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Store of value
Separate surveys show that 14% of Americans owned crypto at the start of 2021 – more than the proportion who owned gold (around 11%). Popularity alone does not validate crypto as more than a collector’s item, but its rapid adoption is remarkable.
Budget spending doubled US debt relative to GDP, from 62.9% in 2007 to 127.5% in the first quarter of this year. Unprecedented monetary expansion saw the Bank of Canada’s total liabilities explode from $ 120 billion to $ 575 billion in a year ending March 2021. Successive rounds of quantitative easing and government spending fuel fears of inflation and even currency depreciation economic advantage erodes purchasing power.
This environment is leading some investors to question whether Bitcoin is digital gold. Both asset classes are “exploited†with a limited supply and are therefore rare; both are portable and divisible; both are fungible, if one ignores the criminal links that may restrict the acceptance of Bitcoin; and both attract zealous support as stores of value and hedges against inflation.
But Bitcoin, which has only been around since 2009, lacks a meaningful history, and gold’s inflation hedging properties are not established law. Note the divergence between inflation and gold after 2008 in Chart 1 below.
Graph 1: Annual change in the consumer price index relative to gold (USD), 1969–2020 (Source: Federal Reserve Bank of Saint-Louis)
Unlike Bitcoin, the value of gold is based on average annual net demand: 34% of jewelry, 7% of technology, 17% of central banks and 42% of investment or speculation, according to Metals. Focus, Refinitiv GFMS and the World Gold Council. Demand for Bitcoin appears to be driven entirely by speculation (illicit activity only accounted for 0.34% of all crypto transactions last year, according to a report by Chainalysis). The correlation between gold and Bitcoin prices was between -0.5 and +0.5 on a 90-day basis between July 2016 and January 2021, suggesting that the relationship is not as strong as some think so.
Bitcoin’s limited supply (a maximum of 21 million coins), which is an advantage as a collector’s item, undermines its effectiveness as a money supply surrogate. Without flexibility and control over the money supply, the number and magnitude of business cycle ups and downs would likely increase.
Frictionless Transactions
Cheap, hassle-free transactions that bypass banks, credit card companies, brokers, and regulators are a fintech goal but a threat to the status quo. Third parties still provide the trust required for most transactions. Despite the blockchain-generated ‘proof of work’ and ‘proof of ownership’ – which are trusted surrogates for cryptos – the extreme price volatility limits the practical use of cryptos as a currency. Bitcoin’s weekly volatility (9.9%) was three times that of the Nasdaq (3.2%) and 4.5 times that of the S&P 500 (2.2%) over the 10 years ending in January 2021, according to Bloomberg and the ICE Benchmark Administration.
To reduce volatility, a range of so-called stablecoins have been launched that are linked to other assets or currencies, including the US dollar and even gold. Stabilization mechanisms resemble central bank money management at fixed exchange rates. Income generation through Decentralized Finance (DeFi), similar to securities lending, allows crypto owners to deposit their coins with a decentralized protocol like Uniswap that provides liquidity to traders, giving coin owners a share of the fees. loan and commissions (Uniswap charges 0.30%), which are collectively known as “gas”. High returns from “yield farming†(30% to 200% annualized) have been reported, but there is little certainty and less confidence in the sustainability of the income stream.
Acceptance of crypto for goods and services is essential for acceptance of the medium of exchange, as shown by the market reaction to Elon Musk’s endorsement. Starbucks and Home Depot have joined Overstock and Microsoft in accepting Bitcoin in the United States. In Canada, Dominos Pizza and Shopify are at the top of the list. Walmart is looking to launch its own coin, Libra (USD). The alternative is for crypto owners to convert to fiat (dollars) through a Bitcoin layer like Lightning or analog exchanges like Coinbase or Coinsquare which are slow and expensive.
Ethereum has an advantage over Bitcoin as a transaction medium because it can be used for digital and blockchain projects like DeFi.
Invest or speculateion?
Cryptos pay no dividends or interest, so they have no expected returns. Serious portfolio building cannot handle them. Nonetheless, their high historical returns and low correlation with other assets suggest that the inclusion of cryptos in portfolios improves Sharpe ratios. But high returns can have a disproportionate impact on this decision. How many portfolios can withstand a 50% price drop regardless of asynchronous volatility? Like gold and fiat currencies, cryptos are speculation, not investments.
Without wide acceptance and vendor scalability – Bitcoin can guarantee 4.6 transactions per second versus 1,700 for Visa – crypto as a medium of exchange is not going anywhere. While the popularity of cryptos gives them a sense of legitimacy, without trust and price stability, peer-to-peer smart contracts may not always be fully embraced.
Are cryptocurrencies the future of the banking system? Perhaps. The decline in the use of cash for retail purchases and the increase in demands for digital transactions have accelerated central bank research into digital currencies. Wide access will come with a digital ID and associated security concerns. Still, the range offered for a “brand new†Valentino the Bear Beanie Baby is $ 1.22 to $ 23,000 on eBay, reminding us that the reality is the last auction, plus shipping.
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