Guess What Delivered in Spades in Thornburg’s Internal 2017 Global 3 Stock/Security Competition?
At the beginning of every year, a number of investment professionals at Thornburg voluntarily place their informal, internal-only bets on which three securities—from stocks to currencies or other financial assets—might together produce the best beta-adjusted returns in the year ahead. In 2017, the winner was Sean Sun, whose three picks included bitcoin. The cryptocurrency skyrocketed last year, of course, helping Sean win the prizeless competition by a wide margin. His thoughts below on bitcoin and blockchain are worth sharing:
There clearly is no shortage of articles, commentary, discussion and bull/bear arguments on bitcoin (XBT) and cryptocurrencies nowadays. So what I have to add here is really my thought process around putting bitcoin into Thornburg’s internal “3 stock/currency/other financial asset” competition in both of the past two years.
When I chose bitcoin for the calendar year 2016 competition, it was hovering around $400. At that time, the ‘investor’ base was limited to a small band of self-proclaimed ‘tech nerds’ (like myself) who understood and appreciated the underlying blockchain technology, which as a decentralized backbone could disrupt established industries and institutions similar to the impact of HTTP protocol and the broader internet just a generation ago. To be sure, suggesting that blockchain is as important an evolution as the internet is an overstatement. But to outright dismiss or ignore it is also a mistake. And those who derided it were clearly either not mathematically inclined enough to understand the cryptographic elements of the system, or industrious enough to take the time to read the elegant and brilliant white paper by Satoshi Nakamoto, the pseudonym used by the person or group founding it all.
Other people that saw value in bitcoin at the time included some prominent venture capitalists. Andreessen Horowitz, for example, was an early investor in Coinbase, which is a leading platform for buying and selling digital currencies. Those with libertarian leanings also liked the completely decentralized, stateless nature of a currency that couldn’t be debased by a nation’s central bank. Fiat currencies are based on trust and confidence in a government, but as we have seen many times in the past, governments oftentimes abuse this privilege in the debasement of currencies. I fell into this libertarian, so to speak, camp, as well. I thought the collective assets from the “quantitative easing” of major central banks that now total some $14 trillion would eventually have an inflationary effect on fiat currencies, and figured bitcoin would act as a nice hedge. Finally, bitcoin served a niche for illegal applications, such as money laundering and the purchase of illicit goods, in a far superior manner to fiat currency. My thinking here was that emerging technologies sometimes see initial use cases led by less ‘legit’ endeavors. There’s the infamous example of porn and its influence on the early infrastructure build-out of the internet. Digital payments stocks, including PayPal, PaySafe, and Wirecard, trafficked in online gambling and ‘adult’ activities in their early days. But over time, they became broad-based and mainstream, and their valuation multiples have expanded.
Another part of my investment thesis involved bitcoin’s low to negative beta to the markets—and this was a beta-adjusted competition. Moreover, the ‘cash cost’ to mine bitcoins at the time was hovering around several hundred dollars; nowadays, the cash cost of a marginal bitcoin is estimated to be around $6,000, and rising to a forecast $14,000 next year. Bitcoin has been volatile in years past, but had clear moonshot potential, and that was perfect for this type of internal competition.
Going into the beginning of 2017, bitcoin was hovering near $1,000 and had powered my victory in the competition in 2016, as well. I decided to continue to roll with bitcoin in the ‘3 Security Competition’ because despite the outsized price movement in 2016, the overall market cap of bitcoin was still less than $20 billion, or less than 25 basis points of the $8 trillion in gold currently discovered and a tiny fraction of the world’s M1, or narrow money supply, of $33 trillion. Furthermore, a new ‘use case’ had also emerged: the Chinese during 2016 had figured out that bitcoin is 1) a great vehicle for speculation, and 2) a great vehicle to evade capital controls that had recently been introduced by the Chinese government.
More than 90% of all bitcoin volume at the start of 2017 was in Chinese renminbi (RMB) and this Chinese demand really helped to drive bitcoin’s gains in the back half of 2016. This was my primary thesis going into 2017. After all, if I were a rich Chinese national and really wanted to get my money out of China, forget Macau gaming or Hong Kong insurance policies! Bitcoin was a far superior option.
