Bitcoin has been hard for the average investor to wrap their head around.
Most people understand that if you own a stock in a company that does well, the value of your share rises, or that when the stock market dives, you can take refuge in bonds.
Much less clear are the value of the digital asset bitcoin — which was created out of thin air by computer software in January 2009 — how it should function in a portfolio, or if it should be there at all.
But that hasn’t stopped about seven million people worldwide from investing in it so far. While they may represent only 1% of current equity investors, they’ve helped propel its price from nothing to $535, pushed its daily trading volume to $1 billion a day and brought its market capitalization to $8.4 billion.
Similarly, a new digital currency created last July, ether, has already reached a $1.1 billion market cap and spawned a related digital asset called a DAO token that investors accepted in return for putting money into the most lucrative crowdfunding project ever, which raised $168 million worth of ether.
A new white paper provides the analysis that would help explain these jaw-dropping phenomena and argues persuasively that Bitcoin (and by extension, other similar digital assets) represents the emergence of a new asset class, and one that should seriously be considered as a diversifier for investment portfolios.
“Bitcoin is consistently the lowest correlated asset to other traditional asset classes,” says Chris Burniske, blockchain analyst at ARK Investment Management, the first public fund manager to invest in Bitcoin, and co-author of the paper, “Bitcoin: Ringing the Bell for a New Asset Class.”
“If an investor who holds bonds and equities swapped a percentage of their prior holdings into bitcoin, because of bitcoin’s low correlation and superior absolute performance, they could have decreased the volatility of the portfolio while simultaneously increasing absolute returns,” says Burniske. “That’s the golden bullet of an asset class.”
The impetus for the paper came from growing institutional and investor interest in Bitcoin, says co-author, Adam White, vice president of business development and strategy at Coinbase, arguably the first professional, venture-backed Bitcoin startup and to this day, still one of the most well-funded. Demand for digital currencies even recently prompted Coinbase to rebrand its institutional trading platform from Coinbase Exchange to Global Digital Asset Exchange (GDAX), and add the trading of ether to and from U.S. dollars and bitcoin.
“It’s time for investors to take a serious look at bitcoin and other digital currencies and see how they may want to include that as a small part of their portfolio,” says White. “What stymies a lot of that is that investors don’t understand the technology behind Bitcoin … I use the analogy that I don’t understand how the Internet works, but I see how it provides a net benefit to society and thereby has value. Bitcoin is very similar. There’s a finite amount of bitcoin that will be created and by owning a small piece of that, you own a portion of this technology that allows you to access the benefits,” which he lists as global payments, micro-transactions, data registry and more.
“Once investors start to understand why Bitcoin creates value to society and trades for roughly $500 per unit of bitcoin, then they can move to the stage of just analyzing this asset class from a purely technical standpoint and say, Does it make sense to add this to my portfolio? That’s our effort in this paper,” says White. Given that at the end of 2015, U.S. households had more than $34.5 trillion in investable assets according to Cerulli Associates, more mainstream adoption of bitcoin as an investment could boost its price, trading volume and market cap by orders of magnitude.
The analysis examines bitcoin according to four characteristics that define asset classes: investability, politico-economic features, correlation of returns or price independence, and risk-reward profile. Burniske and White conclude not only that bitcoin is the first of its kind in a distinct asset class, but that the terms “cryptocurrency,” “virtual currency” or “digital currency” are misleading because they imply that such investments are a subset of the currency asset class. They propose other terms such as cryptomark, cryptobit, cryptostamp, ledgermark or consensobit. Additionally, they assert new terminology could help clarify currently disjointed regulations, in which the Commodity Future Trading Commission calls bitcoin a commodity; the Internal Revenue Service, property; and the U.S. Securities and Exchange Commission deciding its approach on a case by case basis.
“Bitcoin should not be considered a commodity like the CFTC currently labels it. It’s not property as the IRS classifies it. It’s a unique asset class we’re just seeing emerge right now,” says White.
