Today’s podcast features a discussion around bitcoin – its mining, its adoption, and other questions about its role as an asset. To discuss is Frank Cooke, Quantitative Portfolio Manager with our Multi-Asset Solutions Team.
Brandon Brouillard: I’m Brandon Brouillard, and you are listening to On the Trading Desk®.
We’ve got an interesting discussion lined up today around the one, the only, bitcoin. With the value skyrocketed since its debut, many questions have been answered but several still need to be addressed when it comes to its role as an asset. We’ll explore the historical background but also an investment thesis for bitcoin.
And with me to discuss these implications is Frank Cooke, Quantitative Portfolio Manager with our Multi-Asset Solutions Team. Welcome On the Trading Desk, Frank.
Frank Cooke: Thanks for having me, Brandon.
Brandon: Absolutely. So over the summer, we dove into the topic of digital assets, so I want to extend this discussion specifically to bitcoin. Can you provide some perspective on this history of bitcoin and the role it can play in the exchange of goods and services versus being a store of value?
Frank: Yes, certainly. So the standard definition of money is something that’s a store of value, a medium of exchange, and a unit of account. And the title of the original bitcoin white paper actually described bitcoin as a peer-to-peer electronic cash system, which hinted at bitcoin’s usefulness as a medium of exchange.
And in the early years of bitcoin, that was the popular narrative, that it would disintermediate the likes of Visa and Mastercard. But it’s actually the nature of bitcoin’s blockchain and proof of work technology, the fact that you have to save each and every transaction on the blockchain and everyone around the world has to do the same thing means that it doesn’t really scale that well.
For example, the bitcoin network processes around 5 transactions per second and Visa processes around 1,700 transactions per second. So in the middle 2010’s, it was becoming clear to most people that the medium of exchange narrative wasn’t playing out and there were a lot of people in the industry that wanted to change the bitcoin protocol to make it faster and more of a competitor to the likes of Visa or Mastercard.
The problem is if those changes went through, it would cause the blocks in the bitcoin blockchain to become bigger, which would require a lot more hard drive space for people that are running bitcoin notes. It would require faster internet speeds for those people. And so what that would do is make bitcoin more centralized and less secure.
So there was quite a big civil war because the incumbents were really gunning to compete with Visa and Mastercard. The exchanges and the miners really wanted this big block change to come in.
But this actually didn’t end up materializing, so the proponents who wanted to make sure that bitcoin stayed the way it was—decentralized and censorship-resistant—they actually won out and essentially the bitcoin protocol remains relatively unchanged.
And so what does this mean? Well, this means that what it has become is more of a centralized store of value—censorship-resistant store of value—much like gold is, and I’m sure you’ve heard people comparing bitcoin to gold.
I think the last thing I’ll say here is that there is actually a divide between the developed world and the developing world. So I’m in the UK now. Brandon, you’re in the U.S. We both are very lucky that we have stable currencies. We don’t really have capital controls. And so we really don’t need to use things like bitcoin as a medium of exchange.
But there are actually over 4 billion people in the world living under authoritarian regimes, and those people, they have very unstable currencies—currencies that are being devalued very rapidly. And they have all sorts of capital controls. So, for them, the medium of exchange use case is very, very intriguing, because in some ways, they can’t pay people overseas. They can’t pay that friends easily. They can’t easily create a bank account or use internet banking or internet payments.
So for the developing world, I’d say there’s a strong case for a medium of exchange. For the developed world, it’s more of a store of value, but as I mentioned, we are seeing these second layer scaling solutions come in for medium of exchange and fast transactions.
Brandon: Wow, that’s really interesting and I appreciate that background. And to your point, it sounds like bitcoin’s viewed much like we approach commodities today.
So what about bitcoin mining? Currently, annual bitcoin network energy consumption is roughly equivalent to the annual energy consumption of Sweden. Is that really sustainable?
Frank: Great question, Brandon. Look, that’s no question about it. Bitcoin mining uses up a lot of electricity. But that is actually a feature, not a bug. Because in order to reverse transactions, in order to go back into the blockchain and change who owns what bitcoin, you actually need a really huge amount of energy to do that. You also need bitcoin mining hardware, so it’s actually bitcoin’s energy consumption that has kept it from being hacked, at least at the protocol level, for all these years.
