Making Sense of the Bitcoin Buzz

On May 13, Elon Musk posted this tweet:

Soon after, bitcoin tumbled 27%* (Figure 1):

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Figure 1: Bitcoin Price, May 13-20, 2021[/caption]

A Pattern of Volatility

Liquidation events in markets typically begin with a certain level of novelty (see "From an unknown unknown to a known unknown"), and while the catalyst for bitcoin’s latest selloff is unique, the level of volatility is unsurprising if not familiar to holders of bitcoin. In the past five years, there have been 38 (!) 24-hour drawdowns of 10% or more. Even in bull markets, bitcoin has experienced drawdowns of more than 20% with white-knuckling regularity; its journey from $1,000 to $19,000 in 2017 included four drawdowns of at least 25% (Figure 2):

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Figure 2: Bitcoin Price, January – December 2017[/caption]

Swift declines provide an opportunity to reassess risk tolerance and one’s ability to withstand sharp, enigmatic drawdowns. Through the rosy lens of hindsight, drawdowns are nothing more than lines on a chart, unlived. The realized experience is something else entirely.

For the past several years, we have kept a watchful eye on crypto assets, namely bitcoin. Below, we share our view on their (potential) place within portfolios, one that is consistent with our asset allocation framework. Given the human propensity for F.O.M.O. (Fear of Missing Out), we also offer our perspective on the minimum level of education investors should undertake before making an allocation to the space, if any allocation is made at all.

Our Take

To reiterate what we have said in previous blog posts on the topic (here, here, and here), Balentine invests only in assets with compensated risks that are intuitive, consistent, and accessible. For example, we can predict with reasonable certainty that stocks will return somewhere around inflation +4% over the long run, and we can anticipate with some level of confidence how the stock market will behave under certain scenarios. An asset lacking a positive expected return might still receive an allocation if it serves a unique, reliable role within portfolios, such as commodities (reduction in inflation risk) or tail protection (removal of unwanted portfolio downside beyond a certain level).

With crypto assets like bitcoin, we have input failure: there is no extensive performance record through multiple market cycles. Since its inception in 2009, bitcoin’s purported ability to play the inflation-hedging role has yet to be thoroughly tested. Bitcoin might exhibit shock-absorber properties during periods of widespread skepticism regarding the stability of economic institutions, (see Cypriot "Bail-in"); however, this gold-like property is difficult to reconcile with its general risk-on, liquidity-driven nature. Take bitcoin’s returns in the fourth quarter of 2018 and March of 2020, for example (Figure 3):

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Figure 3[/caption]

Simply put, legitimization of crypto assets requires more data. Without this data, we cannot derive reliable estimations of expected return and expected volatility, nor can we properly conduct correlation analysis within the portfolio. Furthermore, the data that we do have is distorted by excessive and speculative inflows and outflows given the relatively small size of the market (at the time of writing, bitcoin has a market capitalization of roughly $750 billion, gold has a market cap of roughly $10 trillion, and the market caps of both global equity and global fixed income markets each exceed $80 trillion).

While its odds of long-term survival grow each year it fails to disappear, bitcoin (and other crypto assets) remain emergent. We concede that bitcoin could eventually function as a censorship-resistant, digital gold, at which point it might reliably serve a useful function within portfolios. But, for now, neither bitcoin nor any other crypto asset have reached states of long-run equilibrium, nor can it be said that they ever will. On the way there, we expect hyper-volatility, replete with leverage, greed, capitulation and all the emotions that accompany boom-and-bust cycles in every asset class. Adoption is nonlinear.

Investors allocating to crypto assets in 2021 are not allocating for the role that these assets currently play within portfolios, but rather, are investing on the prospect that they will eventually play some role within portfolios. For now, we are content to wait while crypto assets, particularly bitcoin, find their footing.

If you feel so inclined…

While our formal view precludes allocation, this does not mean that Balentine is not actively monitoring developments in the crypto asset space. We believe bitcoin’s meteoric rise warrants attention, and to be dismissive of its potential is negligent.

