Bitcoin - Considerations for multi-asset investing
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For Professional and Institutional Investors only – not to be further circulated.
In Switzerland for Qualified Investors only. In Australia for wholesale clients only.
Bitcoin – Considerations
for multi-asset investing
July 2021
“Bitcoin is close to impossible
to value on any standard
metric. Moreover, at present
it is difficult to see how it can
Authors: Alistair Veitch, James Esland, Viktor Szabo,
Martin Yovchev, Catie Wearmouth, Yilun Wu, become a viable competitor to
Gerry Fowler, Justin Kariya, Luke Bartholomew. any existing fiat currencies.”
Contents Introduction03 Section 1 – Background to bitcoin 04 Section 2 – Bitcoin as money 05 Section 3 – Bitcoin as an investable asset 08 Section 4 – Environmental concerns 10 Section 5 – Potential regulatory actions 11
Bitcoin – Considerations for multi-asset investing 03
Introduction
Bitcoin is close to impossible to value on any standard metric. Moreover, at present it is difficult to
see how it can become a viable competitor to any existing fiat currencies. Bitcoin does not have the
characteristics required to challenge the existing monetary system, while regulators and policy
makers hold powerful tools to constrain bitcoin’s growth should they so wish.
However, with growing market interest in bitcoin as a store of Section 1 of this paper provides some background to bitcoin,
value, it is important to consider the viability of bitcoin as a highlighting its key features within the context of the monetary
crypto-asset if not a cryptocurrency. There are a variety of reasons taxonomy we have previously developed. Section 2 explains
why bitcoin is unlikely to become a major investable asset class for why we do not consider bitcoin to be a viable competitor to fiat
institutional investors or form a major component of multi-asset currencies. Section 3 discusses the merits of bitcoin as an
portfolios for some time, if ever. These include: investable asset class in terms of valuation and diversification
1. Its diversification properties are underwhelming. While properties. Section 4 touches on the environmental consequences
correlations with risk assets like equities have been relatively of bitcoin, and Section 5 on regulatory risks.
low, they are now rising as access becomes more widespread. Crucially, this paper specifically concerns bitcoin as an investable
Indeed, bitcoin is more correlated with equities during very asset within a multi-asset portfolio, and its analysis does not
strong or very weak periods, further reducing diversification preclude the existence of investment opportunities in related
benefits. And bitcoin drawdowns can be significant and can technologies and other cryptoassets.
occur in tandem with broader asset price drawdowns.
2. Bitcoin is profoundly environmentally damaging and so is
unlikely to be compatible with ESG objectives.
3. Bitcoin is likely to attract regulatory attention for various
reasons, and its potential to be used in criminal activity means
it carries considerable reputational risk.
04 Bitcoin – Considerations for multi-asset investing Section 1 Background to bitcoin Bitcoin is a cryptocurrency invented in 2008 by an unknown individual, or group of individuals, under the pseudonym Satoshi Nakamoto. It was originally conceived as a peer-to-peer payment network which would allow for the exchange of value without the need for trusted intermediaries like banks and other payment processors. To that end, the bitcoin system involves transactions being verified by a distributed ledger, referred to as a blockchain, using cryptographic techniques. It was the development of cryptographic protocols to ensure network verified trust-less transactions that represented the crucial technological breakthrough of bitcoin. Digital “wallets” are used to store the information to transact in bitcoins. Owners of bitcoins are not identified personally, but all transactions are public on the blockchain and identifiable via bitcoin addresses. “New bitcoins are created approximately every 10 minutes and the rate at which they are created halves every four years until all 21 million will have been created by around the year 2140.” The network is maintained by incentivising “miners” to use computing power to solve the cryptographic problems required to verify transactions and create new “blocks” in the blockchain by rewarding them with newly created bitcoins whenever these problems are solved. The total number of bitcoins can never exceed 21 million. New bitcoins are created approximately every 10 minutes and the rate at which they are created halves every four years until all 21 million will have been created by around the year 2140. Presumably some new means of incentivising miners to continue to maintain the network will, at that point, be required. The total eventual free float of bitcoins is likely to be lower than 21 million as some will be lost over time and there are sizable holdings that rarely, if ever, transact currently. Using the taxonomy to classify money-like units developed in our paper on central bank digital currencies, we can see that bitcoin is: widely available in the sense that it doesn’t require special permission to use; digital; not issued by, or a liability of, a central bank; expressed and exchanged via tokens.
