January 20, 2020

A Calculated Bitcoin Investment Bias: Part 2 of 2

Are there sensible reasons to invest in cryptoassets? If so, which cryptoassets should an investor choose? The second part of this series is devoted to cryptoassets that aim to be money. Does an investor have a better chance of achieving sustainable value accrual over the long term with these types of investments?

As argued in the first part, utility assets from so-called smart contract platforms are unlikely to be of much interest to investors in the long term. At present, the probability that the value of such assets will be kept low by their high token-velocity seems rather high.

This poses a justified question for investors: If classic utility assets of smart contract platforms with their once countless decentralized applications (dApps) will not generate the desired value for an investor, what other cryptoassets will? Are there any cryptoassets at all that could turn out to be an outperforming investment in the long term?

A cryptoasset striving to be money likely is. Again, this is an obvious answer, some crypto enthusiasts might think. What is going through a monetization process and becomes money must be valuable after all, since money is the bubble that never pops. However, there is a nuanced but very important catch to it. Money is not just money. For the purpose of this analysis two major functions of money have to be distinguished: payment and store of value.

When speaking of “thinking” of money, a regular person has the first of the two functions in mind. Money is what you can use to pay for goods. Whatever you use to regularly pay for things in your grocery store, this is considered to be the regular means of payment or in simpler terms: money. And indeed paying for things is a very important attribute when it comes to the functionality of money. So much so that people living in a western economy make use of this function everyday. But then again, as an investor in money, one has to focus on the unobvious and unintuitive when it comes to money: its store of value functionality.

This function is generally overlooked or if not, it is at least considered to be of less importance than the payment function. Let us turn to Ludwig von Mises, one of the greatest monetary economists of the 20th century, to get an adequate assessment of the two functions:

“The service of money is not confined to transactions. It fulfills its task not only at the moment it passes from one hand to the next. It also performs services when it rests in the till, as the most marketable good, in anticipation of its future use in trade as a generally used means of exchange. The demand for money of individuals, as well as the entire economy, is determined by the desire to maintain a cash balance and not by the aggregate of transactions to be carried out during a certain time period.”

According to von Mises, the demand for money is a desire to maintain a cash balance and this desire can only be satisfied because a proper money exhibits the function of a genuine store of value. Other economists disagree and hold the payment function to be money’s essence. While it is hard to conclusively pin demand for money down to either of the functions, there seems to be no denying that the store of value function is an integral part of something being money. Things that do not serve as a general store of value cannot be considered proper money. Therefore they are rather regarded as what is called working capital. 

Again, this could be very much the case with a utility asset on a smart contract platform. Although the platform might offer great use cases that create value for a user, the utility token to access these services is only going to be held the length of time for which a user wishes to transact on the network. Because of the disutility of exposure to the token, exposure to the token will be minimized. A utility asset will most likely be treated as working capital. The same already happens today with all sorts of different goods like oil, other commodities or manufacture items. Inventories are being reduced as good as possible. Especially in a world of near perfect interoperability, a feature the cryptoasset world is currently working towards, frictionlessly reducing working capital for the most marketable good, i.e. money is an easy thing to do.  

Ludwig von Mises (1881-1973) was a great Austrian Economist. His greatest contributions touch the fields of monetary economics, epistemology (theory of knowledge) and praxeology (theory of human action). 

Obviously the world of cryptoassets is a new world. Traditional behaviors, conducts and procedures mustn’t necessarily apply uniformly. There is always the possibility that the future of money will be quite different than what we currently picture it to be. In an increasingly atomized and fragmented society that is paradoxically fostered by a globally connecting internet giving life to digital tribes that form around a common ideology and are therefore at feud with one another because of constantly nurtured conflicting paradigms, imagining different moneys within different contexts and frameworks is not complete nonsense.

Nonetheless, being biased (rightfully so we would argue) towards today’s understanding of how the world is currently working, it is natural to assume that utility assets will be treated as working capital and value will be stored in what is considered to be a better money or more precisely: a better store of value.

Payment versus Store of Value

As a matter of fact cryptoassets can be used for both monetary functions, payment as well as storing value. Given current scalability levels though, a cryptoasset must optimize for either one or the other (this might change in the future). Even as of now, from a user’s perspective again it might even make sense to have different cryptoassets cater to either function, but from an investor’s perspective, only a cryptoasset aiming for the store of value function might really turn out to be a good investment. Let us see why this might likely be the case. 

A cryptoasset focusing on payment is up against many competitors. There are centralized counterparts like Visa, Apple or Google Pay as well as Paypal. Very soon there might be centralized digital currencies either issued by commercial banks or even central banks themselves. Since many of these payment rails actually represent a higher layer setup up the fiat stack of the traditional world of finance, a public blockchain cryptoasset, which is lower-tier infrastructure, does naturally seem at a disadvantage competing against the former. Leaning towards greater network centralization (as many payment cryptoassets seem to be doing) is certainly a means to the end of making up some leeway with respect to centralized contenders. Fortunately enough, censorship resistance might not be the most important characteristic when it comes to (remittance) payment. Accessibility is arguably more essential. While many people around the globe cannot access any of the traditional payment rails, an open public blockchain can act as a remedy and even offer cheaper payments than traditional payment options.

