Institutional Investors' Perspective on Bitcoin as an Asset

In this analysis, I’ll be going over Institutional players related to Bitcoin, which companies and people are bullish on it for what reason, and which others are bearish or against it. I’ll also provide a non-biased conclusion of how to view Bitcoin for your overall portfolio.

What is Bitcoin?
Let’s briefly go over what Bitcoin exactly is. Bitcoin is a digital currency that was developed for peer to peer (p2p) transactions. Unlike conventional monetary transactions, which occur through a centralized bank, Bitcoin transactions take place through blockchain technology, in which there is a distributed network of people who record the transaction information for rewards. The people who participate in maintaining this ledger are called miners.

Arguments for Bitcoin
Based on ARK Invest’s report, Paul Tudor Jones’ letter to his investors, Lyn Alden’s analysis on Bitcoin, as well as reports from Grayscale, here are some of the reasons why institutions are looking to add Bitcoin to their portfolio.

The first reason has to do with scarcity. Water is a necessary commodity for life, but it’s not expensive, because it’s not scarce. Gold is not a necessary commodity, and has relatively less uses compared to water, but its price increases over time due to scarcity.

Bitcoin has this characteristic as well. It’s scarce in supply, as it was programmed to have a supply of only 21 million bitcoins. In reality, there are even less than 21 million, due to a certain number of Bitcoins having been lost (kept in a wallet and forgotten by the owners). Because there is no central entity that can artificially change the amount of Bitcoin’s supply it potentially provides more value, given that there is enough demand.

Additionally, we can see the network effect take place on Bitcoin, based on the Bitcoin dominance chart. Initially, Bitcoin was the only cryptocurrency, but alternative coins started to emerge in the cryptocurrency realm. As a result, it became important to refer to the bitcoin dominance chart (BTC.D), which is a chart that demonstrates Bitcoin’s relative value to that of the broader cryptocurrency market. In the purple Bitcoin dominance graph, we can see that the dominance percentage ranges between 40 to 60, during times of both bull and bear markets, which reflect the network effect of Bitcoin, and people’s views of Bitcoin as a digital asset or a digital version of gold, rather than a currency.

Speaking of Bitcoin as digital gold, or a digital asset, we can compare it to Gold in terms of market cap. Gold has a market cap of about 9 trillion USD. Bitcoin stands at $288 billion. For a bullish case, even with a rough estimate that Bitcoin can grow as big as 10% of Gold’s market cap, that would grow Bitcoin’s market cap to $900 billion, which would price bitcoin at over $40,000 per coin (Refer to the graph on the chart). This analysis based on ARK Invest’s report has an underlying premise that Bitcoin will eventually follow gold’s characteristics as an asset.

Of course, Bitcoin and gold still have massive differences. While Gold has a bigger and better network effect, a better image of a safe haven, and a real life uses in electronics and jewelry, Bitcoin has a finite supply, a characteristic that makes it safer as the network effect grows, and is easier to keep and maintain than gold.

The second reason why institutions are looking into purchasing Bitcoin is due to the macroeconomic changes. People invest in gold because they view it as a hedge against inflation. Ever since modern society found out that the solution against deflation was simply to print more money, the real value of the currencies we use worldwide have been depreciating over time.

In the graph in green, we can see the M2 graph, which is simply the money supply chart. We can see that money supply started growing at an exponential rate of 25% a year starting in 2020. This type of monetary policy trend is not confined to the United states, and is the most important macroeconomic factor that explains the bullish momentum in all markets, including the cryptocurrency market. Institutions are starting to see Bitcoin as a hedge against inflation, and seeing value in Bitcoin as a digital asset.

Lastly, it’s important to take a deeper look at how Bitcoin’s supply works. Bitcoin is supplied to miners who record transactions on the blockchain ledger. Bitcoin is granted to them as a form of reward for contributing to the network. Every several years, the number of bitcoins miners receive decreases over time. This is called ‘the halving’. In the first halving, which took place in November 2012, the number of Bitcoin as rewards decreased from 50 to 25. Then in 2016 July, the reward halved again from 25 to 12.5 btc. The third halving event, which took place this year around May, reduced the block reward from 12.5 to 6.25. The overall trend demonstrates that after the halving takes place, for the next two years, Bitcoin undergoes a bullish rally. Thus, given that the third halving event took place a few months ago, institutions have their eyes on a unique asset that is beginning another major bullish market cycle.