Burniske concurs: “While it’s the first of its kind at its scale, it won’t be the only one over the long term.”
The first lens through which the authors evaluate bitcoin is investability, posing the question, says White, “Can investors or individuals take capital and somehow have exposure to that asset class?” Their answer is yes, based on Bitcoin exchange trading volume averaging around $1 billion a day through the first quarter of 2016 and the fact that Bitcoin has roughly the same liquidity of the largest gold ETF (GLD) and three times that of Vanguard’s REIT ETF (VNQ) even though GLD and VNQ store significantly more in assets — $34 billion and $56 billion, respectively. “In our opinion, equal or superior volume with a fraction of the assets under management underscores that bitcoin is punching significantly above its weight,” they write.
Burniske says this indicates bitcoin could “be a very liquid asset over time, which traders generally love,” adding that its accessibility around the world should drive more liquidity than assets siloed within borders, such as GLD, which only trades in the U.S. and Singapore.
The authors even project that “a larger percentage of the population may be inclined to hold a cryptocurrency than an equity in a publicly traded company.”
2. Politico-Economic Profile
Bitcoin is also distinguished from other major asset classes by its basis of value, governance and applications. What gives it value is the fact that it can facilitate all kinds of transactions, starting with the most basic one of enabling money in the form of bitcoin to be sent across the world near immediately, securely, transparently and at almost no cost. The authors write, “While a purely digital and consensus-based asset may seem foreign, it’s no surprise that such an asset was born in an increasingly digital and socially networked world.”
“It’s governed by a protocol run by a distributed network of computers,” says White. “That’s in stark contrast to fiat currencies, which are dictated by government monetary policy. Bitcoin is really just math, code, run by individuals on their computers all over the world to ensure the credibility of it, and on the opposite end, you have fiat governed by a small group of individuals.” A look at the growth in the supply compared to gold and the U.S. monetary base shows in a glance how differently Bitcoin, which will be capped at 21 million bitcoins and whose release is halved every four years until the maximum number of bitcoins is reached, functions.
Its use cases are vastly different from other assets. “Self-executing contracts with bitcoin” — in which programs run on the network carry out the terms of a contract when certain conditions are met — “are a very real possibility, and we’re just starting to see them come online through other similar cryptocurrency assets,” says White. “That idea of a self-executing contract doesn’t exist in commodities or real estate.”
3. Correlation of Returns: Price Independence
The strongest argument for bitcoin’s inclusion in a portfolio comes from how uncorrelated its price is to any other asset. The authors looked at the one-year rolling correlation of the S&P 500, U.S. bonds, bitcoin, gold, U.S. real estate, oil and emerging market currencies for the previous five years (based on the fact that bitcoin’s value crept past $1 in early 2011). In the chart below, a correlation of 1 would mean that if one asset rises 5%, so does the other. A correlation of -1 implies that if asset A climbs 5%, asset B drops 5%.
“What was important to see to me was how closely bitcoin was bounded to zero because that shows zero correlation, meaning, the way bitcoin performs has nothing to do with how any other traditional asset performs,” says Burniske. “What I saw is bitcoin’s maximum value correlation with the other traditional asset classes was below the minimum the traditional asset classes have with each other. So bitcoin is extremely tightly bounded around zero. It’s the most unrelated to other price movements of any traditional asset class out there, and that’s really important from a portfolio perspective.”
4. Risk-Reward Profiles
The risk-reward profile is best seen through a figure known as the Sharpe Ratio, which measures the amount of returns from a given asset per unit of risk taken. “You can have a really high-performing asset in terms of returns, but if it’s super volatile, you can be getting less returns for the risk you’re taking on,” says Burniske. “What you want to see are assets with high Sharpe ratios because that means you’re getting better compensated for the risk you’re taking on.” As seen in the chart below, for three of the five years examined, bitcoin had superior Sharpe ratios to all other asset classes.
Signs of Maturation
Bitcoin is still shedding its initial reputation as the currency of choice for online drug dealers or as a wildly volatile, speculative investment. More recently, it has behaved more similarly to other asset classes. For instance, its weekly volatility is now only a percentage point higher than oil’s.