Bitcoin – Considerations for multi-asset investing 05
Section 2
Bitcoin as
money
Bitcoin is often referred to as an example of cryptocurrency, with the idea being that it is,
or could become, a rival currency to existing fiat currencies. While there have been some
(generally ill-fated) schemes to allow bitcoin to be used for retail transactions as a potential
substitute to standard fiat currencies, it is clear that right now bitcoin is unviable as a currency.
That is primarily because its exchange value with standard fiat While governments may tolerate the anonymity provided by cash,
currencies is extremely volatile making it exceptionally difficult for it is hard to believe they will welcome or permit the payment
buyers and sellers to transact in the currency with any confidence system to be taken over by an anonymous medium of exchange
about how much purchasing power is actually being exchanged. which makes law enforcement and tax collection systematically
In effect, bitcoin is going through huge waves of inflation and more difficult. This is especially so given various high profile cases
disinflation as its purchasing power in terms of real goods and of bitcoin being used for illegal transactions, to facilitate
services increases or decreases significantly depending on ransomware and to finance terrorism. Thus the very appeal of
market movements. bitcoin to some is precisely one of the reasons that make it likely
Despite this short-term volatility, some advocates of bitcoin claim policy makers will constrain its uptake.
it has the potential to replace fiat currencies over the medium to Finally, it is worth saying the form of anonymity promised by
long run, or, at the very least, has some properties that make it bitcoin can come at a very high cost to users. Anonymous wallets
normatively superior to fiat currencies. In particular, advocates mean that hacks and scams that steal bitcoins are close to
tend to stress the following aspects of bitcoin as making it an impossible to track; unintended transfers are extremely difficult to
attractive form of money: anonymity; removal of the requirement unwind; and lost coins are practically unrecoverable. Society has
for a trusted counterparty; and a fixed quantity of currency which developed a monetary architecture which takes account of the fact
is beyond the discretionary control of policy makers. that mistakes happen and theft occurs, and it has built institutions
However, we are unconvinced that any of these apparent qualities and norms to resolve these problems. It is hard to see how
provide a strong reason to expect bitcoin to replace fiat currency, equivalent safety nets would exist with a bitcoin standard.
and indeed there are reasons for thinking governments and
regulators will take steps to ensure this never occurs. “It is hard to see how equivalent
Anonymity
As a bearer security, cash already provides the private sector
safety nets would exist with a
with a (government-issued) form of anonymised money.
However, as more and more transactions move online, the scope
bitcoin standard.”
to continue to use this anonymous payment medium may decline,
and an electronic record of all transactions is built up. Bitcoin Trust-less transactions
allows for the preservation of this anonymity in the realm of Trust is at the heart of the current monetary system. The payment
electronic exchange through the use of anonymised wallets to network depends on trusted intermediaries sitting in the middle of
store the currency. payment networks to verify that parties have the funds they intend
to transact with, that the funds are not being “double spent”,
Anonymous exchange comes with both social costs and benefits. and that funds arrive at their intended location. This work
One reason people may desire anonymity is to conduct illegal is typically done through certain parties maintaining a centralised
activities, and there are good reasons for thinking that many of the ledger which keeps track of all exchanges. The owner of this
highest denomination currency notes in circulation today are held centralised ledger is clearly in a position of great power and
and used by people engaged in criminal activity. However, there are responsibility, and so must be trusted to ensure the master
also perfectly good reasons why people may wish to maintain record is accurate and accessible at all times.
anonymity, linked to an intrinsic interest in privacy and freedom.
These are issues which might be particularly pressing in countries
with more intrusive governments.06 Bitcoin – Considerations for multi-asset investing
To certain advocates of bitcoin, the current system of trust is Indeed, it seems to us that a trust-less economy is neither
unreliable and vulnerable. Unreliable because the trusted parties desirable nor even possible. Economic exchange involves trust;
can, and do, make mistakes; i.e. our trust might be misplaced. the preservation of value over time involves trust; property rights
Vulnerable because any network which gives privileged positions involve trust. Value is a human construct, and requires constant
to certain entities has weakness in terms of cascading failures and social validation to exist. It is hard to conceive of what trust-less
critical points of attack. Bitcoin is meant to remove these issues by value would even entail or why we might want to create it, at least
allowing for trust-less exchange through a peer-to-peer network. on the macroeconomic level that the monetary and payments
There are, however, several reasons to be sceptical of this system operates on. Computational techniques can be used to
argument. First, it is far from clear bitcoin truly abolishes issues solve problems of trust-less verification of the exchange of
of trust within the monetary system. Should 50% of the mining information, but that does not mean that cryptography can negate
network fall under the control of one entity, this entity would have the need for economic activity to occur within a social context.
