The Bitcoin Investment Opportunity
Cryptocurrencies like Bitcoin have drawn headlines and significant investor interest. In the last year, the price of a Bitcoin increased from $1,000 to $13,700, and rose 300% between August and the end of the year alone. But is Bitcoin and its underlying technology, Blockchain, a legitimate investment opportunity or a speculative bubble heading for a crash? Below, and in the accompanying white paper, we offer insight into the trend and technology behind cryptocurrencies, and the risks and opportunity of investing in Bitcoin.

Back to Basics: The Genesis of Bitcoin

Bitcoin, the first cryptocurrency, was invented in the depths of the financial crisis to replace the banking system. Its anonymous inventor, known as Satoshi Nakamoto, offered up a technologist’s approach to the banking system: Take something fragile, inefficient, and far too large, and disrupt it.

The idea behind Blockchain, the technology that supports Bitcoin, is to create a ledger of transactions as private as the banking system but also as public as the Internet. In the Blockchain, financial transactions are recorded and confirmed anonymously, but are viewable by the public in the form of a distributed ledger of every Bitcoin transaction. The Blockchain was designed to discourage hackers by making any effort to break the chain less valuable than contributing to it, thus forming trust with the user base.

Like gold, Bitcoins are “mined” and the supply of them is finite. Miners earn Bitcoins for contributing computing power to the Blockchain network to verify that transactions are accurate in the system. As more Bitcoin is mined, more transactions require verification, and less Bitcoin is awarded for each successful verified transaction.

<b>Exhibit 1: Bitcoin&rsquo;s Circle of Life</b>

Electricity is a large input cost for Blockchain (it uses more energy annually than Denmark), which makes it costly to operate and inefficient on a per-transaction basis. More miners will continue to join the network as long as they are compensated with enough Bitcoin to justify their costs. Because of its current construction, however, there is a terminal limit when support from miners will wane. This may happen when all of the coins are mined, when it becomes unprofitable to support the chain, or if there is a change in the miner incentive structure, such as the addition of transaction fees, that makes the chain more bank-like than intended.

What Can You Buy with Bitcoin?

Bitcoin bears some similarities to modern paper currency: On its own, it can’t be a trusted store of value and has no relationship with inflation, but participants can trade Bitcoin for other currencies or goods and services, although the number of participating vendors is limited. The first verifiable transaction of Bitcoin for a tangible good was in May 2010 and involved the trade of 10,000 BTC for two pizzas, and that set the first price of a single coin at an exchange rate of .0025 BTC/U.S. dollar. Given the value of Bitcoin as of December 2017, those pizzas would have been worth an incredible $128 million.

The price per coin versus any currency is now determined by inter-exchange trading rather than by purchases. Presently, the trade volume is high but the number of verifiable transactions for goods is negligible, making it difficult to track the currency’s inflation in terms of purchasing power parity. While there are many exchanges, a handful of mostly unregulated exchanges dominate trading and are prone to fraud and hacks.

The Bull and Bear Cases for Investing in Bitcoin

There is no shortage of opinions on Bitcoin from prominent voices in the financial community. In September 2017, JP Morgan CEO Jamie Dimon, for example, called Bitcoin a fraud. Striking a far different view, IMF Managing Director Christine Lagarde believes that cryptocurrencies can become an important part of the financial system.

Bitcoin bulls are calling for a full disintermediation of the global banking system and widespread acceptance of Bitcoin as a common currency. There are rumors Amazon may begin to accept Bitcoin. This would be the first major breakthrough for the bull case. Faster transaction processing times and increased energy efficiency would likely spur wider acceptance of the cryptocurrency.  Additionally, a new, profitable incentive system for miners would offer another promising signal, as it would bolster the Blockchain and cool fears of systemic instability.

Bitcoin bears, on the other hand, are puzzled by the cryptocurrency’s 2017 gains. Speculation is a part of investing and, while the systemic risks posed by Bitcoin are not nearly what we experienced in the Tech Bubble or housing crisis, they are real. There is a non-trivial chance that Bitcoin can go to zero as the economic fundamentals have not caught up with the trading fervor.

Even though Bitcoin experienced an uncharacteristic lull in downside volatility over the past year, that lull consisted of five drawdowns of more than 20%, the definition of a bear market. The average max drawdown before 2017 was 77% during any given year of BTC/USD trading. 

Additional Risks to Consider

In addition to asset risk, there is operational risk in the currency. Hackers exploit the lack of security and oversight among the BTC exchanges. Mt. Gox in 2014 was the most prolific heist so far, with over 650,000 Bitcoin stolen from the exchange. Since inception there have been multiple large thefts, with a total of 1 million Bitcoin stolen. These breaches contribute to Bitcoin volatility. Exhibit 2.

<b>Exhibit 2: Lack of BTC Exchange Security Contributes to Volatility</b>

There is also little government oversight of the Bitcoin market today, something that could change if the volume of economic transactions increases. The IRS, meanwhile, is showing increasing interest in Bitcoin traders that have not properly reported gains on their tax returns.

Finally, the potential for a Bitcoin implosion is high. Its rise dwarfs that of other asset bubbles over the past half century, including Japanese stocks in the ‘80s, tech stocks in the ‘90s, and U.S. homebuilders in the ‘00s. Exhibit 3.

<b>Exhibit 3: Potential Bitcoin Losses Mount Like Previous Infamous Bubbles</b>

An Uncertain Future

In our view, cryptocurrencies are idiosyncratic and deserve review. Finding assets that grow at exponential rates and have little correlation to traditional assets like stocks, bonds, and commodities is the Holy Grail for portfolio construction, as long as future returns are expected to be positive. Bitcoin passes the first part of that test, but its future returns are uncertain.

Investors who have both an interest in cryptocurrencies and concerns about its volatility may find other ways to expose their portfolios to the trend, whether it is through chipmakers that produce the processing power to extract coins, companies that are early adopters of Bitcoin as a payment method, firms that perform Bitcoin-related services, or through traditional financial instruments like futures and options.

Read the accompanying white paper, Bitcoin: It’s Bigger than Trump, North Korea, Brexit and Crossfit Combined for more on the risks, valuation and potential long-term outcomes of Bitcoin.