5 billion of their cash on hand to buy the cryptocurrency. I suspect, at some point, you will be able to buy your new electric vehicle with Bitcoins.
As governments ramp up surveillance capabilities, they are better able to track cryptocurrency transactions through money center banks which are building cryptocurrency divisions. J P Morgan Chase among them! In time governments will likely embrace the digital currency revolution by building their own version of digital legal tender.
Another consideration is security. To become mainstream, consumers must be confident that cryptocurrency transactions are safe. It reminds me of a comment made by Matthew Barrett when he was CEO of Bank of Montreal. It was a time when the big five Canadian banks were reporting record earnings. Politicians played to the gallery, raising the customer gouging card and consumer polls dissed banks with approval numbers south of those garnered by CCRA.
The reporter asked Mr. Barrett to react to the hyperbole. His response was that the polls were asking customers the wrong question. The issue was not whether customers liked their bank, but more importantly, whether they trusted their bank.
The point is, we have faith in the procedures that support our financial system and trust Canadian banks to flawlessly execute millions of transactions every day. We have faith that the balances in our savings and chequing accounts are accurate and that when there is a problem the bank will correct it.
Underpinning cryptocurrencies is a security system known as blockchain. A blockchain is a growing list of records called blocks which are interconnected through cryptography. Each block contains a cryptographic hash of the previous block, a time stamp, providing a hard coded record of each transaction.
Blockchain safely stores information over the shared system, where everybody can see but cannot alter. Blockchain tracks all components of a transaction in a “ledger” and a distributed system that verifies every exchange.
Unlike the banking system, where no client is enabled access to another client’s transactions, the blockchain innovation permits all users access to all transactions. Theoretically, this provides 100% transparency and guarantees that no user can adjust or erase any exchange from the shadows.
From our perspective, it is important to recognize that the algorithms underpinning the blockchain environment have been vetted for years and are accepted as one of the most secure ledgers with the ability to securely manage an unlimited number of transactions. We would argue that blockchain is the real story and cryptocurrency is simply an appendage (see “Blockchain: The New Internet”)
THE BITCOIN VALUE PROPOSITION
How does one value Bitcoin? At its core, the value of any security or commodity is based on supply demand metrics. More buyers than sellers, prices rise, and vice versa. Bitcoin is no exception and since it can be traded on various cryptocurrency exchanges, the price is transparent.
The bull thesis is interesting although upside targets vary widely. The bull case and upside variation hinges on whether you believe Bitcoin will become, as we said, a broadly accepted medium of exchange. That may be a challenge for those of us living in North America where we enjoy the fruits of a stable currency.
However, if you live in Venezuela with inflation running at 1000% per year and a currency subject to exchange controls and daily de-valuation, you may prefer holding a store of value that is portable and can be exchanged for any number of Fiat currencies. In that sense it is no different than how gold was used as a store of value in undeveloped countries. The difference is that gold is more difficult to transfer than a blip on a computer screen.
The most extreme bull thesis implies that Bitcoin will eventually supplant gold as crisis insurance and a store of value. Under that premise, Bitcoin prices could go significantly higher. For some perspective consider that, at one point, gold backed government issued Legal Tender. In the 1960s, the expansion of money supply was based loosely on the amount of gold governments held in reserve. The price of gold was fixed between US $30 and US $40 an ounce.
When the US government under President Nixon, went off the gold standard in 1971, the price of the metal was eventually allowed to rise or fall based on market forces. By 1980, gold was trading between US $700 and US $800 an ounce (see chart).
Per Ounce Price of Gold
Bitcoin has followed a similar trajectory. Bitcoin has been around since 2009, but it was not until 2017 that cryptocurrency garnered the attention of average investors and consumers. As the demand side of the equation grew, Bitcoin’s price surged surpassing US $20,000 per coin in December 2017. Today it is trading above US $56,000 per coin.
Understanding why gold surged in the 1970s may help explain the upward trajectory in the price of Bitcoin. Gold is in limited supply, its’ price determined by how much is mined and of that total, how much was earmarked for jewelry, industrial projects, and government storage facilities.
Bitcoin is also in limited supply and is typically mined by large institutions where new coins get “minted” after solving complex mathematical problems. Supply is further constrained by the fact that Bitcoins’ circulation will be limited to 21 million coins. What we have then is limited supply and rising demand.
Some Bitcoin bulls argue that Bitcoin has already replaced gold as a store of value citing golds’ recent pullback. The implication is that traders have moved some of their hedges out of gold and into Bitcoin. Note gold is currently trading around US $1,700 an ounce well down from its’ recent high above US $2,000 an ounce. At the same time Bitcoin has surged 100% year to date.