the power to determine verification of all exchange. It could Fixed supply
validate or deny whatever transactions it pleases, and plausibly In our current monetary system, the money supply is determined
direct funds to itself with little to no recourse. through a complex public/private partnership between the central
bank and private banks. The central bank is able to set the supply
“The computational power required to of bank reserves at whatever level it wishes. In the past, reserves
were set to control short-term interest rates, but now the supply of
create the peer-to-peer trust-less reserves is no longer a priority. A large quantity of reserves has
system is incredibly energy demanding. been created as a bi-product of quantitative easing, as the means
to finance asset purchases. Critically, these reserves cannot in any
The blockchain payment system is sense be “lent out” to the real economy.
around 20,000 times more energy Private banks create new money every time they lend. This lending
demanding than a Visa payment.” is not constrained by the quantity of reserves the particular bank
holds; banks are never unable to create loans because they
This is not a hypothetical problem. As the computing demands somehow lack the reserves to do so. So creating more reserves
of mining have increased, so the resources required have similarly does not ease some constraint on the quantity of lending. As such,
increased, mining has been increasingly centralised and cartelised there is no mechanical relationship between the supply of reserves
in the hands of a few big players. It is therefore entirely plausible and the money supply. Instead, the amount of money created by
that 50% of mining power could fall under the control of a single private banks depends on their risk appetite, their financial health,
mining consortium. At this point, the bitcoin payment network and the prevailing macroeconomic outlook, all of which the central
would be entirely at the mercy of this entity. bank seeks to influence at the margin through controlling
This kind of power over the bitcoin payment network is far greater short-term interest rates and ultimately financial conditions.
than the control exercised by players in the current system, as there Some bitcoin advocates fear this public/private partnership is
is a structure of laws and norms that supports and constrains their inherently inflationary as policy makers cannot be trusted to limit
activities. Such external constraints are much harder to construct the creation of money. Hence the appeal of a strict upper boundary
in a system where “the code is the law”, and so whatever the on the issuance of bitcoins. However, this argument seems to
blockchain validates is what goes. The bitcoin system is therefore involve a major misunderstanding of the inflationary process.
likely to involve its own form of trust, and trust, moreover,
First, as discussed, the fact that central banks can set the level of
in unregulated and potentially unscrupulous institutions.
reserves does not give them complete control over money supply,
Second, the computational power required to create the and there is no reason to think a large expansion of reserves
peer-to-peer trust-less system is incredibly energy demanding. should cause a large expansion in bank lending and the money
The blockchain payment system is around 20,000 times more supply. Indeed, the salient empirical fact of reserve creation
energy demanding than a Visa payment. It is also much slower through quantitative easing (QE) is how limited its impact on
than the existing network and more expensive given the money creation and inflation has been.