So cryptoasset payment rails can have an addressable market. However, even if they found broader adoption, their token would again have a hard time accruing value, since not only would greater market adoption mean high usage, which would again go hand in hand with high token velocity and suppressed token value. A respective cryptoasset would most likely also have to share the payment market with not only centralized competitors from the traditional world of finance, but with other blockchain payment solutions as well. Because the focus would be primarily on getting payments processed as fast and efficiently as possible, any cryptoasset payment rail would do. And here again, only what is temporarily needed to conduct the payment would be held in the respective cryptoasset. Convergence would most likely not happen towards one cryptoasset payment option, since people would not want to hold their excess capital in any of the blockchain payment rails but in the digital store of value itself.

Highly Underappreciated: Hoarding

So let us now turn to the arguments of why a store of value functionality is of paramount importance in light of a potential cryptoasset investment. A monetary store of value is characterized by having a value that is decoupled from its utility for other purposes and from the cost of making/powering and storing it. In other words a monetary store of value is valued for its ability to serve as a means to store value in, regardless of other potential utilities.

Here we are back to von Mises’ argument, but we try to refine it somewhat: People want to store value, because as humans we feel an inherent tendency to make provisions in the presence of an unknown future. Storing value is an attempt at disentangling from uncertainty. It is a strategy to counteract the ravages of time. The easiest and most natural way to do this has always been hoarding. Throughout history, people have hoarded many different things. Whenever there was some natural scarcity associated with the thing to be hoarded, storing value worked more efficiently. 

Over the course of time the act of hoarding and storing value has always naturally been accompanied by astounding and perplexing dynamics. Because of accumulating private hoards, seemingly inconspicuous hoarders could suddenly get ahead of almost everybody else in terms of accrued value. Once stored value was unleashed all of a sudden, things could change radically for associated actors. Because of such rather unholy, despicable and unsettling dynamics resulting from hoarding, there seems to be a great war against it that permeates history ever since. Much of what is considered to be different monetary reforms throughout history actually falls within the scope anti-hoarding efforts. The fight against hoarding continues to be a controversial topic in politics and the history of ideas to this day. Central bank quantitative easing as well as negative interest rates are the fight’s most current manifestations. 

Non-Sovereign Store of Value

In order to escape the war on hoarding, people have sought refuge in various things. Among these, the undisputed non-sovereign global store of value has been gold for thousands of years. Exactly how big of a market is gold today? Since gold is virtually indestructible all the gold that has ever been mined must still be among us in some form or another. Estimations suggest a total of around 190,000 tons. That is about 6.1 billion ounces. At today’s dollar price (a little above $1,500 per ounce, as of December 31st 2019), that comes to about $9.15 trillion.

However, we are interested in gold as part of the financial market, i.e. private investment and official gold reserves. Jewelry, which also serves as a store of wealth in many cultures but is quite often more than just that, needs to be left out of the picture. That makes about 50 percent of the total gold stock that needs to be subtracted. At the same time, the amount of gold used in different industries for technological applications must be cut out too. In sum, this leaves us with a gold market capitalization of about $2.5-3.0 trillion. It is an enormous number, which surpasses the size of all European sovereign debt markets.

A breakdown of gold into its major constituents (subjectively valued use cases)

A cryptoasset emerging as a new monetary store of value could possibly tap into this $2.5-3.0 trillion value stored in gold. In comparison to gold a cryptoasset is way more portable, offers better divisibility and its supply is a lot easier to verify. Because a cryptoasset is in essence just information, it can be stored in a person’s mind. These and potentially other benefits will most likely make gold lose market cap to a digital store of value contender. 

International Reserve Asset

Chipping away at gold’s market capitalization could just be the tip of the iceberg. While financial and monetary gold already represent a seemingly big figure, international reserves make up an even greater number: a total of almost 13 trillion dollar. Among the biggest holders of international reserves are China, Japan, the Euro Area, Switzerland, India, Russia and Saudi Arabia. Most of the reserves are either held in US dollar or Euro. It has been known for years that particularly China as well as Russia chafe at this situation. Instead of holding the currency of geopolitical rivals, a non-sovereign, non-fiat, non-manipulable, censorship-resistant cryptoasset might be a far better alternative. Therefore it is not implausible that a monetary store of value cryptoasset could absorb some of that market as well.

Besides the two obvious markets of gold and international reserves a non-sovereign store of value cryptoasset could soak up even more of global finance. There’s even the (theoretical) possibility that the US Dollar could be supplanted as the dominant unit of account for global trade and commodity pricing. Only about two centuries ago, the other non-sovereign store of value asset gold has powered international trade enabling an international division of labor on a large scale that has enabled the great wealth creation of the late 18th and early 19th century.

