What is Bitcoin?

Bitcoin (BTC) was launched in 2009 and has since become the world’s largest cryptocurrency by market capitalisation.  Bitcoin has outperformed any other asset classes since its launch and as a result has attracted a lot of interest.

Bitcoin and other subsequent cryptocurrencies have been lauded as a “democratic disruption of finance” because they ignore the monopoly of issuing money that is reserved for central banks.  Bitcoin also offers other advantages that other currencies do not offer, such as decentralisation, a limited supply, full anonymity of transactions and a ledger-based transaction system.

Whilst we agree that Bitcoin offers some advantages, we do not recommend that clients invest in it.

In this paper we present the reasons why we think that Bitcoin should not be recommended within portfolios.  We first discuss the reasons why Bitcoin cannot be considered a currency; then we present additional difficulties that Bitcoin currently faces; the challenges to invest in Bitcoin and finally we give our overall view.

Is it a currency?

A currency serves three purposes: it functions as a medium of exchange, a unit of account, and a store of value.  We look at the three criteria in turn.

Looking at the criteria of medium of exchange, Bitcoin only partially succeeds at this function for two reasons:

  • Bitcoin is not universally accepted as a means of payment.

Beyond some merchants and online apps that have accepted Bitcoin as a payment, Bitcoin is mostly not accepted anywhere for most transactions.  The fact that almost no-one uses Bitcoin as a unit of account severely limits its potential as a medium of exchange.

  • Bitcoin is not internationally recognised as a currency in law

In order to legally qualify as money, a means of payment must be recognised by a country’s laws as its official monetary unit.  At the time of writing, the only country that has recognised Bitcoin as legal tender is El Salvador.

 

Looking at the criteria of unit of account, Bitcoin fails for the three following reasons:

  • Bitcoin is not a simple unit of account

A unit of account has to be user friendly in terms of how it can be used but Bitcoin is disconcertingly difficult to use to price goods.  Assuming an orange is worth 50p in a supermarket, its Bitcoin price would be 0.000014, making it very difficult to use for any normal transaction.

  • Bitcoin is not used commonly to price transactions

A currency becomes a unit of account if it becomes the common measure that people use to set prices or record debts.  Bitcoin is not recognised as a currency to set prices or record debt and hence it is very likely that it will not be used to price common transactions.

  • Bitcoin is not matched to units of account commonly in use

A currency could have a chance to gain some traction if it is matching existing units of accounts.  For example, if 1 BTC matched 1 USD, it could potentially be easily used in some transactions.  The fact that Bitcoin does not match to any unit of account traditionally used such as the US Dollar, the Euro, the Japanese Yen or even the Chinese Renminbi makes it very difficult for Bitcoin to gain any traction as a unit of account.

Looking at store of value criteria, there are three components for the value of a currency: price stability, scarcity and durability.  Bitcoin fails on each of the three components as explained below:

  • Bitcoin does not exhibit price stability

To see how ineffective Bitcoin is as a store of value, we look at the volatility of Bitcoin versus the dollar as well as the volatility of the British Pound versus the US Dollar as a comparison in Figure 1 below.  The volatility of the BTC/USD pair oscillates between 0.8% and 15% while the volatility of the USD/GBP pair oscillates between 0.15% and 2%.  As a result, it is clear that Bitcoin does not exhibit price stability.  In addition, Bitcoin’s daily exchange rates, as seen in Figure 2, exhibits virtually zero correlation with other known currencies, meaning that Bitcoin does not move in line with or against any existing currencies.

 

bitcoin stats

Source at end August 2021: Bitcoin volatility index (https://www.buybitcoinworldwide.com/volatility-index/)

 

Source at end August 2021: https://www.twosigma.com/articles/risk-analysis-of-crypto-assets/

 

  • Bitcoin exhibits scarcity but not intrinsic value

Bitcoin is a scare currency because its supply is increasing slowly and is capped at 21 million coins.  At 15th of August 2021, 18.77 million have already been ‘mined’ meaning that 83% of all the Bitcoin that will ever come into existence have already been brought into circulation.  However, scarcity only matters if an asset has intrinsic value.  In the case of gold, its intrinsic value comes from its use in jewellery and as an industrial commodity.  Bitcoin, by contrast, hasn’t yet demonstrated that it has any inherent value.