I also think that there are lots of public misconceptions about bitcoin’s energy usage. So bitcoin mining itself produces zero emissions. You are simply using hardware to run some software and solve a mathematical problem and add another block. So it’s just like running your PC at home. No emissions.
Obviously, though, bitcoin mining does consume a lot of electricity. So where is that electricity coming from? I think that’s what people are focusing on.
And actually, bitcoin is one of the greenest industries on the planet in terms of the percentage of renewable energy it uses. I’ve seen a lot of estimates ranging from 40% up to 70%, which I think is probably a little bit ambitious, but either way, those numbers are very, very high in terms of which industries use the most renewable energy in the world.
Now why is this the case? Well, it’s because bitcoin mining is location agnostic. You can do it anywhere in the world as long as you have an internet connection. So a lot of renewable energy, specifically hydroelectricity, is generated in far-off areas of the world where it’s difficult to get the infrastructure to move the electricity, so most of the electricity gets wasted anyway. So if you can move your bitcoin mining operation to those areas, then you’re using a lot of renewable electricity, which is what we do see today.
Another point I’ll make is that of perspective. So you said it’s equivalent to the energy consumption of Sweden, and that’s correct, but what is that in terms of global electricity consumption? That’s actually 0.5% so arguably it isn’t that much. And then if you compare it to things like gold mining, the energy expenditure of the bitcoin network relative to gold mining is actually half of that. And also, you don’t have the environmental damage that comes along with physically mining gold.
But back to your original question in terms of is it worth this energy expenditure, I guess the question is very subjective and it depends on your perspective. Bitcoin mining is the sixth-largest base money on Earth with only the Eurozone euro, Japanese yen, the U.S. dollar, the Chinese yuan, and the UK pound ahead of it. So it’s quite a substantial asset in terms of its value, its market cap. So you could make the argument that it is worth it.
In terms of developing countries, that decentralized censorship and seizure-resistant property that it has is really, really useful for people in authoritarian countries just to sort of escape the wealth confiscation and the currency collapse that happens to them. And we’ve seen numerous examples of this all throughout Africa, Venezuela, Lebanon, Pakistan. If you look at the peer-to-peer usage data of bitcoin, it’s very, very high in these countries and seems to correlate with how draconian the currency regime is in those countries.
Brandon: That’s incredibly interesting and it raises the question in my mind of that’s great, so what’s the cost, right? And so I think, shifting over to this idea of price, most investors have seen the price of a coin nowadays, which seems prohibitive to broad adoption. So how practical is bitcoin for everyday consumers and business-to-business use?
Frank: So the good thing about bitcoin is that it is divisible by 100 million. The smallest unit of a bitcoin is called a satoshi. That’s 100-millionth of a bitcoin. So just because bitcoin is currently at $50,000 (U.S.) doesn’t mean you can’t buy $5 worth of it, for example.
And then in terms of adoption, what’s actually happening in terms of consumers and businesses, again, I want to separate the developed world and the developing world. So in the developed world, I’d say apart from the asset use case, you also have lending platforms where you can actually lend out your bitcoin. You have the risk of that bitcoin being lost by a provider, but you will get a yield on your bitcoin. We know yields are very low, so that’s quite interesting for a lot of people.
In terms of business-to-business use, I think it’s very limited in the developed world. I think it’s basically only really niche bitcoin enthusiasts and business owners that are using bitcoin. So that’s the developed world.
Moving to the developing world, the use case, rather than lending platforms and collateral—we’re not really seeing that in the developing world—what we’re seeing is medium of exchange and store of value and businesses also adopting this as a way to get around potentially these capital controls or restrictive banking systems that they’re operating in.
Brandon: So shifting the conversation to the investment side of bitcoin, what role does this asset play in the context of a broad portfolio?
Frank: I think first of all you need to have a view that there’ll be a reasonably high probability that bitcoin’s price will be higher in the future before you make any allocation to any asset. In the Multi-Asset Solutions team, we’ve done a lot of work on this, mainly looking at supply dynamics and demand dynamics. And we did come to a positive view, but of course, other people may come to a different conclusion.