constraints around block sizes, and so the number of transactions
that any one block can contain. These problems would only
increase were bitcoin to be used more. This seems like a very
high price to pay to achieve the goal of a trust-less system.Bitcoin – Considerations for multi-asset investing 07 This should not be especially surprising given that all QE ultimately entails is an asset swap between different arms of the government, where bonds are swapped for reserves. Such an operation does have macroeconomic consequences, but these effects are relatively small and much less powerful in terms of their inflationary impact than standard monetary policy. As such, there is little to worry about in terms of the inflationary impact of QE in particular, and central bank control of reserves in general, as long as the central bank remains focused on the maintenance of long-term price stability. Second, inflation is determined by the balance of supply and demand in both the money and the goods markets. As such, money supply alone is an insufficient gauge of the stance of monetary policy. The economy is constantly buffered by shocks which affect the demand for money, and so price stability depends on ensuring the supply of money matches the demand conditions. Positive demand shocks for money (for example due to higher risk aversion in a recession) would lead to deflation if not met by policies to increase monetary accommodation, while negative demand shocks for money would lead to inflation if not similarly offset. This requires active direct or indirect management of the money supply in response to changing economic conditions. A fixed supply of bitcoin is therefore no guarantee of price stability when the conditions that determine the demand for money are constantly in flux. Indeed, a currency with a fixed supply is likely to lead to more volatility in, and uncertainty around, the evolution of the price level. This was one of the key problems that plagued the pre-WWI gold standard, and ultimately led to its demise. Summary Even if we are not convinced that an anonymous, trust-less, inflexible currency is desirable or practical, we acknowledge that many private citizens disagree. Far more importantly policy makers are also unconvinced of the merits of the current monetary system being replaced by a private currency with these features. It is within the gift of policy makers to create a regulatory regime that is more or less conducive to the survival of bitcoin. The recent developments in the field of central bank digital currencies (CBDC), suggest policy makers will work hard to create alternatives to private digital currencies, and the most likely scenario is that CBDCs will eventually crowd out would-be currencies such as bitcoin. It is therefore hard to give much credit to the idea that bitcoin represents a feasible competitor to fiat currencies.
08 Bitcoin – Considerations for multi-asset investing
Section 3
Bitcoin as an
investable asset
Bitcoin is extremely difficult, if not impossible, to value using any standard valuation techniques.
To the extent that the forgoing analysis that bitcoin is highly unlikely to become a viable medium
of exchange is correct, then it is possible argue that the fundamental value of bitcoin is close
to zero, or at least considerably lower than what it is today.
Moreover, the factors that appear to drive bitcoin’s price at the Looking at historic data, bitcoin stands out for its very low, or lack
moment are close to being unpredictable, or certainly beyond of, correlation with traditional asset classes. In theory, this makes
any fields where we may have a plausible comparative advantage. it a good candidate for portfolio diversification. Indeed, portfolio
For example, it is clear that much recent price action in the asset optimisation studies find that a small (1-6.5%) allocation to bitcoin
has been driven in part by the social media activity of Elon Musk. increases long-term portfolio efficiency in a multi-asset portfolio.
There is no reason to think we could predict, or should expend The relatively low allocation, despite bitcoin’s returns, can be
resources on trying to predict, Elon Musk’s next tweet. explained by its high volatility.
However, in the short-term it is unlikely that regulators will However, there are several reasons for thinking these studies
sufficiently crack down on bitcoin to render it valueless. As such, overstate the portfolio benefits of holding bitcoin. First, its
it is worth considering whether it offers any attractive portfolio correlation with cyclical assets has recently increased, suggesting
diversification properties. its diversification properties are already diminishing. Moreover,
In its relatively brief history, bitcoin has delivered a very high return improving access through financial technology and other products
and has displayed a very high volatility profile. While it has been for both retail and institutional investors may facilitate the
several times more volatile than more established assets, its Sharpe mainstreaming of cryptocurrencies, which is likely to further
ratio is superior due to extraordinary returns in some years. increase correlations.
Figure 1: A seemingly superior volatility-adjusted return
(%) Volatility-Adjusted Cumulative Return
150
100
50
0
-50
-100
Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017 Jan 2018 Jan 2019 Jan 2020 Jan 2021
Bitcoin ACWI US Duration BCOM Index Gold US Dollar Index US High Yield
Source: Bloomberg and Datastream. March 2021.
Figure 2: Bitcoin’s return characteristics
No. of Avg. excess Sharpe Maximum Max loss Max gain
years return Volatility ratio drawdown (1 week) (1 week) CVaR (90)1 Skew CVaR/Vol2
Since inception 8.4 137.19% 94.11% 1.46 -106.65% -47.28% 61.83% -19.16% 0.56 -1.47
Last 5 years 5.0 118.19% 80.76% 1.46 -35.83% 48.20%
Last 3 years 3.0 83.26% 77.01% 1.08 -34.17% 42.14%
Last 1 year 1.0 172.93% 68.46% 2.53 -30.52% 22.82%
Source: Bloomberg. March 2021.
