The Real Case for Bitcoin
I will be on holiday for the next two weeks but will continue to monitor markets and if I decide to make changes to The Spark’s portfolio, will post a flash note on our Instagram page and Linkedin Page, and also via email. If you would like to receive these updates I recommend following these pages/signing up using the above link. Anyway, onto this week’s article!
Bitcoin – The Basics
Bitcoin is a decentralised digital currency created in 2009 - This means that it cannot be held in physical form (digital) and no one person has control over it – unlike, say, the US Dollar which is controlled by the Federal Reserve. In fact, no one even knows who created Bitcoin!
Bitcoin is ‘mined’ – Supercomputers (called nodes) owned by people like you and me ‘mine’ Bitcoin. This process involves such computers solving complicated algorithms or computer code in order to strengthen the Bitcoin network, making it more secure. These supercomputers also verify the transactions recorded on the blockchain. In return for this, the miners are rewarded with a certain number of Bitcoin.
The blockchain – A ‘decentralised ledger system’. In short, the blockchain is a database that records every transaction conducted by a particular cryptocurrency and helps with the security of the cryptocurrency. All Bitcoin transactions are recorded on the Bitcoin blockchain. Think about every payment you make in pounds being recorded in a big book that everyone can see.
Nodes run the network– Transactions on the blockchain do not rely on any single node (computer) for safety, security, or verification of transactions, therefore there is no single point of failure. If one supercomputer gets hacked, the other nodes will shut it down, and the blockchain transactions will be moved to another computer.
It has a limited supply – The biggest attraction to Bitcoin is that there will only be 21m Bitcoin created, ever. Roughly every four years (depending on how fast the nodes solve the algorithms), the number of Bitcoin that miners receive halves – known as a ‘Halving’ cycle. The next halving is due in 2024 and will mean miners receive 3.125 Bitcoin (currently 6.25).
The number of Bitcoin awarded to miners halves every four years (roughly)
The bitcoin supply is capped at 21m
With the basic concepts out of the way, now I think it’s time to get into the nitty-gritty of the financial system, and why moving a portion of one’s wealth to Bitcoin may be wise, in my opinion. Fear of missing out (FOMO) and hype are major issues with this asset and cryptocurrencies in general, which in a way have held it back from being taken seriously by some investors. Hopefully through this article you can understand my rationale for investing a sensible amount of capital into Bitcoin and why it should be taken very seriously as an investment.
2008 – The failure of regulation
Although regulation is the most boring thing in the world, it is paramount to the case for Bitcoin in my opinion, and I urge you to read this section in full. This section was not written to scare you, but hopefully, it will help you understand the repeated incompetence of the elite to protect our wealth.
Basel I was the original rules governing what banks could and couldn’t do. Despite much tweaking of these rules after the 2008 Financial Crisis, nothing has fundamentally been reformed.
Basel I was originally formed as a common standard for banks’ debt and risk to be measured globally. The regulation required banks to have capitalisation (equity + retained profits + some forms of debt) equal to 8% of risk-weighted assets - the capital reserves ratio. Assets for a bank are the loans that it makes, with liabilities being deposits (our cash – more on this later). Under Basel I, different loans were categorised under different risk scores, with governments being risk-free so weighted at 0. 0 multiplied by any number = 0, so sovereign loans were not accounted for. This is an absurd rule, given what happened in countries such as Greece and Cyprus during the EU Debt crisis – more on that below.
Outside of the absurdly low sovereign bond risk ratings, housing loans were rated half as risky as other loans under Basel I, incentivising lenders to create the multiple housing bubbles witnessed in the past. Could it get crazier? Yes. The derivatives (CDOs) which caused the 2008 financial crisis were rated at… 1/16th the risk of other loans. These derivatives multiplied the magnitude of the 2008 disaster and should have been the highest risk, since the failure of some of the mortgages in these CDOs caused the entire derivative to collapse, as we witnessed first-hand – watch ‘The Big Short’ on Netflix for a full explanation.
Out of sight, out of mind
The main ratio used by investors to measure the fortitude of a bank’s balance sheet, as mentioned previously, is its capital reserves ratio. Comparing the new Basel II and III regulation brought in to replace Basel I (see below), the new rules have only reduced the denominator (bottom number), therefore exacerbating the ratio. This gives the impression that banks have never been in better shape, when in fact, they are exactly the same as they were.
