11 min read2020 has been crucial for Bitcoin, we see it as the year of legitimisation for the broader public and investors, accelerated by the COVID crisis and the consequent rapid escalation of QE. Our conversations with institutional clients have changed considerably over the course of 2020. What was typically a desire to speculatively invest has now become one of being fearful of extreme loose monetary policy and negative interest rates, with clients looking for an anchor for their investments. As understanding of bitcoin improves, clients have grasped that bitcoin has a limited supply and fulfills this role as an anchor for your assets while fiat is being debased.
Over the course of 2020, we saw cumulative flows (stripping out the price effect) into digital asset investment products rose from US$1.35bn at the start of the year to US$8.0bn at the end, with only 24 days of outflows for a total of 250 trading days. Investors are buying and holding, a good indicator that it is slowly developing into a store of value.
Bitcoin remains a volatile asset, and many expect a store of value to have much lower volatility, but as gold was developing into an investment store of value in the 1970s, it too had extremely high volatility. As it has matured as an investable store of value, so too has its volatility declined. Similarly, we expect volatility in bitcoin to continue to decline over the long term as it matures as a store of value.
Bitcoin, gold & loose monetary policy
Until recently, bitcoin and gold fund flows had been following a similar path. Since the beginning of 2020, a combination of loose monetary policy and a weak economy precipitated by COVID-19 led to fund inflows into both gold and bitcoin. However, following the news of a vaccine and consequent hopes of an improving economy, we have seen gold prices fall and gold fund outflows. Conversely, bitcoin prices have continued to rise alongside inflows of US$2.5bn over the last 9 weeks (see chart below, note that scales are different magnitudes).
We believe the increasing trend of legitimisation and corporate adoption are the likely reasns for bitcoin’s recent price rise. Some fund newsletters also suggest a trend of investors selling gold positions and diversifying their hedges by adding bitcoin.
At present, bitcoin’s market capitalisation represents just 3.2% of gold’s. If it were to take further market share from gold, its price would increase commensurately. For example, if bitcoin were to take 10%, we estimate, its price would equate to US$62,493 (as shown in the table below), at current gold prices.
Rhetoric around government ban (unlikely)
The US gold ban of the 1930s was quite unconstitutional and a deeply political move – it was an attempt to prevent bank runs with huge penalties for hoarding. Almost 100 years later, the political risks for gold remain: one entails dollar debasement pushing gold levels higher, and the other is gold being used as a governmental scapegoat for not fixing its paper-based money regime. We believe a similar argument could be made for Bitcoin.
We think Bitcoin does have risks of being banned but that this is an unlikely outcome. It has been banned in China and India, and although this has reduced its usage, it hasn’t stopped it. In 2018 China bitcoin volumes represented 16% of world volumes, it now represents 4%. Bitcoin is incredibly hardto completely eradicate due to its pseudonymous features – hence why we call it a non-sovereign store of value. However, it could be effectively banned for any investor operating within a standard regulatory regime.
On balance, governments will more likely try to compete with Bitcoin by issuing their own Central Bank Digital Currencies as an outright ban only increases the risk of it becoming a widely used as black-market money. Furthermore, banning Bitcoin will likely have far greater political consequences than it did in the 1930s as government/central bank profligacy is much more widely known than it was back then. We believe the unprecedented volume of comments protesting FinCen’s recent crypto regulation proposal, as well as the FCA’s recent ban of retail participation in crypto derivatives, are both clear indicators that citizens are increasingly unwilling to stand by in silence while poorly informed or heavy-handed regulations harm their interests. Whilst the Chinese Communist Party may act entirely in its own self-interest and without much fear of political repercussions, the same is not true of Western democratic governments.
Bitcoin and Inflation
One could surmise that as an increasing number of the world population is vaccinated, demand for goods and services will recover. However, this demand will enter into an economic environment where many supply chains have been decimated, leading to potential bottle-necks in supply. Whether inflation will rise in 2021 is inconclusive. There’s little evidence in current macro data to suggest that it will. Nonetheless, it remains a tail risk.
