Bitcoin has drawn speculative attention recently in part because of the much-anticipated ‘halving’ taking place in the coming weeks. Correspondingly, the bitcoin price has recovered modestly from a well-established prior downtrend. But is the correction over? And should we see the Covid-19 scare as a positive for bitcoin given that most monetary authorities have loosened policies and enacted various unconventional, emergency lending measures in response? I still think bitcoin is an elegant monetary experiment of potentially useful social value, but I believe gold instead is most likely to be the monetary ‘winner’ from these developments.
The Promise of Bitcoin
Bitcoin captured the alternative investment industry’s imagination as early as 2014 – about the time mainstream publications began reporting on the phenomenon. The attention corresponded to a bull market not only in bitcoin, but in other digital currencies and non-monetary blockchain applications too. Not long after, the Initial Coin Offering (ICO) boom got going, only to be followed by a bust. But bitcoin has retained its leading position in the sector, perhaps due to its unique design including the ‘halving’ of mining seignorage income every four years, which is due to occur again imminently.
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Bitcoin has drawn speculative attention recently in part because of the much-anticipated ‘halving’ taking place in the coming weeks. Correspondingly, the bitcoin price has recovered modestly from a well-established prior downtrend. But is the correction over? And should we see the Covid-19 scare as a positive for bitcoin given that most monetary authorities have loosened policies and enacted various unconventional, emergency lending measures in response? I still think bitcoin is an elegant monetary experiment of potentially useful social value, but I believe gold instead is most likely to be the monetary ‘winner’ from these developments.
The Promise of Bitcoin
Bitcoin captured the alternative investment industry’s imagination as early as 2014 – about the time mainstream publications began reporting on the phenomenon. The attention corresponded to a bull market not only in bitcoin, but in other digital currencies and non-monetary blockchain applications too. Not long after, the Initial Coin Offering (ICO) boom got going, only to be followed by a bust. But bitcoin has retained its leading position in the sector, perhaps due to its unique design including the ‘halving’ of mining seignorage income every four years, which is due to occur again imminently.
The original bitcoin paper, pseudonymously published by the mysterious ‘Satoshi Nakamoto’ back in 2008, explained that the key principles of its design were in many respects intended to mimic properties of the world’s most venerable and universal money: gold. Choosing ‘mining’ as the term for new coin creation was not accidental; nor was the decision to limit the overall supply that was mineable or the amount of seignorage income that miners could earn by growing the supply over time. So, as with gold, bitcoin supply is limited and, as the stock-to-flow ratio increases, the implied seignorage income of mining more to add to stock naturally declines.
In this way, Satoshi Nakamoto attempted to replicate the timeless monetary qualities of gold but as a purely digital asset, and one for which third parties could verify transfer of ownership through a distributed ledger network. This prevents counterfeiting, but in a way not dependent on a central authority to verify transactions – hence the appeal of bitcoin not only to those inclined towards technical solutions to socioeconomic problems, but also those with anti-authoritarian political leanings.
Yet for all its technical elegance and widespread coverage in the financial press, bitcoin has yet to achieve much in the way of practical use as an alternative money. Sure, it has invited a great deal of speculative interest and imitation, with other coins, coin exchanges and derivative instruments springing up all over the place. But in terms of being an actual money used for actual final settlement in exchange for real economic goods, with the exception of a few illicit cases, it has come up short.
Is Covid-19 Bitcoin Positive?
That could change, of course. Bitcoin might not have legal tender status, but if producers and consumers generally chose to adopt it, then it would serve as a de facto alternative money. The authorities might decide to regulate its use and to tax it, as is already the case in many countries, and that might limit its appeal, but if there was enough public demand then it would likely gain some money ‘market-share’ in any case.
A recent paper made a particularly bullish case for bitcoin, arguing that bitcoin demand has been growing through a series of ‘phase transitions’, each of which shows a quantum leap. It is an interesting take on bitcoin evolution to date – I highly recommend a read if you are curious.
Could the Covid-19 scare and the monetary and fiscal policy responses to it perhaps initiate another such ‘phase transition’, resulting in a surge in bitcoin demand? The case appears straightforward. In ways similar to yet arguably greater even than in 2008-9, economic officials are implementing many unconventional policy measures including large increases in base money creation and direct payments to households and businesses. Some believe that these measures risk undermining monetary credibility and stability and could, in time, lead to inflation through debasement. Indeed, a recent Bloomberg Opinion article boldly claimed that ‘money is losing its meaning’.
However, one potential downside to bitcoin is that it has become, to some extent, a victim of its own success. Bitcoin is no longer the only potential alternative money out there. Other digital currencies circulate alongside it and are traded on many of the same exchanges. Some bitcoin miners also mine other coins. So while bitcoin has achieved a clear first-mover advantage in the area, it has given potential imitators the opportunity to study its specifications in detail and offer rival coins with what their designers claim are significant improvements.
Does Bitcoin Have an Achilles’ Heel?
One potential flaw in bitcoin that I, among others, have been pointing to for years, is its reliance on miners receiving substantial seignorage income in order to grow and maintain the network. For bitcoin transactions to be verified, miners must perform ‘proof-of-work’ calculations that consume computer power and hence electricity.
That’s one reason to watch the upcoming ‘halving’ of bitcoin seignorage closely. The past halvings have not been price negative, so the bitcoin optimists see no threat now. But prices are set at the margin. As long as seniorage income remains sufficiently high, then notwithstanding a gentle decline, miners will keep on mining. But the moment seignorage income falls below whatever return a given miner demands, they will withdraw from the network.
As such, the halving reveals a potentially fatal flaw in bitcoin’s design. As the network grows further and seignorage income eventually dries up entirely, something else must replace that income to compensate those who maintain the network by processing transactions. By some calculations, the amount of computing power and electricity required at that point will make doing so prohibitively expensive. The next ‘phase-transition’ for bitcoin could therefore be a drop in demand rather than another surge.
If that is indeed the case, then bitcoin may be doomed in the long run. But in the world of investing, the long run can become a sudden run for the exit if people begin to see something purely as a speculation rather than an investment with inherent, tangible value. While I would stop far short of calling bitcoin a Ponzi scheme—I see no evidence of fraud in the design, which is entirely open source—I do question its long-term sustainability as an alternative money.
That said, I’m criticizing bitcoin specifically, not the general blockchain distributed ledger ‘proof-of-work’ concept, which may have numerous potential applications in future. But a widely accepted alternative money is highly unlikely to be one of these, at least on any reasonable investment horizon.
Enter Gold
Perhaps ironically, a potential beneficiary of bitcoin losing its lustre could be that which it was designed to imitate: gold. All the fundamental concerns about official money and monetary policy mentioned above not only highlight the potential advantages of a digital money alternative such as bitcoin but also that of the original global money.
While some might see gold as an old-fashioned, cumbersome money, there is no reason why modern fintech value propositions cannot be applied to it. Indeed, several firms are already or in the process of providing a form of gold-backed digital money that can be bought and traded online or via app.
While such networks also require maintenance, they don’t need to be built out. The gold has already been mined and refined. It sits mostly idle in high-security vaults in Switzerland, London or other jurisdictions. It need never move again. But title to gold bars, or fractions thereof, can be exchanged electronically, within a digital ledger, for near-zero cost. In other words, the benefits of a digital money can be combined with the timeless store-of-value properties of gold.
So could it be that gold, rather than bitcoin, will be the biggest monetary beneficiary of the Covid-19 scare and the myriad policy responses to it? It think it rather likely. But much depends on if central banks and other economic officials can navigate their way through this period without losing credibility, or without their respective official monies losing their meaning.
John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)