Basel rule changes just meant banks declared less assets as risky
All that has really happened is that banks have now removed previously risky assets from their balance sheets and therefore from investors because large banks are now allowed to rate the risk of their own assets (rather than an outside regulator doing so). It’s akin to marking your own homework… but what’s wrong with that?
Following the financial crisis, a blame game ensued but no one was jailed. Why? Because everything these institutions did was within the confines of the regulations at the time. The same issues apply today (more below), meaning your savings are by no means risk-free if your bank runs into trouble.
As if that wasn’t enough reason
Fast forward to the European Debt Crisis (2009-2013), and we have even more evidence as to why holding your savings in a bank account isn’t risk-free. As mentioned, a commercial bank’s assets include all of the loans it writes, and its liabilities comprise of deposits (the money we have in our bank accounts).
Without going into too much detail on the European Debt Crisis, what happened was that due to the Financial Crisis of 2008-2009, many EU banks needed to be ‘bailed-out’ by the government (given money to survive due to many of the loans turning ‘bad’ – the person the bank loaned to couldn’t pay it back). Following this, countries such as Italy, Greece, and Cyprus were unable to repay or refinance its government debts, or bail-out their indebted banks which were collapsing. The governments had effectively run out of money. Therefore, these countries needed the funding of a third party like the European Central Bank or IMF to save them.
Taking Cyprus as an example, in March of 2013, in exchange for a €10bn bail-out by the above institutions, Cyprus was ordered to close its second-largest bank and impose a bank deposit levy. Wait a minute, you said my cash was called a deposit, didn’t you? That’s right, this fancy term meant that all ‘uninsured’ deposits would be taken. Again, more fancy jargon, so let me keep it simple. Cyprus was ordered to take 47.5% of all bank deposits over €100,000 so it could receive the €10bn bail-out by the ECB. Everyone with a bank account holding over €100,000 had 47.5% taken from them. In contrast to a bail-out, where the government supplies the bank with money to keep it running, this is called a bail-in, where the bank’s account holders supply the bank with money. Imagine waking up one day and seeing half your life’s savings vanish. In exchange for their money, depositors were given equity (shares) in the bank. Who wants shares in an essentially bankrupt bank? The sane rules apply today, with any amount over £85,ooo in the UK uninsured if your bank goes under.
Tying all of this back to Bitcoin, its limited supply and security (as you can hold it in a cold wallet which is impossible to hack), gives holders a secure savings account that cannot be taken from them. Should the volatility diminish, as I discuss below, Bitcoin could be a great place to store wealth in the future.
But today it’s different, right?
Proving that the same insanity applies today, and since this is applicable to The Spark’s portfolio through Discovery Inc’s (DISCA) shares, let’s discuss the collapse of Archegos Capital. Archegos was a hedge fund that used fancy derivates to gain leveraged (think - multiplied) exposure to stocks and other assets. Therefore, when an asset Archegos bought rose 30%, it could make 120% profit, but if it dropped by the same amount, it could lose 120% i.e. more than it had put down in cash. Needless to say, some market turbulence led to a margin call and a subsequent wind-up of the fund. One bank with significant exposure to Archegos was Credit Suisse, and you will see through this bank how regulations haven’t been corrected since 2008.
Liquidation of Archegos Capital caused Discovery’s share price to tank, Source: TradingView
Credit Suisse reported global derivative exposure of ₣146bn (₣ = Swiss Franc) but because of regulation, the risk-weighted assets were only reported as ₣25bn. With ₣3.23bn in the capital, the bank had a capital ratio of 13% (above the required 8%). Seems pretty secure, right? BUT, the collapse of Archegos cost it over ₣5bn, or 150% of its GLOBAL capital reserves, and that was in a stable economic environment. How would Credit Suisse cover losses in a major recession if the capital it held wasn’t even enough to cover the collapse of one hedge fund? This shows the major flaws with regulations today.
Banks have no incentive to change because the authorities back them – as we saw when governments guaranteed business loans during the Covid-19 pandemic. When a bank is on the brink of failure, it is recapitalised (saved) by the government through taxpayer money. We absorb its losses. This is why it’s a good idea to have some capital outside of the financial system. This can be done through precious metals, real estate, artwork, and Bitcoin. Its limited supply is even more attractive today, as I explain below.
