Updated: Feb 15
Our thesis here is that the extraordinary interest in digital assets in late 2020 and early 2021 has significant, fundamental factors that begin with the broader environment of global macro investing conditions, is supported by recent trends in global investment decisions, and that the digital asset sector has matured so that it is ready for institutional interest.
Although there is obviously room for price correction, given the extraordinary bullishness of relentless bidding into digital assets in late 2020 and early 2021, we discuss reasons why we don't think that this volatility will print a multi-year high, as it did in 2017/2018.
Recent interest in the assets saw the market cap of Bitcoin reach $500 billion USD, then the market capitalisation of the cryptocurrency (digital asset) asset class reached $1 trillion USD. More recently, Bitcoin is approaching the $1 trillion USD mark with almost $1.5 trillion USD market cap for the asset class.
The move is rapid and at least somewhat unexpected.
At the time Bitcoins market capitalisation was around $300 billion USD and it felt at least a little risky to write, although I was confident that within a year it would show itself to be prescient.
Numba go up
As a result of these changes, Bitcoin is now trading about 200% higher!
‘Trillion Dollar Bitcoin Market-Cap is just the Beginning’ also mentioned other digital assets to keep an eye on.
Ethereum (ETH), a de-centralised computing platform - now trading about 270% higher
Cardano (ADA), a de-centralised computing platform - now trading about 1,000% higher
Polkadot (DOT), a de-centralised computing platform - now trading about 450% higher
ChainLink (LINK), an oracle – now trading about 100% higher
Uniswap (UNI), a de-centralised exchange – now trading about 500% higher
Aave (AAVE), an asset lending platform – now trading about 500% higher
Yearn.finance, a lending / yield-farming aggregator – now trading about 75% higher
Maker, a de-centralised stablecoin – now trading about 515% higher
Compound, a de-centralised interest rate protocol - trading about 350% higher
Zcash, a privacy coin – now trading about 100% higher
Algorand, a de-centralised computing platform – now trading about 373% higher
The article acknowledged the potential for phenomenal growth potential, writing that
‘The industry could be the most exciting set of technologies we have ever seen…(that)…is maturing, is coming of age’ and that ‘the monetary base of that system must be at least $1 trillion USD for almost any serious purpose’ and that ‘the number (the value of USD locked into Decentralised Finance projects) is growing exponentially’.
However this growth is much faster than expected, and quite extraordinary. Given the risks associated with such a rapid rise (such as a rapid descent, or long-term consolidation), I have to point out that we are not talking about the price increases to entice you to make a decision and to get involved with one or any of these assets.
The asset class is new, there are many traps and the situation is changing rapidly. You may have missed the best part of the move – you may not have, but the point is that we mention the price to develop a thesis on what is happening in the industry.
Why are there such significant flows into this asset class? What are the changes occurring in global financial markets that make digital assets so attractive?
What we are going to do is discuss what has developed in traditional markets, and what has changed in digital assets over that time.
1. Global Macro
a. No Yield
b. Systematic Risk
c. USD Fragility
d. Inflation Risk
2. Technology Investment
3. Maturation of Digital Assets
a. Institutional infrastructure created for Bitcoin in 2019/2020
b. De-centralised finance proof of concept established 2020
a. No Yield
Global markets have been afflicted with low yield (income) ever since Alan Greenspan’s increasing interventions in the fiat currency system and the development of digital technology alongside a problem of maximum capacity in the global economy.
The chart below shows the marginal productivity of debt at very questionable levels (at 0, $1 of debt creates $1 of output)
Yield collapses in the 1990’s under the growth of digital technology as well as Alan Greenspan’s policy as Chairman of the Federal Reserve.
Today it is 1.49%, below the lows before the Black Tuesday and Black Monday stock-market crashes.
Bonds (USDT 10 Yr)
Fixed interest yields are in long-term and probably terminal decline.
Ratio of S&P500 Yield to 10-Year Treasury Yield
This relationship becomes especially skewed during the Global Financial Crisis, now sitting in remarkably high territory now that fixed interest yield approaches 0.
(Fixed interest yield can go negative, but equity yield cannot (although total return can obviously be negative)
As a result of these conditions, technology stocks, which can’t be priced using the traditional valuation methods we might find in ‘The Intelligent Investor’ have been ultra-bullish, with price to earnings ratio’s as below
Historic P/E for S&P500: 13-15
Some of these price to earning ratio's are extraordinarily high, especially for relatively mature companies such as Amazon, Alphabet and Netflix and are a result of a lack of yield across asset classes, as well as demonstrating a belief in future, exponentially increasing profitability of these companies.
Finally, without yield in global assets, it makes sense for institutional investors to allocate risk to the new and exciting asset class of digital assets. Additionally, the long-term conditions that have removed yield from assets also create systematic risk and digital assets are a hedge for systematic risk in the traditional global financial system.
b. Systematic Risk
The broader context in global financial markets towards year end 2020 was extraordinary monetary expansion in the worlds money, the US dollar.
In 2020, USD M1 money supply grew 62.5% (!)
USD M2 Money Supply grew 23%
Into this money supply increase was a 4.3% contraction in global GDP in 2020
Global debt increased by $19.5 trillion USD in 2020 – a 13% increase.
Gross debt to GDP was 18% higher in 2020, now 122.7% in advanced economies
Into this significantly shrinking capacity, massive money supply increases and massive debt increases came extreme increases in commodity prices, including energy in a year that saw a collapse in travel and overcapacity in oil revealed in the United States
1 Year Performance of Assets
In short, there is an enormous amount of new Dollars (as well as Yuan, Yen, Euro – you name it, it’s out there) in the global financial system, chasing a smaller number of goods and services in a dramatically shrinking economy.