If you buy into that thesis, the upside potential is enormous. It is estimated that the total market capitalization for the entire supply of gold in circulation is approximately US $7 trillion. The total value of USD currently in circulation is close to $11 trillion (based on the number of physical notes).
Now apply those numbers to the limited supply of Bitcoin assuming there are a maximum of 21 million coins in existence. If we divide the maximum number of Bitcoins into the global supply of gold, we get a top end valuation of roughly US $333,000 per coin. Apply the same criteria to the number of USDs in circulation we arrive at a best-case valuation that tops US $520,000 per coin. Either metric, say Bitcoin bulls, justifies over-the-top optimism.
HOW DO WE GET THERE?
To get to that best case bull scenario requires more than simple supply / demand metrics. The accompanying table sets out the Traits of Money which are the requirements for any cryptocurrency to be viewed as a medium of exchange. As you can see from the table Bitcoin checks all but one of the boxes.
Another consideration is that it be fungible. The price quoted for Bitcoin reflects the value of a single coin. Typically, the average Bitcoin transaction is about US $250, which means that transactions are a fraction of a Bitcoin, rather than an entire coin.
These fractions are known as Satoshis, and there are 100 million of them in each Bitcoin. It is highly likely that if the value of Bitcoin continues to rise over time, transactions will eventually be quoted in Satoshis. Otherwise, it makes it difficult for consumers to figure out just how much they are paying.
THE DEMAND STORY
The demand side of the equation is the most interesting. Bitcoin is getting a lot of mainstream attention as an alternative investment and with new securities coming to market, average investors can take positions using familiar products.
For example, Purpose Investments recently launched the first Exchange Traded Bitcoin Fund (symbol BTCC). There are at least another 10 ETFs in the pipeline which should launch over the next two months.
As Canada often does (Canada was the first to launch ETFs with the TSX 35 Index ETF), we are well ahead of the US in the design and construction of investment grade products that hold Bitcoin.
At this point, the US Securities and Exchange Commission has not allowed US ETF manufactures to launch digital currency products. In time, this will change! When US regulators open the flood gates you can expect ten to twenty times the issuance south of the border. This creates buy and hold demand for a product that has limited supply.
That said, one should not view cryptocurrencies through rose colored glasses. There is a reasonable basis for the bull thesis and many pitfalls that could derail the enthusiasm.
Better to ease into the digital evolution when the macro story is in the early innings. To that end, our investments in alternative assets are held inside our pools. This allows us to manage risk by actively trading positions when utilizing options when appropriate.
The exchanges have just launched options on the Purpose Bitcoin ETF. Not surprising, given that daily price swings in the 3% to 5% range are common, having 80% drawdowns and 100% upside moves over the course of weeks and months.
BLOCKCHAIN – THE NEW INTERNET?
Blockchain is the brainchild of a person or group of people known by the pseudonym, Satoshi Nakamoto. Nothing like a clandestine conspiracy to arouse suspicions about an investment thesis centered on a complex alternative asset.
However, if we ignore the dark side and focus instead on the technology, an investment thesis emerges. Simply stated, Blockchain allows digital information to be distributed but not copied. Originally designed to serve as the ledger of record for digital currency transactions, it morphed into something bigger; an open-ended technology that securely facilitates no fee transactions -instantaneously across the Internet.
A blockchain is a time-stamped series of permanent records managed by a cluster of computers not owned by a single entity. Each “block” of data is secured and linked to other blocks (see accompanying schematic) using cryptographic principles (i.e. chain).
 Cryptography refers to the act of writing and deciphering code.
The potential for blockchain to become a serious disrupter rests with the decentralized architecture that feeds into ledgers that users can see but not alter. In theory, visibility provides checks and balances making users accountable for their actions.
Companies wanting to utilize blockchain technology can develop internal systems or outsource development and maintenance to a third party. IBM is one of many companies that develops and maintains secure blockchain systems for small, medium, and large size businesses.
According to Ameer Rosic, of BlockGeeks.com, blockchain is a simple way of passing information from A to B in a fully automated and secure manner. “One party to a transaction initiates the process by creating a block. This block is verified by thousands of computers (referred to as “Nodes”) distributed around the net. The verified block is added to a chain, which is stored across the net, creating not just a unique record, but a unique record with a unique history.” Hacking a single record would require one to hack the entire chain across numerous systems.
As you can imagine, this model is ideal for executing cryptocurrency transactions. But, beyond that, it has applications for almost any business. Think about it in terms of a transportation company. You purchase an airline ticket on your Visa card. Visa earns a fee paid by the company which is factored into the cost of the ticket.
