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May 13, 2021

The New Kids on the Block: Is Crypto a Smart Investment?

The New Kids on the Block: Is Crypto a Smart Investment?

Intro: Discussion around cryptocurrency has skyrocketed over the past year, and so have the prices. What’s driving this inflow of capital and how viable are these technologies as legitimate investment opportunities. Jason Seeb and Vincent Qiao join the conversation to answers these questions by examining the basic concepts of cryptocurrency and the use case for the technology going forward.

Starting out simple, what is Bitcoin?

Vincent: “The Bitcoin is a coin made out of bits.” (Vincent with the early zinger)

Jason: “Bitcoin is the most prominent and largest by market cap cryptocurrency. Basically, it can be transferred from user to user without any intermediaries, operating in a similar way to dollar bills but in a digital form. The transactions of Bitcoin that occur are verified and kept on a public ledger known as a blockchain.”

How many are in existence, can more be created, and what is Bitcoin mining?

Jason: “There are about 18.7 million Bitcoin in existence today, out of the 21 million that can possibly be generated. Essentially, these coins are created through a process called mining. In this process, a very smart person with a very powerful computer solves an incredibly complex math problem, and the output of that transaction is a Bitcoin. The process of mining Bitcoin is lucrative for the miner, being that they are rewarded with the Bitcoin produced, but it is also beneficial for the Bitcoin network, because the mining process plays a role in the verification of Bitcoin transactions and the overall strength of the network’s blockchain.”

Vincent: “To address your question about why we can’t just create more Bitcoin, that’s because the algorithm of this technology will not allow it. That algorithm can’t be altered so there’s no way to change the total possible number of Bitcoins. And theoretically, Bitcoin can be divided infinitesimally, so there is really no need to create more.”

Jason: “One more interesting note. Bitcoin was created in 2008, so over the past 13 years we have mined 18.7 million Bitcoin, but it is estimated that it will take another 100 years to mine the remaining 2.3 million Bitcoin because the task of mining the Bitcoin becomes exponentially more difficult as more and more are mined.”

What are some of those characteristics of Bitcoin that advocates claim make it a superior currency?

Jason: “The first would be its finite supply. It’s a pretty basic economic concept that scarcity gives things more value. The fact that someone can’t go out there and create more Bitcoin means that the Bitcoin that you do have should hold its value because more can’t be produced out of thin air.”

Vincent: “Another characteristic that gets people excited about Bitcoin’s potential is the fact that it is not controlled by a centralized power. The traditional criticism of central banks printing their own currencies is that the currency is essentially a piece of paper backed by the government, but if they wanted to, the government could print more money and flood the market, causing inflation. With Bitcoin, no one has the authority to do that, and even if someone controlled the entire blockchain, they are mathematically prohibited from printing more. Also, on the decentralization note, this excites people because, in general, we have a distrust of traditional institutions. Having a decentralized version of society is many individuals “idealistic” view of how we should operate, so that’s a big reason people are fond of Bitcoin.”

Jason: “The security of the technology is another thing that excites people. I can’t really comment on that without getting very technical, but yeah, it’s very secure.”

Vincent: “At the risk of sounding very very stupid to anyone that has studied this, the Bitcoin system is secure because no single person has the computational power to control over 50% of the existing blockchain. And even if someone had the power to control the majority of the blockchain, and in theory had dominance over Bitcoin, it would be to their economic detriment to do so. That would ruin the decentralized aspect of the coin and the value would plummet. I would like to make a distinction, however. The entire Bitcoin system is more secure, on a relative basis, than the current system we use, but your individual Bitcoin that you hold is no more secure than a US dollar. Someone could hack your computer and take your Bitcoin, just like someone could hack your bank account and steal your cash. But actually, that cash is backed by the government. Once Bitcoin is through the ledger, it is gone and is no more protected than anything else.”

What is the bear argument for why Bitcoin could never replace our current system?

Jason: “There’s a couple reasons that people don’t like the technology. One being that Bitcoin is often used for illegal transactions. I saw something about a guy that flagged a bunch of Bitcoin that had been used in illegal transactions which pushed people away from touching those specific coins. Another thing that people really don’t like about it is the amount of energy that the technology uses; it’s pretty impactful environmentally. The sheer computing power to operate this technology is significant and will increase as the network grows and the mining of coins becomes more difficult. However, I don’t think that either one of those arguments by themselves would stop Bitcoin from being adopted as a common form of currency. I think its more about getting regulators to be ok with this new idea and getting people that aren’t as familiar with this technology to accept a switch from dollars to Bitcoin. Even for myself, I don’t know how comfortable I would feel replacing all my cash with Bitcoin, I think that’s the biggest hurdle facing the currency.

