Bitcoin as a financial asset

  (photo credit: INGIMAGE)
(photo credit: INGIMAGE)

Bitcoin has become a cultural and financial phenomenon. In this paper, we provide Clarity clients with a  brief introduction to the world of Bitcoin (and cryptocurrencies in general) and with what we believe is a  sensible framework for thinking about it and its potential role in an investment portfolio. After presenting a summary of the history and main features of Bitcoin, we explain why we believe that although Bitcoin should not be considered as money, it can be seen as a financial asset, and specifically, as a financial option. As such, it is characterized by a very high-risk/high-return speculative profile and is therefore suitable only for investors with a long investment horizon and a high tolerance for risk. Furthermore, given  that investors can lose a significant part, if not all, of their investment, those seeking to gain exposure to  Bitcoin should allocate only what they can afford to lose, and in any case, probably not more than 1-2%  of their portfolio. 

What is Bitcoin? 

In October 2008, Satoshi Nakamoto, an anonymous person, or group, published a paper often referred to as the ‘Bitcoin Manifesto’ in which he/she/they introduced Bitcoin. A few months later, in January 2009,  the first Bitcoin transaction was completed. In Nakamoto’s paper, Bitcoin was presented as a “peer-to peer electronic cash system” that would allow “online payments to be sent directly from one party to  another without going through a financial institution.” 

Features of Bitcoin include: 

• Bitcoin is a purely digital phenomenon, a set of protocols and processes. It was originally designed as a technological peer-to-peer system to facilitate instant payments. 

• The Bitcoin network, or system, is a collection of computers (also referred to as ‘Nodes’ or  ‘Miners’. Their number is estimated at tens of thousands) that all run Bitcoin's code and store its public ledger (or ‘blockchain’) which is public, transparent, and decentralized.

• A blockchain can be thought of as a collection of blocks. In each block is a collection of transactions. Because all the computers running the blockchain have the same list of blocks and transactions and can transparently see these new blocks being filled with new Bitcoin transactions, no one can cheat the system. 

• Bitcoin is secured by cryptography. It is verified and maintained by the servers and computers on the Bitcoin network that are incentivized by monetary incentives. The transaction verification process rewards them with newly-created Bitcoins – this is known as ‘Bitcoin Mining’. 

• Other participants in the Bitcoin market can buy or sell tokens through cryptocurrency exchanges or peer-to-peer. 

• In contrast to fiat money whose supply is (at least theoretically) unlimited, Bitcoin’s ultimate supply is pre-determined and limited to 21 million coins (of which around 19 million have already been issued). 

Bitcoin is the first, most well-known, and largest of the cryptocurrencies, of which around 4,000 are currently available. As of August 31st, 2021, its $890 billion market value represents 42% of the $2.1 trillion total market value of the entire cryptocurrency market. 

Bitcoin is not Money 

Money's a matter of functions four, 

A Medium, a Measure, a Standard, a Store. 

The above couplet became widely popular in macroeconomics textbooks as a concise and poetic summary of the uses of money. Most modern textbooks now list only three functions (not considering a standard  of deferred payment as a distinguished function, but rather subsuming it in the others): 

1. Medium of Exchange: When money is used in transactions to intermediate the exchange of goods and services, thereby avoiding the inefficiencies of a barter system. 

2. Measure of Value (or unit of account): A standard numerical monetary unit of measurement of the market value of goods, services, and other transactions.

3. Store of Value: To act as a store of value, money must be able to be reliably saved, stored, and retrieved – and be predictably usable as a medium of exchange when it is retrieved. 

Although the names ‘Cryptocurrency’ and ‘Bitcoin’ metaphorically refer to currency and coins, Bitcoin is not money. It does not meet the basic requirements to be considered as money: • Bitcoin does serve as a medium of exchange, but only in a very limited fashion. You can buy certain products using Bitcoin. However, this use is limited to certain vendors and given complexities in transacting in Bitcoin, is not practical in small day-to-day purchases. 