We can also view the stock-to-flow model, which measures the relationship between the currently available stock of a resource, and its production rate. In the case of gold, the ‘stock’ we refer to would be the entire amount of gold mined throughout history, while ‘flow’ refers to the amount that can be newly mined.

Gold, which is a monetary commodity, has a high stock-to-flow ratio between 50 and 60. The World Gold Council estimates that 200,000 tons of gold exists above ground, while the annual supply is around 3,000 tons. Bitcoin, similarly, has a stock-to-flow ratio in its upper 50’s, as 18 million Bitcoins have been mined so far, and since 330,000 new ones are mined every year. The good news is, this ratio will continue to increase, until it reaches over 100 around 2024.

As for gold, we don’t know what the actual supply is. We could end up finding significant amounts of gold in North Korea. But Bitcoin is finite, with a supply cap of 21 million, which makes Bitcoin harder than gold.

Neutral Stance on Bitcoin
Ken Fisher, the chairman of Fisher Investments, was one of the few people who accurately predicted the covid-19 pandemic’s impact on the stock market, as well as a sharp V shape recovery.

His stance is that he doesn’t know enough about Bitcoin, and that he doesn’t really need a stance on it, just as he doesn’t need a stance on other types of speculative assets. He knows that the cryptocurrency community (developers who lead the community) consist of extremely smart people, but he has seen smart people do stupid things in the past.

One thing is clear to him; Bitcoin is not what a lot of its proponents think it is. By this, he refers to Bitcoin not having value as a currency, but as something else. He is right about this in the sense that the narrative in the cryptocurrency community has changed from “Bitcoin is going to be the next world currency” to “Bitcoin is a digital asset that acts as a safe haven against inflation”.

Arguments against Bitcoin
Two major figures that represent institutional investors emerge when discussing arguments against Bitcoin: Warren Buffett from Berkshire Hathaway (BRK.A) and Ray Dalio from Bridgewater Associates, the biggest hedge fund in the world.

In 2018, Warren Buffett went on to say that Bitcoin is an asset that doesn’t create any value. Unlike a farm or a company, which leaves investors not only with what they bought in the first place, but also something that the asset produced, with a non-productive asset like Bitcoin, all you’re counting on is whether the next person is willing to pay you more, because they’re excited about the next person coming along to pay an even higher price for it.

This is completely reasonable coming from a value investor like Buffett. One of his main investment styles involve purchasing large amounts of shares of a company, and profiting from the dividends over the long term.

Ray Dalio, in a similar context, wasn’t overly bearish on Bitcoin, but did pose questions regarding his concerns. Dalio says that Bitcoin is not a good store of wealth due to high volatility, does not protect his purchasing power, and will most likely be regulated by governments should it threaten traditional fiat, not to mention the fact that he can’t imagine central banks, institutional investors, and businesses owning Bitcoins in their reserves or using it.

His main concerns stem from the older narrative of Bitcoin as a currency, but as I have explained above, the newer narrative is that Bitcoin holds value as a unique digital asset.

Businesses
Businesses have recently started jumping on the cryptocurrency trend as well. Paypal (PYPL) has launched a new service that enables its users to buy, hold, and sell cryptocurrencies. This is big news as Paypal allows cryptocurrency to reach out to over 26 million people, marking the beginning of a potential mass adoption.

Square (SQ), an American payment solution company, has invested over $50m, claiming that Bitcoin aligns with the company’s purpose in that it provides economic empowerment, and encourages people to participate in the global monetary system. They ended up purchasing 4,709 btc, which is approximately 1% of the company’s total assets at the end of Q2 2020.

Microstrategy (MSTR), a company that provides business intelligence, mobile software, and cloud based services, invested over $400m in Bitcoin through Coinbase. Interestingly, their investment profits from Bitcoin exceeded $100m, which is more than their operating profits over the past three years combined.