  • Bitcoin does not have particular durability qualities

Gold does not corrode and cannot be destroyed.  Bitcoin in contrast requires an ‘always on’ computer network that runs on electricity and can ultimately be destroyed.  In addition, Bitcoin can be lost: if you lose your private keys you lose all your Bitcoins.  Finally, Bitcoin wallets can be hacked with the latest example being the $600m hack of the Poly network in August 2021.

 

Bitcoin suffers additional issues

We have four additional concerns about Bitcoin, namely:

  • Criminal activity and money laundering

As Bitcoin transactions are completely anonymous, it is impossible to determine the extent to which Bitcoin is used for illegal activities.  A peer review study published in 2018[1] estimates that 46% of Bitcoin transactions involve illegal activity.  Whilst the illegal share of Bitcoin activity declines with mainstream interest in Bitcoin and with the emergence of more opaque cryptocurrencies, such a level of illegal activities suggest that Bitcoin will face enormous pressure to be regulated.

  • Future regulations

Bitcoin does not offer any protection and is currently poorly regulated.  It needs a vast amount of protection such as Anti-Money Laundering rules and Know Your Customer regulation to fight the financing of terrorism.  In addition, Bitcoin needs additional regulation for consumer protection and stability of financial institutions.  Such regulations could limit the amount of interest in Bitcoin and contribute to its fall in value.

  • As governments do not see Bitcoin as a currency, Bitcoin gains will be taxed

In the UK, HMRC does not recognise Bitcoin (or any other cryptocurrency) as money but instead as an ‘exchange token’.  HMRC has published guidance[2] for tax filing as capital gains must be taxed.  In the US, taxpayers also must report Bitcoin transactions and also incur capital gains tax.

  • Bitcoin transactions are slower and less efficient than conventional money

Visa can process around 1,700 transactions per second on average while Bitcoin can only process 4.6 transactions per second.  Bitcoin faces significant challenges to evolve the network and it is unclear whether processor speed can ever evolve significantly due to the way Bitcoin is designed[3].

 

Could we add Bitcoin to Client portfolios currently?

Even if we became comfortable that the risks were small or could be managed, we face two additional issues:

  • Bitcoin ETFs (Exchange Traded Funds) or ETPs (Exchange Traded Products) are not widely available in the UK

Currently, we cannot find Bitcoin ETFs on FundsNetwork or James Hay.  Platform Securities offer access to a few Bitcoin ETFs: we’ve found seven on Financial Express Analytics – but only one [BTCetc Bitcoin Exchange Traded Crypto – ISIN DE000A27Z304] is registered for sale in the UK.  However, the Total Expense Ratio (TER) for this ETF is 2% which is very expensive.

  • Bitcoin ETFs will likely be challenged by any reasonable Compliance department on liquidity grounds

ETFs are liquid only because market-makers trade to ensure there is no gap between the market price and the underlying price of the assets in the index they track.  This implies that the underlying asset needs to be liquid as well which is not the case for Bitcoin.  In the case of a market plunge, investors could find themselves locked in and not be able to redeem their investment easily – even if the vehicle owns the Bitcoin outright.

 

Conclusion and view

In conclusion, we do not believe that Bitcoin is a currency as it does not fulfil any of the criteria required for a currency to function.  Instead, we consider Bitcoin to be a speculative investment that, while possessing some useful attributes for some economic participants, for most investors Bitcoin is potentially dangerous due to its lack of transparency and regulation.  As Bitcoin is a speculative asset, we believe it is impossible to take a fundamental view on its future price direction and therefore we cannot recommend it in portfolios.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Saunderson House Limited. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them. The content and any opinion expressed in this note, is for information purposes only and should not, in any way, be construed as financial advice.

Read more about our investment services.

 

The value of investments and the income therefrom can go down as well as up and you may not get back the full amount you invested.

Saunderson House Limited is authorised and regulated by the Financial Conduct Authority. 

 

[1] Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies?

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3102645

[2] https://www.gov.uk/hmrc-internal-manuals/cryptoassets-manual

[3] The Blockchain scalability problem https://towardsdatascience.com/the-blockchain-scalability-problem-the-race-for-visa-like-transaction-speed-5cce48f9d44

About The Author

Quentin De Bottini
Quentin joined Saunderson House in April 2020 and focuses on equity sectors such as US, EM and Global. Quentin ...
Read more

Contact us

If you would like further information about our services or would like to arrange a complimentary, obligation-free telephone conversation or meeting to discuss your requirements, please contact us.

GET IN TOUCH