• Given its high volatility, Bitcoin does not serve as a unit of account (or measure of value). Products are not priced, denominated, in Bitcoin. Bitcoin is not used to measure or represent value. • Bitcoin can be seen as a store of value in that holding Bitcoin can be instrumental in transferring wealth from the present to the future. Furthermore, given that Bitcoin is somewhat outside of government control, it can be seen by some as a ‘safe-haven’. 

Bitcoin as a Financial Asset 

As a store of value, Bitcoin can be seen as a form of a digital commodity -- as a financial asset. By purchasing, holding, and selling it, one can transfer wealth from one person to another, and from the present to the future. It can potentially carry purchasing power in a liquid form. In fact, as Bitcoin is neither issued nor directly controlled by government, and its supply is finite, it is often likened to gold (and characterized as  ‘Digital Gold’). 

When choosing the suitable tax framework for Bitcoin, governments around the world have taken this stance as well: They too determined that Bitcoin, and cryptocurrencies in general, are a financial asset/security, that is typically taxed, rather than a currency, that is not taxed. 

As we will see in the next section, the price of Bitcoin is highly volatile. This volatility may undermine the credibility of Bitcoin as a store of value (although the relatively volatile price of gold has not prevented it from serving as a store of value historically). It is therefore perhaps best to view Bitcoin not as a regular financial asset, but rather as a financial option. Bitcoin can be seen as representing an option to participate in a rapidly developing new world of digital financial applications (e.g., Decentralized  Finance, etc.), to which Bitcoin, the most established and liquid cryptocurrency, acts as an ‘entry ticket’. 

Risk and Return 

Bitcoin is a highly speculative financial asset with a very high-risk/high-return profile: You may earn much but can also lose a great part, if not all, of your investment. 

The historical price behavior of Bitcoin is as follows: 

Bitcoin – Calendar Year Returns 

Year            Return2021 YTD   60%2020           302%2019           88%2018           -72%2017           1325%2016           125%

It is important to note that intra-year price swings can be significant. For example, although 2021 year-to date returns are +60%, between mid-April, when the price of Bitcoin reached above $60,000, and mid-

July, as it dropped below $30,000, i.e., within three months, you would have suffered a loss of more than  50%. 

In addition, even though Bitcoin has been around for more than ten years, its adoption is very gradual, and it still suffers from various operational issues and risks. Among these is heightened risk of electronic theft and fraud. Regulatory risk is another one: governments may decide to restrict the use of cryptocurrencies or even ban them altogether (as recently happened in China). These risks must be taken into consideration within the overall risk/return profile of Bitcoin. 

It was previously stated that Bitcoin can be seen as an option. This is also a useful framework through which to consider its financial risk/return profile: options often offer significant potential upside, but they also come at a cost of very high price volatility and the potential for them to expire worthless. 

Investing in Bitcoin 

Given that Bitcoin is a financial asset with speculative characteristics, it is only suitable for investors with a long investment horizon and a high tolerance for risk, enabling them to stomach the significant price swings. 

Even so, investors should allocate to the opportunity only what they can afford to lose, and in any case,  probably not more than 1-2% of their portfolio. 

It is still complicated to purchase Bitcoin directly, and due to anti-money-laundering concerns, financial institutions are not always happy, or ready, to receive funds converted back from cryptocurrencies. Furthermore, engaging directly with cryptocurrency exchanges could expose investors to increased operational risks to which they are not aware or prepared to deal with. To somewhat mitigate these risks and provide easier access, we can now gain exposure to Bitcoin and to other cryptocurrencies indirectly through investment funds and other financial instruments --such as Bitcoin-linked bonds, Bitcoin-tracking exchange-traded funds (ETFs) and stocks of cryptocurrency-related companies – some of which are managed by reputable firms with significant experience in the cryptocurrency world and beyond.

We hope you found this paper useful. We are happy to answer any questions you may have on this subject and/or to further discuss any aspect of it. 

The content of this publication does not replace and should not serve as substitution for Investment  Advice services that take into account the special characteristics and needs of each investor. Clarity has no affinity or interest in Bitcoin.

This article was written in cooperation with Clarity Capital