Blockchains allow the airline, railway, or bus company, to eliminate processing fees, by transitioning the entire transaction on the blockchain. The two parties in the transaction are the transportation company and the passenger.
According to BlockGeeks, the ticket is a block, which will be added to a ticket blockchain. Just as a monetary transaction on the blockchain is a unique, independently verifiable, and unfalsifiable record, so too is your ticket. Incidentally, the final ticket blockchain is also a record of all transactions for, say, a certain route, or even the entire transportation network, comprising every ticket ever sold, every journey ever taken.
BLOCKCHAIN AS A DISRUPTOR
What makes the technology disruptive, is that all transactions can be executed at zero cost to both parties. Over time, we can envision a scenario where the blockchains’ ability to transfer and store money (i.e. cryptocurrency) could theoretically replace business models that rely on charging fees for a transaction. A single wire transfer from one bank to another, costs about $25 to execute, sending money via Western Union can cost as much as $35 to $50 per transaction. Not surprisingly, money center banks are aware of the competitive threat which is why they are setting up internal digital currency divisions.
The threat is real for other disruptors like Uber and Airbnb. By encoding the transactional information for a car ride or an overnight stay, Blockchain cuts out fee-processing middle-men, posing a serious threat to match-making platforms.
The most obvious application is within the financial services industry. Blockchains could change the way stock exchanges work, how loans are bundled, and how insurance is contracted. Banks are at the greatest risk once the advantages of a safe ledger technology without transaction fees are widely understood and implemented. In time it will challenge the concept of administration fees to facilitating simple transactions.
THE ADVANTAGES OF DECENTRALIZATION
Everyone has interacted with a centralized system. A bank, for example, is a centralized entity that stores all your data, and any interaction takes place between you and the financial institution. The financial institution utilizes a centralized client-server model to warehouse your money and execute transactions. The only way that you can access funds to complete a transaction is by engaging with your financial institution.
A client-server model is nothing more than a link between the individual and the server. For example, with online banking you send a query to your bank which then sends you the relevant information. This is the basis of a centralized system using a client-server.
But centralized systems are vulnerable. Because the information is stored on a single server (or more likely a series of servers) your data is stored in one spot making it a target for potential hackers.
When centralized systems go through software upgrades – which they often do – it shuts down the entire system. The worst-case scenario is when centralized systems get corrupted by malicious hacks compromising the data inside the system.
In a decentralized system the information is not stored on a single entity. Everyone in the network owns the information. If you want to interact with a friend, you can do so without going through a third party. That was the main ideology behind Bitcoins. You manage your Bitcoin wallet which allows you to transact with anyone without a financial institution intermediary.
TRANSPARENCY WITH PRIVACY
Perhaps the most interesting and misunderstood concepts in blockchain is that it is transparent while maintaining privacy. In what seems like an oxymoron, individual identity is hidden via complex cryptography and represented only by a public address. So, if you were to look up a person’s transaction history, you will not see “Bob sent ONE Bitcoin to Joe” instead you will see “1MF1bhsFLkBzzz9vpFYEmvwT2TbyCt7NZJ sent 1 BTC”.
So, while the person’s real identity is secure, you will still see all the transactions that were done by their public address. This level of transparency has never existed before within a financial system. It adds that extra, and much needed, level of accountability which is required by some of these biggest institutions.
A PERMANENT RECORD
When a transaction has been entered into the blockchain, it cannot be altered. Underpinning this permanent record is a cryptographic hash function. In simple terms, hashing means taking an input string of any length and generating an output of a fixed length.
According to Rosic, In the context of cryptocurrencies, transactions are taken as input and run through a hashing algorithm (Bitcoin uses SHA-256) which gives an output of a fixed length. This cryptographic hash allows governments to track criminal transactions if they can tie the tag to a specific bad actor. This removes the principal concern that governments had, by effectively shining a light on Dark Web activity.
For non-criminals it is important to note that blockchain provides no cost transparency, privacy, and flexibility.
THE CROFT INVESTMENT THESIS
We consider Bitcoin, Blockchain and Special Purpose Acquisition Companies (SPACs) as alternative assets. Much like we would with say, a physical gold ETF like SPDR Gold Shares (Symbol GLD). The principal role of alternative assets is to act as a portfolio diversifier, and as such, exposure to this asset class should be limited to no more than a 20% weight in your overall portfolio.
Most importantly, investors need to understand there is a significant learning curve to alternative assets and to effectively manage volatility, the manager must be able to move in and out of positions seamlessly.
Richard Croft, Chairman & CIO