1
Conditional Value at Risk at 90% Confidence Level
2
Conditional Value at Risk/VolatilityBitcoin – Considerations for multi-asset investing 09
Figure 3: Bitcoin has shown low but increasing correlation with other asset classes
Rolling correlations ‘180w’ and ‘52-w half-life’
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Jan May May May May May May May May May
2013 2013 2014 2015 2016 2017 2018 2019 2020 2021
Bloomberg Barclays Global-Aggregate Total Return Index Value Hedged USD Bloomberg Barclays Global Aggregate Credit Total Return Index Value Hedged USD
Bloomberg Barclays Global High Yield Total Return Index Value Hedged USD Bloomberg Barclays Global Aggregate Treasuries Total Return Index Hedged USD
J.P. Morgan GBI-EM Global Diversified Composite Unhedged USD J.P. Morgan EMBI Global Diversified Composite MSCI World Gross Total Return Local Index
Source: Bloomberg, 2021.
Figure 4: Bitcoin has shown very large drawdowns during periods of market turbulence
Scenario Name Start Date End Date Bitcoin
Covid-19 Sell-off 18/02/2020 01/04/2020 -39.02%
August Sell-off 31/07/2019 30/08/2019 -1.71%
Q4 18 01/10/2018 31/12/2018 -49.98%
Volmaggeddon 26/01/2018 08/02/2018 -23.70%
Trump in town 01/11/2016 30/11/2016 2.08%
US arrest 31/12/2015 11/02/2016 -12.06%
China devaluation 10/08/2015 25/08/2015 -16.12%
QE jitters 22/05/2013 24/06/2013 -15.78%
Source: Bloomberg. March 2021.
Second, over the period for which bitcoin has been tradable, it has Thus while bitcoin may appear to have some attractive
been ranked as the least reliable hedge during periods of acute diversification qualities – and its recent return has undoubtedly
market stress, as seen in figure 4 above. been spectacular – without any clear sense of how it could be
Finally bitcoin is more correlated with equities in the extremes, valued or how its correlation structure will evolve, it is hard to
which is not a useful diversification property. argue for an allocation to bitcoin within multi-asset portfolios.
Figure 5: Bitcoin performs poorly during periods of equity market turmoil
(%) Decile distribution ranked on ACWI weekly return since 2013
6
4
2
0
-2
-4
-6
1 2 3 4 5 6 7 8 9 10
Bitcoin ACWI
Source: Bloomberg. March 2021.10 Bitcoin – Considerations for multi-asset investing
Section 4
Environmental
concerns
Bitcoin mining is incredibly energy intensive,
and over time will only get more so as the
cryptographic problems that need solving to
mine a bitcoin get more computationally difficult.
For example, in 2018 the computing power
required to mine bitcoin increased fourfold.
Moreover, the energy used by bitcoin miners tends to be
disproportionately generated by highly carbon-intensive sources
due to their location within China, where coal is still a major
energy source and likely to remain so for some time despite the
country’s Net Zero 2060 targets.
Bitcoin’s global carbon emission is roughly equivalent to
several mid-sized countries, including Sweden and the Ukraine.
Unless bitcoin fundamentally changes is verification protocol,
mining moves out of China, or Chinese energy sources become
radically more sustainable, it is hard to see how bitcoin avoids
being (rightly) associated with environmental destruction.
Figure 6: Bitcoin electricity consumption compared with
various countries (in terawatt-hours per year)
Argentina Ukraine
125.03 128.81
TWh per year TWh per year
Bitcoin
130.00
TWh per year
Sweden Malaysia
131.80 147.21
TWh per year TWh per year
Source: Bloomberg and Datastream. March 2021.Bitcoin – Considerations for multi-asset investing 11 Section 5 Potential regulatory actions Bitcoin has gained a lot of attention already from regulators. The UK’s Financial Conduct Authority (FCA) has suggested bitcoin investors should be prepared for the possibility that they could lose all of their money. Meanwhile, the United States’ Financial Crimes Enforcement Network (FinCEN) recently introduced rules requiring customers to file a report with FinCEN if they purchase more than US$10,000 worth of cryptocurrencies. What is clear is that regulators are concerned about both the harm to retail investors of getting involved in bitcoin and the criminal potential from unregulated bitcoin funds. Regulators will not sit idly by if they perceive retail investors to be at risk of being misled. They will not passively allow the payment system to fall under in to the hands on unregulated entities. They will resist loss of control of the monetary system. Therefore, the risk of regulatory action on bitcoin is high, and the reputational risk of being involved in offering such a product isn’t trivial.
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