Velocity of money has collapsed to near 1
Velocity is an interesting factor in the global financial system and has trended lower ever since the policy response to the crash of the NASDAQ bubble in 2000. There may be ramifications with low velocity for liquidity in fixed interest markets, especially overnight re-purchase agreement markets and there may also be a relationship between the need for extraneous liquidity in the global financial system and reduced velocity, high asset prices and funding liabilities in financial institutions.
The environmental context is that systematic risks in the global financial system are heightened and Bitcoin and digital assets are a systematic hedge to that risk.
c. USD Fragility – For more information on this please see my article here
d. Inflation – For more information on this please see my article here
Most asset classes and sectors of assets are disadvantaged by changes in geo-politics that reintroduce friction to global trade (China/US trade war, Coronavirus, China perceived as a threat), inflation, challenges to fiat currencies and creating instability to pricing. Digital assets benefit from all of these things.
Along with economies of scale, technology is one of the long-term value-creating mechanisms in global financial markets. These efficiencies in industry and production, as well as growing markets (whether through population growth or the removal of trade friction) create compounded returns.
Digital technology is separate consideration in investable assets. Digital technology is a product that as long as it meets the needs of the market and is a self-contained, self-referencing system (like software), can be re-iterated many times, with each iteration improving both its ability to create value and logarithmic (reducing) marginal costs.
Some digital technologies have a threshold limit of market capture that is required before they achieve economic success. Overcoming these hurdles (product-market fit, is a true digital technology, hurdles the threshold limit) creates exponential returns.
These differences are probably the best way to understand why traditional investment styles such as value-investing have struggled as digital technology has had a greater impact in asset returns.
Show me the money
The typical digital technology investments are Microsoft Facebook, Amazon, Apple, Netflix and Alphabet
The parabolic curve is a common feature as a pricing arc for technology assets, due to the exponentially growing value function inherent to digital technology.
The parabolic curve is a common feature as a pricing arc for technology assets, due to the exponential growth value function inherent to digital technology.
These exponential returns have created enormous sums of capital that are tuned into investing into digital technology such as Bitcoin and digital assets. With a phenomenal 5-year return, there are also new funds entering this space, with Cathie Woods ARK Investment managing $50 billion USD up from $3.6 billion USD a year ago in almost exclusively disruptive technology assets.
With the macro-conditions we already mentioned – no yield, systematic risk, USD fragility, inflation risk and geo-political changes, digital assets become a very exciting, new sector for these well resourced, well-established technology funds to consider, as some already have in 2020.
Maturation of Digital Assets
a. Institutional infrastructure created for Bitcoin in 2019/2020
Recent price appreciation in Bitcoin and digital assets is different to 2017/2018 in which the asset was still unproven from the institutional investment side, especially lacking the infrastructure required.
Now, there are custody solutions for cryptocurrencies that have been accepted by the traditional financial institutions and institutional investment structures like the Grayscale funds.
America’s oldest bank, BNY Mellon recently announced that they will custody Bitcoin and Grayscale holds around $27 billion USD in their collective offerings across 8 assets.
Bitcoin has terrific investment characteristics for institutional portfolios including low correlation with existing assets.
There is also greater access for cryptocurrency transactions from the traditional financial system with exchanges having greater access to banks and respected financial markets figures like Paul-Tudor Jones and Bill Miller promoting their investments in Bitcoin. Now Elon Musk, the worlds most famous and influential technologist has purchased Bitcoin for his company Tesla and Michael Saylor of MicroStrategy has also been a renowned bull, bull, bull.
Also recently, PayPal and Mastercard have enabled cryptocurrency payments.
a. De-centralised finance proof of concept established 2020
As well as this, de-centralised finance was proven as a concept in 2020 with assets like Uniswap, Aave, Maker, Synthetix, Compound, SushiSwap and yearn.finance and combined market capitalisations over $50 billion USD in the de-centralised finance sector. This paves the way to make use of the fundamental monetary value inherent in Bitcoin, validates higher values in de-centralised computing (smart contract) platforms (with a combined market capitalisation above $270 billion), bringing immense resources and skills to develop financial services on top of the rising and now meaningful Bitcoin monetary value as well as next generation de-centralised computing platforms.
Bitcoin is the Foot in the Door
We have described Bitcoin elsewhere as a Trojan horse in the Western world. Presenting as money – in fact as a superior type of money – Bitcoin carries an implicit critique of the global financial systems fiat currency with it, as well as principles of de-centralisation and trust-less transactions that are threatening to institutions like central banks.
These aspects of the asset lead Bitcoin investors into the rest of the digital asset landscape, especially in de-centralised computing platforms like Ethereum, Cardano, Polkadot and Algorand and DeCentralised Finance applications such as lending, loans, insurance, asset exchanges, debt and other tokenisation.
Given the pressures in the global financial system that impact asset allocation decisions in institutional investment portfolios, we think that the insatiable bidding in digital assets is not a bubble, and that in fact we continue to see extraordinary flows into the digital asset space all the way throughout 2021.
By Thomas Kuhn, CFA
Thomas is the author of 'Bitcoin: A Revolutionary Investment' and has previously written for the Asia-Pacific Research Institute of the Chartered Financial Analyst Institute, QuantumEconomics, Hackernoon and Medium.
Get my book here: Bitcoin: A Revolutionary Investment
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