And despite its reputation as a speculative investment, although it is traded more than it was two years ago, proportionally, it is still used more often in transactions than trades compared to fiat currencies, mostly because conventional FX markets are so much more active.
Burniske and White also speculate that some gold bugs are turning to bitcoin. They note that in 2013, the price of gold fell only 25%, but the two largest gold ETFs depreciated by half — from $74.5 billion to $30 billion, and from $11.9 billion to $6.2 billion. “So it’s safe to assume that a large chunk of this [assets under management] drop can be attributed to capital outflows,” the authors write. Meanwhile, bitcoin’s AUM grew 60-fold.
Additionally, professional traders have entered the market. “Many of our largest traders are professionals who trade many times on technicals or algorithmically,” says White. “They watch the market, have their strategies and they’ll apply those to bitcoin.”
What differentiates bitcoin is the large arbitrage opportunity. “A bitcoin is fungible. It’s the same no matter where you have it or what exchange or what region of the world. A bitcoin is a bitcoin is a bitcoin,” says White. “And yet that bitcoin trades for sometimes very different prices, upwards of 3%, even 5%, across different exchanges. What we see are that traders that have access to different exchanges — ones in Asia, Europe or North America — will arbitrage that difference. They’ll buy where the bitcoin is cheapest, move it to another exchange and sell it there for a profit.… But the vast majority of GDAX’s trading volume come from a handful of its largest traders — those that trade almost certainly by API, programmatically. They’re not clicking a buy and sell button. They’re high frequency trading using scripting — computer code — to access our API.”
Aside from the launch of GDAX, Bitcoin has established its toehold on Wall Street in other ways. Since September 2013, Grayscale Investments has offered a traditional investment vehicle called the Bitcoin Investment Trust (GBTC), that offers investors exposure to the price movement of Bitcoin without requiring them to store actual bitcoins. One of the largest derivatives exchanges in the world, CME Group, announced in May that, in the fourth quarter of this year, it will launch both a Bitcoin reference rate and a real-time index.
"The CME CF Bitcoin Reference Rate will be a more traditional once-a-day reference rate," says Sandra Ro, executive director and digitization lead. "Just like in the metals and FX markets, people need a price discovery mechanism -- that's our way of adding credibility to a nascent market."
"From my background, I'm a foreign exchange and metals person," she says. "The new asset class, that contains Bitcoin and ether, has attributes of both but it is neither one or the other and isn't correlated to other asset classes. I've been banging on about it for a few years -- when I hear 'cryptocurrency,' I cringe at this point. It has some attributes of a currency, but it acts differently, and therefore, should be classified as a new asset class. Bitcoin and ether have potentially three uses: as an investment so people buy and hold and trade around it and hedge; then as digital value so you can use it as digital cash; and a third, as a transfer mechanism, so you can move along a digital rail."
In 2015, the prevailing narrative in financial services was that the technology behind Bitcoin, called blockchain, was revolutionary, but the currency not so much.
“We’ve seen peak hype cycle for ‘blockchain, not Bitcoin,’” says White. “The pendulum is swinging back to the value of open, distributed networks like Bitcoin…. In the early 90s, as the internet was coming online, if you had asked someone about Wikipedia, a global library or source of information, people wouldn’t have been able to imagine creating that. If the internet had been closed and private and managed by large companies, I don’t think they would have had the innovation or the ability to come up with those services on that technology. It was purely because the internet was open — anyone could innovate and build on top of it — that led us to creating such a valuable technology that we all rely on every day. I think we’ll see the same happen with Bitcoin and Ethereum and emerging blockchains that we haven’t even considered.”
Update, Thursday, June 2, 2016, 3pm: The article has been corrected to reflect that despite the fact that bitcoin's trading to transacting ratio (not transacting to trading ratio) has gone up, it still sees proportionally fewer trades than transactions when compared to fiat currencies.