Hoarding technology

A non-sovereign store of value cryptoasset does indeed have great potential for value upside. As a hoarding device velocity will be naturally suppressed, while value from many different holdings would be absorbed. Not only the marco prospects seem to be in place, it is also the micro level that offers quite a bullish outlook. A non-sovereign store of value cryptoasset is not only digital, its supply can also be easily verified and its private keys can be securely stored by a single person. This way a new freely accessible hoarding technology enabling the escape from history’s seemingly everlasting war on hoarding is at the disposal of each and everyone. It enables the rise of sovereign individuals that will diversify within the system or even opt out from it each at a time.

It cannot be underestimated how important a new hoarding technology in the form of a non-sovereign store of value cryptoasset will turn out to be. Not only institutions, but family offices as well as private individuals will have a proper instrument of hoarding. As such the non-sovereign store of value cryptoasset could indeed act as a monetary black hole, siphoning off capital from different sources. While shares like the FANG stocks and real estate in pretty much all of the major cities around the world have been used to park capital - as a consequence of the war on hoarding because people are looking for alternatives since conventional currency is being devalued on a recurring basis -, these assets could lose some of their monetary store of value character, because a non-sovereign, digital store of value cryptoasset has come along and has established itself.

Concluding remarks 

All of the above points to the lucrativeness of a non-sovereign store of value cryptoasset for an investor. However, the question remains: Among the current selection of cryptoassets, which one is best positioned to take up this position? It seems to us that the most likely answer based on the current state of knowledge and information is bitcoin (BTC). From the very beginning it has set out to become money of uncompromised store of value functionality. Although many would consider bitcoin a technological breakthrough - and it certainly is - the cryptoasset’s main essence is rooted in its monetary characteristics. In all of cryptoland bitcoin is the desired reserve asset, is used as a medium of exchange most often and has the most convincing supply cap corroborating its function as a store of value. It has the most advanced decentralized (to the point of dysfunctional) governance. Its hashing power tops that of any other cryptoasset by far. No other social contract layer of any other cryptocommunity revolves around being a monetary phenomenon so strongly. It has been around the longest and has never really been hacked for that matter. No other cryptoasset is ontologically better suited to be a non-sovereign store of value because no other cryptoasset has a more mysterious (to the point of being mystical) origin and cleaner genesis story. And no other cryptoasset may so relentlessly focus on this one use case of becoming a store of value (probably the simplest of all cryptoasset use cases), and bitcoin has been and continues to acquit that functionality immaculately.

This goes to show: Our investment focus is wholeheartedly on bitcoin and its wider ecosystem. What about other cryptoassets? Investing in a smart contract platform of any sort (like Ethereum) can be a positive-sum game and an investor might reap an upside. But compared to bitcoin, which strives to be a non-sovereign store of value asset, where velocity will be naturally low (a valid assumption, since it is being relentlessly “hodled” by many) holding a smart contract platform token (like ether) one will most definitely lose out and not nearly capture as much value in the long run.

On top of that it is even still possible, that similar smart contract functionality is going to be possible on bitcoin at some point, just higher up the technology stack (consider Bitcoin not as a mere cryptoasset but as an entirely new financial system). If that were indeed the case, there seems to be no logical reason why all the various smart contract services should not be developed on top of the most secure and non-sovereign store of value cryptoasset. By all means: It is quite possible that other cryptoassets will exist alongside bitcoin in the long run. Especially smart contract platforms could boast a greater adoption in everyday life - at least by the look of it. However successful usage of the platform does not necessarily translate into high value accrual for investors. As uncompromising investors, value accrual is what counts in the end, which is why bitcoin is the most interesting asset at the moment. 

One last question remains: What could possibly go wrong in all of this and lead to the dethroning of bitcoin? The most imminent threat: Bitcoin beating itself. More precisely: Bitcoin’s immaculate design could be too good to be working in reality. What do we mean by that? 

Bitcoin seems to be the perfect hoarding technology and “hodling” (hoarding bitcoin) is using bitcoin. But this perfectness could be the catch in the end. If bitcoin‘s ultimate usefulness is really just hoarding, absolute hoarding every bitcoin could infringe Bitcoin‘s network security. For Bitcoin to keep on existing, it needs to be powered by miners indefinitely. With block rewards decreasing (disinflationary money supply), miners do this as long as incentives in the form of sufficient network transacting lead them to. 

It is perfectly reasonable that the Bitcoin network will serve a powerful purpose in the future, like timestamping for example, that will lead to vibrantly enough transaction value. But it is also possible that a network that seems to disproportionately favor hoarder over spenders (a hoarder that hoards bitcoin for one year does nothing to uphold network security and piggybacks on other people’s usage of the network), will just not be sustainable in the long run. Maybe reality is not so easy after all and demands some sort of light inflation for money to persist in this world. We simply do not know at this point. As investors we cannot categorically rule out such a scenario, which is why we need to stay vigilant. Ultimately, we do not want to be driven by ideology (a very lofty goal indeed) but the unbiased search for truth - this we owe to our clients and investors.

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