Investors interested in the potential of crypto assets might consider:

1. Small allocations, sized so as not to derail any financial goals.
2. Lengthening investment time horizons. We posit that “store of value” should be conceptualized in a matter of years, not months.
3. Avoiding the use of leverage.
4. A “first principles” understanding of the asset, and a thesis built on sound reasoning, ideally with little to no sensitivity to Saturday Night Live. The goal is to avoid this sort of thinking:

For a 101 primer, we encourage you to head over to this unrivaled repository from Andreessen Horowitz: Crypto Canon. This collection from Jameson Lopp is also impressive, specifically this comprehensive list of bitcoin investment theses.

We recommend starting with any of the following, depending on your preference of medium:

• But how does bitcoin actually work? (3Blue1Brown, YouTube)
• Crypto, an Oral Essay (Andreessen Horowitz, Podcast)

And for those more inclined to text (ordered from shortest to longest reads):

• "What Is Bitcoin in 5 Minutes" (Cryptopedia)
• "How the Bitcoin protocol actually works" (Michael Nielsen, 2013)
• Mastering Bitcoin, 2nd Edition (Andreas M. Antonopoulos, 2017)

We end with 15 links to our favorite crypto blog posts, twitter threads, and longer-form pieces along with what we consider to be the most interesting soundbite contained within each. These pieces are included less for the explicit views that they promote, and more for the level of thought and discourse which they provoke. We consider these to be the most important reads for investors considering allocations to crypto assets.

If time only allows for one read:

• "Letter to Jamie Dimon and Anyone Still Struggling to Understand Cryptocurrencies" (Adam Ludiwn, 2018)
  “Here’s my definition: cryptocurrencies are a new asset class that enable decentralized applications. If this is true, your point of view on cryptocurrencies has very little to do with what you think about them in comparison to traditional currencies or securities, and everything to do with your opinion of decentralized applications and their value relative to current software models…It’s not at all clear yet that decentralized applications are actually useful to most people relative to traditional software.”

Of high importance:

• "The Many Faces of Bitcoin"(Adam Taché and Murad Mahmudov, 2018)
  “These individuals believe that, for the foreseeable future, the goal of the Bitcoin project isn’t to facilitate the buying of coffee, but to become “high-powered” money, an even better form of gold. They claim it to be a digital asset superior to physical gold due to a truly limited supply and more deflationary emission. They also claim that, if used properly, it is unseizable, unhackable, arbitrarily unprintable, and is an attempt to engineer a superior form of money. Bitcoin is often discussed as a settlement network where the raw block space is not meant to facilitate small-value individual transactions. It is believed, rather, that its usage is for settling transactions of a larger value, where fees are less of an issue.”
• "Fat Protocols" (Joel Monegro, 2016) “The previous generation of shared protocols (TCP/IP, HTTP, SMTP, etc.) produced immeasurable amounts of value, but most of it got captured and re-aggregated on top at the applications layer, largely in the form of data (think Google, Facebook and so on). The Internet stack, in terms of how value is distributed, is composed of “thin” protocols and “fat” applications. As the market developed, we learned that investing in applications produced high returns whereas investing directly in protocol technologies generally produced low returns… This relationship between protocols and applications is reversed in the blockchain application stack. Value concentrates at the shared protocol layer and only a fraction of that value is distributed along at the applications layer. It’s a stack with “fat” protocols and “thin” applications.”
• "4 eras of blockchain computing: degrees of composability" (Jesse Walden, 2018)
  “Many argue that that the most important property of a decentralized money system is security, not programmability, and that a limited scripting language is thus a feature, not a bug. Through that lens, we can view Bitcoin as more of a calculator than a computer (and that is intended as a positive remark!). It is purpose built and good at it’s task, but for developers keen to tinker and build new applications an evolution to a new architecture was required.”
• "Our Thoughts on Bitcoin" (Bridgewater, 2021)
  “Rather than it being far-fetched that the government would invade the privacy and/or prevent the use of Bitcoin (and its competitors) it seems to me that the more successful it is the more likely these possibilities would be.”