Disregard for currency leads to distrust
Today, the aggressive spending by governments and central banks is causing them to lose control of their fiat currency (US Dollar, British pound, etc). Every crisis has led to ever-more excessive printing (see rising public debt below - both bar charts). Today, the bloated balance sheets of central banks are having an ever-weakening effect on our economy.
Previously, the printing of money boosted economic activity and helped us recover faster from crises. But just like a drug addict who needs to increase their intake to feel the same rush, our economy needs an even greater supply of money each time to achieve the same effect. We can see from the left chart that GDP growth is slowing in the US due to structural factors such as an aging population and the rising debt level is doing little to combat this. The right chart shows how the velocity of money is also falling as debt rises. This conveys how new debt creation is having less and less of an effect on economic activity through the exchange of goods and services. This is declining toward $1, meaning that $1 of new debt no longer has a multiplier effect on economic activity. The rising debt levels are now coming to an end, as inflation has entered the fore.
As debt rises, its affect on economic growth diminishes, Source: The Spark & Fred website
Inflation today means that if an economic slowdown comes, governments cannot print money or cut interest rates (as it’s already at 0%) since this would stoke inflation further. Central banks are stuck between a rock and a hard place. Raise rates to kill inflation but cause a recession, or let inflation run hot to reduce the size of their debt (in real terms) but risk the possibility of hyperinflation. Bitcoin removes the need for inflationary worries for an investor since, as mentioned, it has a limited supply and cannot be printed.
Also, money-printing and inflation are causing heightened distrust in governments globally. It has been noted that in places where there is high distrust in governments, such as Turkey and Venezuela, cryptocurrency adoption is high. If inflation continues to remain high in western nations, the appeal for alternative assets to store wealth such as Bitcoin will continue to grow.
It isn’t perfect, but that will change
Many crypto gurus make the argument that Bitcoin will replace fiat currency. This is unlikely, as governments will not allow a decentralised currency to remove their control. Not only that, but the verification process for transactions is too low and costs are too high for Bitcoin to be a viable currency. However, it could be an excellent store of value in the future. Today, the volatility of Bitcoin is too high for it to be an effective store of value like gold, but that could change. There are currently about 240m digital wallets in the world, the same as the number of internet users in 2000. As this continues to grow and the adoption of Bitcoin becomes mainstream, the price will stabilise. Also, today we see a high correlation (0.82) between Bitcoin and the NASDAQ100 - a proxy for technology/growth stocks (see below). This is not an effective store of value, unlike gold, which has held up well since the risk-off environment took hold in November 2021.
The Bitcoin price has a high correlation with growth stocks, Source: TradingView
A major argument against Bitcoin is that it is not backed by anything, unlike the US Dollar which is backed by the US government and Federal Reserve. However, Bitcoin and the US Dollar are much the same with regard to their functioning as a means of exchange. Both are built based on confidence by the public that this means of exchange will be worth something tomorrow. If inflation remained high for long enough or continues to soar as it has recently, that confidence would diminish substantially, and the public would find alternative assets to maintain their purchasing power. Looking at Turkey, second-hand cars have become the go-to asset to escape from 54% inflation of the Turkish Lira. Bitcoin could be another solution.
Mass adoption will continue
Back in 2017, Bitcoin was called a scam when the price hit a high of $20,000 and crashed to as low as $3000. It has come back roaring and is not going anywhere. US President Biden has made an executive order to examine cryptocurrencies, and as they become regulated and physically backed ETFs are created in the US (the largest financial market in the world), institutional adoption of Bitcoin is likely to grow exponentially. This would cause not only an explosion in the price but also a reduction in volatility. Gold currently has a $10trn market cap, and Bitcoin has a market cap of $880bn. This gives Bitcoin the potential to 10x if it one day becomes a serious store of value. By 2030, I do not view this as impossible. At that point, I have no doubt its movements would decouple from technology/growth stocks, becoming a true inflation hedge and a way for you to protect your savings from a fractured financial system. Who knows, Bitcoin could find its way into The Spark portfolio someday!
Portfolio Return Year-To-Date: 7.8% vs S&P500: -5.2%
Total Return since inception (20/09/21): 14.3% vs S&P500: 4.3%
Until Next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.