Institutional Players
One of the main institutional players worth noting in the cryptocurrency space is none other than Barry Silbert’s Grayscale. Grayscale is an asset management company that focuses their investments on cryptocurrencies. Aside from Bitcoin, they also own certain altcoins such as Bitcoin Cash, Ethereum, Litecoin, XRP, Stellar Lumens, and Z cash.

Grayscale became the first company to offer a publicly quoted Ethereum investment product in the United States through their Ethereum Trust (OTCQX: ETHE), which was approved by the SEC. Prior to this, they had Grayscale Bitcoin Trust (OTCQX:GBTC) become an SEC reporting company as well.

Grayscale’s assets under management (AUM) has recently surpassed $10 billion. While this is a lot for a cryptocurrency fund, this is still relatively small compared to the AUM of traditional asset management companies, indicating high potential for growth in the industry.

Another player is Guggenheim Partners, a global investment firm with an AUM of $270 billion. They recently reported to the SEC that they had the right to spend 10% of their Macro Opportunities Fund to gain exposure on Bitcoin through Grayscale’s Bitcoin Trust. This would amount to a $530 million dollar investment.

In Grayscale’s reports “Valuing Bitcoin” and “Bitcoin Investor Study”, they also note the importance of Bitcoin’s role from the larger context of macroeconomics. They have noticed the number of speculators in the markets decreasing, while the number of holders increase, which substantiates the argument that Bitcoin is a good store of value. Grayscale’s Whale Index, which looks at wallets with over 1,000 bitcoins, also demonstrates an increasing trend, signifying accumulation.

Bitcoin for Your Portfolio
In ARK Invest’s Report, they conducted quantitative research on the correlation of Bitcoin’s price to other assets, stocks, and indices. They looked at the S&P500, Gold, Oil, Bonds, Emerging Currencies, Real Estate, Bank of America stocks (BAC), Apple stocks (AAPL), and Tesla stocks (TSLA). Results demonstrated that Bitcoin had very low correlation with all other assets, stocks, and indices that were compared. The only asset that demonstrated a moderate correlation was real estate, but this isn’t completely accurate either because ARK only looked at the price correlations for a short period of time, and thus did not take into account the long market cycle real estate properties have. (Real estate properties have been on a bullish rally without any meaningful corrections over the past 12 years)

The fact that Bitcoin is not clearly correlated to any other conventional asset, security, or index is what makes it unique, and worthy of including in one’s overall portfolio.

If so, how much Bitcoin should one own, in terms of percentages?

ARK simulated over a million portfolios with different percentages of Bitcoin constituting each portfolio from 0 to 100 (Refer to the graph on the chart). The graph demonstrates annualized volatility on the x axis, and annualized returns on the y axis. The portfolio with the lowest volatility consisted of 2.55% of the entire portfolio as Bitcoin. The result with the highest Sharpe ratio (a ratio that demonstrates the highest returns compared to its risk) consisted of 6.55% of the entire portfolio as Bitcoin. What’s interesting to note is that despite Bitcoin’s extreme volatility, due to its low correlation with other assets, it plays a complementary role in one’s portfolio.

In a similar context, an academic research was conducted by Aleh Tsyvinski, an economist at Yale, where he assesses Bitcoin using textbook finance tools to conclude the following:
1) If you believe that Bitcoin will continue to perform as well as it did throughout history, you should hold 6% of your portfolio in Bitcoin.
2) If you think it’ll do half as well, hold 4% of your portfolio in Bitcoin.
3) In all other circumstances, even if you think it’ll do much worse than it historically performed, since past historical performance is not a reliable indicator of future performances, you should still hold 1% of your portfolio in Bitcoin, due to its massive potential returns.

Mike’s Concluding Remarks
I have been a big proponent of Bitcoin (and other cryptocurrencies) for many years, and even from a realistic approach, this may be the best time to start looking into investing in cryptocurrencies. Especially considering that investors should and are looking for hedges against inflation, Bitcoin, which demonstrates little to no price correlation with other assets and securities, offers a very appealing investment opportunity. Moreover, the growing interests from institutional investors also suggest potential for massive corporate capital to flow into the market, which would eventually stabilize volatility in the long run. Risking 1-6% of your entire portfolio on an investment opportunity that could multiply is a calculated risk worth taking. As such, my final opinion on Bitcoin as a long term investment is a “buy”.

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