Worth consideration:

• "In Praise of Bitcoin" (Epsilon Theory, 2021)
  "When these regulations go into full effect, as I understand them, the only remaining safe harbor for keeping your Bitcoin hidden from the BSA/FBAR Eye of Sauron will be to maintain a self-hosted wallet that never connects with a money transmitter that does business in the US."
• "What Bloomberg Gets Wrong About Bitcoin’s Climate Footprint" (Nic Carter, 2021)
  “First of all, Bitcoin and Visa are fundamentally different systems. Bitcoin is a complete, self-contained monetary settlement system; Visa transactions are non-final credit transactions that rely on external underlying settlement rails. Visa relies on ACH, Fedwire, SWIFT, the global correspondent banking system, the Federal Reserve and, of course, the military and diplomatic strength of the U.S. government to ensure all of the above are working smoothly. Any energy comparison must take the above into account – including the externalities from the extraction of oil, which implicitly backs the dollar…Bitcoin transactions, by contrast, rely just on bitcoin.”
• "Bitcoin Network Effects" (Elad Gil, 2017)
  “In the crypto world, Bitcoin is perceived as slow to change, clunky technologically, and as having bad governance. While all these things may be true, Bitcoin has strong network effects that will maintain its status as the primary value store in the short to medium term.”
• Why Ethereum Architecture is Flawed (Hugo Nguyen, 2019)
  “Bitcoin is specifically inefficient in 2 dimensions: a) It mandates that rate of blocks produced must be slow b) It uses broadcast communication. To highlight how counter-intuitive this is. How often do you: a) Purposely make a job slower, even if you figured out a way to make it faster? B) Tell everyone you know about every single thing that you did, every minute of the day? To do this in a network setting is even more insane. Not only you are slow, everyone else must be slow. Not only you scream at everybody, everybody screams at everybody else…It turns out that being maximally inefficient has its advantages. By intentionally forcing things to be slow, Bitcoin makes it costly to cheat. By using broadcast communication, it minimizes the need to trust individual members (or maximize fault-tolerance, in computer science terms)”
• "The case for Ethereum maximalism" (2018)
  "More generally, you can think of each cryptocurrency as being characterized by a multi-dimensional set of attributes: security, transaction cost, network size, governance quality, robustness of scripting languages, and several others. My mental model is that when one coin is better than another on some attributes and no worse in any other, then it dominates the other coin. A dominated coin can have no value in equilibrium."

More esoteric:

• "Bitcoin Is Winning the Covid-19 Monetary Revolution" (Niall Ferguson, 2020)
  “The point is simply that the financial data of law-abiding individuals is better protected by Bitcoin than by Alipay. As the Stanford political theorist Stephen Krasner pointed out more than 20 years ago, sovereignty is a relative concept.”
• "Why the Lindy Effect predicts that Bitcoin will last" (2018)
  “The Lindy effect is an idea that the future life expectancy of some non-perishable things like a technology or an idea is proportional to their current age, so that every additional period of survival implies a longer remaining life expectancy.”
• @breakingthemark (2021)
  “I think the only way BTC works as envisioned if the transactions can’t be cornered. You need plentiful capacity in the transaction network to bring bitcoin’s vision of a free and open store of value/monetary system with no counterparty to reality at meaningful scale.”
• "Bitcoin’s natural long-term power-law corridor of growth" (Harold Christopher Burger, 2019)
  “The model predicts ever increasing prices, although at a slower and slower rate.”
• @jonty (2021)
  “Short version: The NFT token you bought either points to a URL on the internet, or an IPFS hash. In most circumstances it references an IPFS gateway on the internet run by the startup you bought the NFT from. Oh, and that URL is not the media. That URL is a JSON metadata file”

*with some “help” from harsh Chinese regulatory rhetoric and excessive leverage