Bitcoin, monetary innovation and the business cycle
By Manuel Anguita – At Silver 8 Capital, we believe that the future global monetary system will look considerably different than that of today. In our view, the combination of technological progress and geopolitical and social developments are going to change the current forms and uses of money.1
Ultimately, we strongly believe that blockchain technology will form the backbone of this monetary evolution.
In the modern world, currencies are primarily sponsored by groups or individual nation states, together with institutions that represent their interests. Currencies are, to a large extent, a public and managed good, tied to a specific geography and embedded in a legal framework. Currency management (ie monetary policy) has different aims, but is primarily used as a means to support economic stability and growth, together with a semi-disguised government funding goal. As any other centralised economic decision, managing monetary policy is no easy feat, with many historical and current examples of both good decision-making and mismanagement, with pronounced social implications.
In contrast, Bitcoin and other cryptocurrencies are stateless and global in reach.
There is no central entity making monetary policy decisions: Bitcoin’s monetary policy is predetermined and written into its transparent protocol. We know that there is a hard limit of 21 million bitcoin units to be minted, as a function of time, irrespective of economic developments or the need for any government funding.
Notice that cryptocurrencies operate within blockchain networks, completely outside of traditional payment systems. Therefore, cryptocurrencies are subject to idiosyncratic, early-stage technology risks, but at the same time, they are isolated from disruptions to the current financial system.
Libra, a digital currency project that is being promoted by Facebook, offers us a third proposition.
Libra shares Bitcoin’s ambition of becoming ubiquitous and borderless. However, it is a currency that is governed by a central authority: the Libra Association in Switzerland, with 28 founding members and open to more participants, primarily private companies. Therefore, it is a corporate-sponsored currency.
To a large extent, the Libra Association is very similar to a central bank, in the sense that it has the ability to mint new currency. However, the Libra Association intends to outsource the monetary policy of this new currency to the world’s largest central banks (with the exception of China), by simply backing it with low risk assets denominated in the major currencies.
As a result of this design, Libra’s monetary behaviour will depend primarily on the combined decisions of the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan, each of which has its own goals and constraints. In this sense, Libra is a pass-through currency, as its monetary policy is purely accommodative of that of these large central banks.
In view of the significant regulatory hurdles that they will face, it remains to be seen how successful Libra or other similar initiatives will be on a global scale, but it is clear to us that the international monetary landscape will change very significantly.
In the not too distant future, people around the world will be able to choose between competing forms of money. State-sponsored currencies may well continue to work as the primary medium of exchange in developed economies, with some penetration of cryptocurrencies and corporate-sponsored currencies in e-commerce. In contrast, in developing economies with fragile financial systems or weak institutions, new digital currencies have a higher short-term penetration potential, both as a general purpose medium of exchange and as a savings instrument.
To date, the reactions of governments and central banks to cryptocurrencies have been tame, focusing on the need to monitor illicit activities (money laundering is illegal, regardless of whether it is being conducted in USD, in EUR or in bitcoin). From the perspective of central banks, cryptocurrencies have been primarily looked upon as an experiment with interesting attributes, still too small to be a source of concern in terms of their impact on monetary policy or financial stability. In an instant, Libra has brought to the spotlight the potential impact of technological disruption on the status quo of state-driven monetary policy.2 The sheer size of Facebook’s over 2 billion users and its international reach are clearly worthy of attention, and even concern, for central bankers.
In terms of portfolio management, we believe that Bitcoin and other decentralised cryptocurrencies offer an economic profile that is in stark contrast to that of these new corporate sponsored currencies. Bitcoin is transacted and stored outside of the traditional financial system. In addition, it has a hard, fixed supply that is not elastic to changes in demand or sensitive to macroeconomic conditions. Bitcoin may or may not work as a medium of exchange, but due to its unique design, it has the potential to become a store of value and a hedge against inflation and systemic risks.
Based on recent news headlines and commentary from fund managers, it seems that institutional investors are starting to explore Bitcoin as a means of diversifying investment portfolios.
This coincides with US Federal Reserve Chairman Jerome Powell’s recent characterisation of Bitcoin as “an alternative to gold”.3 In fact, Bitcoin has historically been uncorrelated to traditional asset classes, such as equities, bonds, real estate and a number of commodities.4
In our view, Bitcoin’s phenomenal performance since inception, and the volatility associated with it, has been dominated by risk factors common to early-stage technology investments, which are typically related to assessments of technological feasibility and adoption rates under conditions of extreme uncertainty. As a result, business cycle considerations have had a muffled impact on the historical return profile of this new asset. As the technology matures, uncertainty over its feasibility diminishes, changing the weight of the risk factors behind expected returns and correlations towards those related to its economic nature.
As we approach a change in the business cycle, the important question for investors is how to protect their portfolios, particularly given the limited scope for central banks to adopt countercyclical monetary policies.
Bitcoin is still an early-stage technology, and as such, it will continue to be subject to a high degree of uncertainty and idiosyncratic technology risks. From this perspective, we believe that in the short term, adding exposure to Bitcoin within a well-diversified portfolio may well contribute to achieving a better risk-reward profile, as Bitcoin’s volatility results from risk factors that are uncorrelated to the economic cycle.
For investors with a longer investment horizon, scarcity and independence from the traditional financial system are extremely rare economic attributes that can potentially provide Bitcoin with a negative correlation to economic shocks. In our view, these economic variables will become more prevalent in Bitcoin’s risk profile as the technology matures. n
1. See Mark Carney’s recent speech at the Jackson Hole Symposium: The Growing Challenges for Monetary Policy in the current International and Monetary Financial System (August 23, 2019).
2. See Bloomberg, Don’t Rush to “Squelch” Facebook’s Libra, IMF’s Lipton Says (July 16, 2019).
3. See Jerome Powell’s testimony on Libra before the Senate Banking Committee (July 11, 2019).
4. We refer the reader to the correlation data from CoinMetrics.io (accessed August 26, 2019).
Co-Founder, Silver 8 Capital
Manuel Anguita, CFA is the co-founder of Silver 8, a US-based fund focused on financial technology. Silver 8 is one of the pioneer institutional investors in blockchain technology and digital assets. Manuel has a 20 year career in investment management. He initially worked for Goldman Sachs and Merrill Lynch, before moving into hedge fund management; Manuel worked for multi-billion dollar funds (Vega, Proxima Alfa) primarily in global macro and structured credit. Manuel received an MBA as a Fulbright Scholar from the Stanford Graduate School of Business in 1998 and an MSc in Engineering (Hons) from the Madrid Polytechnic University in 1992.