Unlike gold, bitcoin has not been around long enough to endure a period of hyper-inflation in order to establish its credentials as a true inflationary hedge, but conceptually it makes sense that it would be. Early observations suggest that bitcoin’s relationship with inflation since 2017 has been improving in line with its increasing use as a store of value. Admittedly, 12 years isn’t enough data, but we are encouraged by the improving relationship.
Because of its characteristics (scarcity, liquidity, high uptime) — the very features that theoretically help protect from inflation and debasement of fiat money supply — it makes conceptual sense that users would look to bitcoin as a long-term store of value. And evidence suggests investors are increasingly using it as such.
Bitcoin’s volatility problem
What has put many investors off Bitcoin has been its volatility, and we see this as a valid criticism, particularly for institutional investors where quarterly and annual performance is so important. Early in 2021 we have already seen intraday volatility rear its ugly head and we believe it is likely to do so again throughout the year.
We believe we are witnessing Bitcoin transitioning from a speculative asset to more of a store of value, but this transition doesn't happen overnight leaving Bitcoin vulnerable to speculative frenzies and subsequent unwinds. Such patterns undoubtedly lead to high volatility. As Bitcoin slowly evolves into a store of value however, we expect its longer term volatility to decline.
We are already seeing evidence for this decline in 90 day trailing volatility which has fallen from 200% volatility spikes in 2011 to 2015 to around an average of 50% today. Current downward trends suggest we are likely to see Bitcoin volatility fall more consistently over the next few years. A continued trend of diminishing volatility would further increase bitcoin’s usefulness as money, a likely driver of future increased monetary value.
Bitcoin, Authoritarian Regimes & Negative Yields
Global Google searches for the phrase “bitcoin” highlights that 2017 was the year that bitcoin entered the broader public consciousness. Since then, searches have declined and not really picked-up to previous levels during this more recent rally. But there are important geographic and jurisdictional differences in these search trends. In economically weak and authoritarian regimes we have seen a much stronger rise in searches for bitcoin. In Argentina for example, where recent years have brought about a sharp decline in the Peso, there has been a corresponding rise in searches for bitcoin. We observe similar patterns in other jurisdictions where local currencies are rapidly depreciating.
We believe this is a result of individuals looking for a non-sovereign store of value that is easily accessible and that can provide a value anchor relative to their native currency. The World Bank Political stability index versus bitcoin volume growth helps strengthen this hypothesis.
Political stability in the western world is better, but there are also other prompts for greater bitcoin adoption present among western citizens. The rapidly increasing pot of negative yielding debt heightens the risk of ordinary consumers becoming subject to negative yielding deposits in commercial banks, and in some cases negative yields already exist in deposits over a certain size. This coupled with the onset of COVID-19 (leading to a drastic reduction in the use of physical cash) will make it much easier for central banks to enforce negative yields on ordinary people if they so choose.
There also seems to be some support in the data. We are witnessing an improving relationship between bitcoin prices and negative yielding debt and we believe this will be an interesting trend to follow in 2021.
Bitcoin’s liquidity is steadily improving
In late 2020 and early January 2021 Bitcoin trading volumes reached record levels, with daily trading volumes on trusted exchanges rising to US$26bn. To help put that in perspective, the total average daily trading volumes on the London Stock Exchange is approximately US$7bn.
In 2019 Bitcoin average daily trading volumes were US$2.5bn, we believe as institutional adoption began in late 2020 volumes began to rise.
While assets under management for Bitcoin investment products rose dramatically in size in 2020, adding US$6bn net new assets and assets under management peaking at US$35bn, they continue to remain an increasing but relatively small part of the Bitcoin network. Average daily turnover of Bitcoin represents just 10% of total Bitcoin trading turnover, this has risen from an average of 2% in 2019 highlighting increasing investor participation in 2020/21.
Continued improvement in its underlying liquidity is another factor driving an increasing usefulness of bitcoin as a monetary store of value. We believe steadily improving liquidity and volatility are key drivers of future bitcoin value.