The mechanics for moving RMB to XBT to an offshore exchange outside of China were pretty straightforward and didn’t require the usage of any traceable financial intermediaries. As a digital asset, for instance, bitcoin Wallet can be instantly ‘moved’ anywhere, except at the very end of the line, when you want to convert it to a hard fiat currency such as dollars or euros. At that point, if you have some creative lawyers, you could set up various layers of shell companies to receive your fiat, and have no trace of where it came from if you had been smart along the way about ‘tumbling’—a method to cover your bitcoin transaction tracks.
Currently, China has banned all bitcoin exchanges, but there is still plenty of volume in renminbi-based bitcoin investing. It just happens in the dark on peer-to-peer platforms like WeChat if it’s a small amount, or Telegram (a fully encrypted messaging service) if it’s is a large amount. In effect, there’s a shadow bitcoin market. Bitcoin was hit hard when China cracked down on the exchanges, but the fact that even China, with its regulatory heavy-handedness, couldn’t stop bitcoin as a global force largely demonstrates the enduring value of the asset.
What bitcoin—and all these other alternative-coins—has become today is something I didn’t expect to happen this quickly. Its retail investor focused, especially in Japan and Korea, and the get-rich quick mania driving it appears to be making for one of the great bubbles of our generation.
So what’s a fair price for a single bitcoin? You can look at it as a percentage of gold ($8 trillion); or, again, as a percentage of the world’s narrow money supply M1 ($33 trillion); broader M2 money supply ($85 trillion); or all outstanding financial assets and instruments ($400 trillion). In each of these cases, both bitcoin and all other viable cryptocurrencies combined are still relatively tiny. At this point, I take no real view on the underlying value of bitcoins, other than to say I’d be on balance a seller rather than a buyer, but with the understanding that bubbles can inflate for some time before busting.
There’s value and there’s price. There’s clearly value in bitcoin as the first mover and in the distributed ledger blockchain technology broadly. But there’s also a good chance we have run too far too quickly, given the retail mania surrounding the asset. In particular, you are seeing the retail mania extend into over 1,400 wannabe alt-coins, very few of which will have long-run staying power. I think there are some that are very interesting, such as Ethereum, which is more token than currency, and some which may not even exist yet. That is part of the beauty of the blockchain, each ledger can offer its own technology properties, such as speed, privacy, scalability, consensus mechanisms, that are well suited to various purposes. Issues that exist today can be solved as the technology evolves. Blockchain’s technology is durable, and will only improve and strengthen over time. I don’t think there will be a single blockchain to rule them all, but we won’t have 1,400+ viable ones a decade from now.
Although bitcoin has an advantage over fiat as a ‘programmable form of money,’ so to speak, and can evolve over time, the lack of a clear driving force (where are you, Satoshi?) and the low entry barriers to launching new coins mean that the ultimate winner probably isn’t classic bitcoin. As I mentioned, the most interesting competitor to bitcoin in my view is Ethereum, which has platform elements and is “Turing-complete,” that is, able to solve any problem that a Turing machine can. Ethereum can act as a ‘blockchain computer’ so to speak, executing smart contracts or automating administrative functions. I think this is the area where the most value will be created over time, decentralized applications that sit on top of a blockchain foundation. The analogy to use here might be Linux or a video game graphics engine, and how iterative levels of innovation and application infrastructure have been built on top of them over time. And it is this application layer, as opposed to the protocol layer, where value is going to captured, much like Google capturing value as opposed to the HTTP layer.
Cryptocurrencies and bitcoin are really just the introduction to blockchain technology, the first killer app of the blockchain, so to speak. The next evolution is for more digital assets to be converted to crypto assets, like stocks, bonds, derivatives, etc. Then from there, it will be about trying create a full operating system or platform on a distributed public ledger and building applications on top of that. The technological shift is happening, and there is hype and excesses, but in a way this is a typical precursor to all the eventual innovation to come, which makes it not all that dissimilar to the dot-com bubble.