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Crypto assets: The round-trip from ‘no fundamentals’ to the moon

02 August 2021 Gareth Stokes

Few instruments have captured retail investors’ collective imagination as completely as cryptocurrencies. In fact, the frenzied price action of the best-known digital coin, bitcoin, has spawned a global community intent on milking the phenomenon for all it is worth. We are talking about consumers who now believe 10x is a normal construct in the world of financial market returns; exchanges that facilitate billions of dollars in crypto transactions daily; and social media influencers who proclaim “bitcoin to the moon” to anyone who will like and subscribe, among others. As we power through 2021, we are subject to a broad church of opinion re the asset class, ranging from Warren Buffett’s ‘bitcoin has zero fundamentals’; to former hedge fund manager, Raoul Pal, who reckons a 100% allocation to crypto makes perfect sense; to everything in between.

Five counters to the zero fundamentals case

We have become accustomed to bitcoin and crypto asset discussions taking place in the strangest places. Friends dissect prospects for their favourite altcoin on WhatsApp group chats; asset managers debate whether to allocate clients’ funds to these risky assets at the margins of their annual investment outlook conferences; and governments and market regulators debate whether to allow citizens to own and / or transact in these currencies at all… On 27 July 2021, we attended an intriguing ‘bitcoin investment case’ presentation that took place during the Actuarial Society of South Africa (ASSA) Investment Seminar, themed Rethinking Sustainability. 

Imran Lorgat, an actuary at Reinsurance Group of America (RGA), set the scene with a talk titled ‘Bitcoin, investment and the environment’. In his opening remarks he offered that bitcoin was a three-in-one construct comprising open-source software; a network of users; and a tradable asset. Lorgat illustrated the cryptocurrency’s versatility as a payment mechanism by sharing screenshots of a transfer of a fraction of a US cent from a bitcoin wallet to an online gaming platform, before returning the initial stake plus 200% in ‘winnings’ back to the digital wallet. “Bitcoin is to money what email was to surface mail,” he opined, while the audience marvelled at the infrastructure that allowed such low value payments to take place at all. 

Many market commentators have observed that bitcoin’s rapid adoption and resultant surge in market capitalisation are tied to a development cycle typical of other revolutionary technologies. They use the internet as a recent base case before postulating that bitcoin, which is just over a decade old, will exceed 80% global adoption way faster than the almost three decades it took the internet to do so. Lorgat offered up five factors that explained the growth in bitcoin over the past 12 years and could make a fundamental value case today. “Demand [for a speculative asset] tends to go all over the place in the short-term; but in the long-term it is driven by whether people see value in the system,” he said. You will have encountered most of these arguments before; but they are worth revisiting. 

Factor 1: Ongoing technological development.

The continuous addition of new features to the bitcoin environment, driven by a growing universe of contributors to this development, is held up as a major underpin of the cryptocurrency’s fundamental investment case. It could be argued that each innovation and new use case will prove to be value accretive over time. 

Factor 2: Hash rate.

The hash rate is the measuring unit of the processing power of the entire bitcoin network. It is commonly held that the hash rate correlates with the bitcoin market price, though this could be entirely anecdotal. Processing power and the rate of processing is important because the network must make intensive mathematical operations to ensure the integrity of the blockchain. It is thus fair to say that the sheer computational power of the global bitcoin mining universe is not only a measure of the network’s security but an integral part of the value debate. 

Factor 3: User count.

It is difficult to estimate the total number of individual bitcoin users; but the number is clearly rising over time. Recent estimates point to around 160 million unique users worldwide… And to get to 80% global adoption would require that number to grow by around 45 times! The user count is important due to Metcalfe’s Law, which holds that “a network’s value is proportional to the square of the number of nodes in the network”. Equity investors have seen the power of this law in action as shares in Amazon, Facebook, Twitter and others run ever higher. 

Factor 4: Transaction value.

The value of daily transactions involving bitcoin surged to over US$7 billion per day during parts of 2021 and have averaged north of US$1.5bn per day for the past year. And a snapshot of data, taken at 3pm on 29 July 2021, recorded 251432 blockchain transaction in the preceding 24 hours, involving almost $45 billion in bitcoin. Although these statistics vary from website to the next, they illustrate the growing adoption of the crypto currency as a transactional tool. 

Factor 5: Scarcity.

The scarcity argument remains the stock-in-trade of most bitcoin pundits. Bitcoin is limited to a total circulation of 21 million coins which will have to satisfy the needs of all those who use the network. Scarcity stands alongside the ‘inflation hedge’ argument as the main underpin in bitcoin price forecasting, though the jury is out on whether the vaunted Bitcoin Stock-to-Flow model will prove accurate over the longer term. The scarcity angle explains why the likes of Cathy Woods of Ark Invest and other bitcoin bulls place a US$500000 per coin (or higher) future valuation on the cryptocurrency. 

The fundamentals cannot guarantee a moon landing

There are a range of other push factors for bitcoin, including that it has ‘miles to go’ before its market capitalisation rivals that of gold or other top fiat currencies and that it is liquid and tradable, thanks to the more than 400 crypto asset exchanges that have sprung up globally to support it. But while the journey to the moon may be underway, there is no guarantee of a safe moon landing. The result is that many professional speculators view their bitcoin ‘investment’ as a type of option that will either end ‘deep in the money’ or expire worthless. 

Can we make a fundamental investment case for the cryptocurrency? The world’s greatest investor believes not; but then he has said similar things about gold. Lorgat concluded that since bitcoin was a new technology it might not make sense to weight it against established fundamentals. “We are talking about a software, a network and a currency that [already boasts a circulation] larger than that of 100 other fiat currencies; it is clearly driven by fundamentals,” he said, later adding that everything discussed should be tempered with the cautious, conservative actuary caveat: Past performance does not imply future performance.

 

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