CBDCs will become a buzzword in 2021
The concept of Central Bank Digital Currencies, or CBDCs as they are commonly known, have garnered considerable attention from central banks in the second half of 2020. We expect there to be increased hype and confusion in 2021 as more details on their intended structure is revealed.
The European Central Bank’s recent CBDC project concluded its digital euro public consultation this month but details remain scant. It will decide to formally create a digital currency by mid-2021. There were a high number of responses to their consultation indicating great interest in the initiative. ECB President Lagarde has said she expects there will be a digital euro, hopefully within the next five years. Interestingly, the ECB reiterated the four potential reasons for issuing a CBDC, namely demand for electronic payments, a decline in cash usage, potential dominance of a private digital currency such as Bitcoin, and European adoption of a CBDC issued by another central bank.
Here are what we believe are some key considerations:
CBDCs present an array of compelling merits, including the promise of near instantaneous payments and settlements, the eradication of black-market transactions, reductions in the costs of cash management and efficiency gains in accounting.
They also present certain risks. Of these, privacy is perhaps the most pressing. CBDCs could potentially be programmed to control the spending of citizens, enforce negative yields on deposits and bail-ins, as well as to monitor income and spending in a way that is far more intrusive than we are accustomed to.
While the momentum established in 2020 has been significant, we should not expect fully functional CBDCs to emerge for some years – certainly not in the western world. There are a plethora of questions still to be answered, including whether central banks will adopt a direct ‘core ledger’ with the central bank or use an existing wallet provider utilising Distributed Ledger Technology, how KYC (know your customer) and AML (anti-money laundering) checks will be carried out, and how to manage the risk of hollowing-out systemically important commercial banks.
CBDCs are likely to become very large and therefore a scalable wallet infrastructure will be required, this could become a big theme in 2021 as central banks look for credible wallet providers.
Finally, we at CoinShares feel it is important to stress that CBDCs are not a candidate to replace bitcoin. The two are inherently different instruments, the latter being a distributed ledger, peer-to-peer system, with a predetermined monetary policy where the supply cannot be altered, which acts as an attractive non-sovereign store of value. CBDCs, on the other hand, look as though they will be designed to mirror their respective issuer’s fiat currency.
Bitcoin development and usability
Aside from Bitcoin’s increasing use as a store of value, the development and usability of Bitcoin itself is making great progress. This is perhaps best illustrated by the improvement taking place on the Lightning Network, Bitcoin’s second-layer protocol for instant, casual-size payments. After some years of consternation and disappointment as it became clear that microtransactions on the blockchain itself was incompatible with decentralisation, the Lightning Network promises to breathe fresh air into the question of bitcoin’s potential as a medium of exchange.
With the recent announcement of its global rollout for international payments and remittances, Strike, a payments app that seamlessly integrates Lightning payments with traditional bank accounts, has taken an important step forward in Bitcoin’s journey towards becoming a more scalable and user-friendly option for day-to-day transactions.
The Lightning network itself has shown promising signs of growth in both liquidity and node count during 2020 and we expect this trend to continue into 2021. Total network capacity recently passed $40m whereas total node count surpassed the 8,000-level, both all-time-highs. Increasing usefulness of bitcoin as a medium of exchange is likely an important metric to watch in order to ascertain its longer-term likelihood of success as a medium of exchange.
Conclusion
In summary, we believe 2021 will be a pivotal year for bitcoin, with much greater institutional investor and corporate adoption. This new set of investors are likely both a result and driver of bitcoin’s increasing use as a long term store of value. Its budding price relationship with inflation and negatively yielding debt will be one of the interesting metrics to watch over the course of 2021.
If the price continues to significantly increase there’s a good chance that volatility may rise again, but we still expect it to remain lower than in previous years of large price growth such as 2013 and 2017. We also expect there to be much hype and confusion on the timing and implementation of CBDCs but ultimately CBDCs and bitcoin are very different and unlikely to compete for the same monetary demand. If bitcoin is viewed through a pair of golden spectacles, there is the potential for even further price rises on top of its meteoric rise in 2020.