In terms of the supply dynamics, what’s very positive there is that you have a limited supply. There’s only ever going to be 21 million bitcoins and those are the rules of the game. We know what bitcoin’s issuance schedule is going to be and that’s all fixed.
But you need to look at demand dynamics, as well. And a few of the things we highlight or like to highlight here, number one: institutional adoption. So we’ve seen a lot of institutions over the last 18 months really start to adopt bitcoin. We see university endowments, listed S&P 500 companies. We see a lot of our peers in the asset management industry all starting to embrace bitcoin.
Then we have the macroeconomic backdrop, which is incredibly positive. We have very loose monetary policy. We don’t see that changing anytime soon. Huge fiscal deficits. So these kind of macroeconomic reasons really bolster the fact that bitcoin is a provably scarce asset. We think that that’s very positive in terms of price appreciation.
We also have demographic trends. So millennials and zoomers (Generation Z), they are really embracing things like bitcoin. Personally, I don’t know if you have, but I personally haven’t met one that isn’t very positive on bitcoin. And millennials are going to inherit an incredible amount of wealth from baby boomers in the coming years.
Brandon: Great. So most securities have some kind of asset underlying them. Does bitcoin have any underlying assets supporting its values, and if not, what’s driving current valuations?
Frank: That’s a great question. I think the short answer is no. No, there are no cash flows or revenue projections that allow for traditional valuation approaches used for bonds and stocks. However, you can say the same for gold and even currencies, to a certain extent, valuing these assets is also extremely difficult.
Our approach to valuation was to think about, as I mentioned earlier, the macroeconomic backdrop and what kind of store of value type assets there are out there that hedge against inflation and money supply expansion. So if you think of the traditional assets to hedge against these kind of things—gold, stocks, real estate—currently bitcoin’s market cap is around $1 trillion (U.S). That equates to about 9% of gold’s market cap. It equates to 1% of global stocks’ market cap. It equates to 0.4% of global real estate value. So these numbers aren’t that high and what we’ve seen is increasing trust in bitcoin. So given those small numbers in terms of the value of bitcoin relative to other store of value type assets, we think that bitcoin’s market cap or total value can definitely go higher.
But I guess to go back to your question about what is driving current valuations, we think it’s those positive supply-side and demand-side factors that I mentioned earlier.
Brandon: Okay. So as we think about evaluating opportunities for investment, most investors consider risks and you alluded to some of these risks a little while ago. And so I wondered if you could maybe expand on how the team thinks about bitcoin’s key risks and employs downside risk management in a portfolio context?
Frank: Good question. So key risks, I think number one would be a government crackdown, like we saw in China. We don’t assign a high probability to this scenario, but it is something that we need to think about. Actually, the U.S. has most of the bitcoin capital of the world at the moment. You have a number of congresspeople and maybe one or two senators that are very big advocates of bitcoin. So I don’t think that it has a high probability of happening, but we don’t rule it out and for us, it’s probably the biggest risk to bitcoin.
I think another risk is essentially financial discipline. So what happens if interest rates rise, inflationary concerns abate, and the economy goes back to normal, the bull case for bitcoin suffers a bit. So I think that’s another key risk that we think about.
Brandon: Perfect. So we have a minute or so left and I wondered if you could just share a parting thought for our listeners.
Frank: Yeah, I think for me, I’ll come back to this question of what is bitcoin. And that question can be very overwhelming.
So what I wanted to give to the listeners was how we think about it, our framework for thinking about it. And we actually think about it in terms of three different aspects.
Number one, that emerging store of value assets that could potentially perform well in both an inflationary and deflationary scenario.
The second part is it’s both an asset and a settlement network at the same time.
And then the third piece is that growth or technology play.
So that’s our framework for thinking about bitcoin from an investment point of view.
Brandon: Thanks for that, Frank, and I appreciate speaking with you today. This has been an enjoyable and really informative discussion, so thank you again for making the time to join us today.
Frank: Thanks, Brandon. Really appreciate it.
Brandon: Well, that wraps up this episode of the On the Trading Desk podcast. To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Stitcher, Google Podcasts, Overcast, or Spotify. Thanks for listening, I’m Brandon Brouillard and we’ll catch you next time.
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