Vincent: “Yeah, as opposed to answering that question, I’d like to approach it another way. Saying why something cannot succeed is less fun than saying why something can succeed. But truthfully, I just can’t find that many arguments that support Bitcoin becoming the primary currency of society. All the supposed benefits that we discussed earlier, (finite supply, decentralized, secure) those are all fine reasons, but they aren’t good enough reasons for Bitcoin to become the most widely used currency. So again, instead of presenting a bear case, I don’t think the bull case is compelling enough in the first place. You can always find bear arguments against just about anything, but that exercise isn’t as useful if you don’t have a bull case to begin with, and I just don’t see it. Evidently, I just can’t dream big enough.”

Talk a little about the argument against Bitcoin being a store of value.

Jason: “For sure. Bitcoin’s history has shown periods of extreme volatility, which makes it unreasonable for Bitcoin to function as a major currency. The dollar also fluctuates in price, but obviously to a much lesser extent. I would theorize that if Bitcoin did become a mainstream currency, the price would stabilize and move much more in line with how we see the dollar move. And the only way for that stabilization to happen would be through market equilibrium.”

Vincent: “My thoughts on the argument that volatility will prevent Bitcoin from becoming a currency is that I don’t think volatility actually matters. Bitcoin is quoted in US dollars. If a transaction needed to happen in Bitcoin, party A would convert US dollars into Bitcoin, pass Bitcoin through, and then party B would instantaneously convert that Bitcoin back to US dollars, so while Bitcoin is volatile, in the case of actual transactions, the timeframe is so minuscule that volatility has no effect. Now obviously if the parties aren’t instantaneously converting USD into Bitcoin and then back to USD and instead are holding the Bitcoin with hopes of appreciation, that’s a different story, but for the utility of transactions, volatility doesn’t matter.”

The price of Bitcoin has exploded over the last year or so. What has led so many investors to pour into this asset?

Jason: “FOMO.”

Vincent: “Yeah I would agree with that. There’s also this argument that you should throw 1% of your net worth into Bitcoin. Worst case you lose 1% of your net worth, best case you have a major advantage in the brave new world that we are stepping into. That’s just a bad argument. When you think about investing, you always think about how the concept of cost of capital applies to your investment opportunities. If you invest in X, then you aren’t able to invest in Y; there’s always a finite constraint. For Bitcoin, you have to define the upside/downside for that capital being deployed in order to actually make a conscious decision to invest or not. The argument of throwing that 1% in ignores that calculation and invests without framing what the probability of realizing the upside is verses the probability of realizing the downside. If you want to invest in Bitcoin after making those calculations, that’s great, but to do so without thinking through those scenarios and just thinking “well it’s Bitcoin so I should throw in 1%” that’s just not thinking. I could give you the name of a penny stock and tell you to throw in 1% of your net worth but you probably wouldn’t do that because you don’t trust the penny stock and you don’t trust me, so how is this any different, why do you trust Bitcoin?”

Is Bitcoin a potential hedge against inflation or a market correction?

Jason: “This is a big argument that people have been having recently because Bitcoin has been going up in an inflationary environment, however, I would argue that based off the economics behind it, this is more of a coincidence and not a true causation. The reason that gold is viewed as an inflationary hedge is because its price is tied so closely to the money supply, there’s a very simple mathematical formula that shows you why gold is an inflation hedge, and that’s not true for Bitcoin.”

Vincent: “To me, Bitcoin is a risk-on asset, meaning that its an asset that people use to speculate. Generally, these assets have a positive beta relative to the overall equity market. Case in point, when the markets crashed in March of last year, Bitcoin also crashed. As a portfolio diversifier, its obviously not perfectly correlated, so portfolio theory would dictate that is it should have a place in a portfolio, but I just don’t see it that way.”

So many investment professionals laugh off the idea of Bitcoin as a serious investment, and maybe for good reason. Is there any part of you deep down that thinks just maybe they are missing something and that this could, in fact, be a massive opportunity that will pass them by?

Vincent: “I would disagree with the idea of so many investors laughing Bitcoin off. It’s clear that, based off its price, a lot of people have identified incredible potential in the currency and its ability to replace the current system. Obviously, that hasn’t happened yet, so people are placing an incredibly high value on the potential call option that is Bitcoin taking over. Its at what, $57,000? That’s not chump change. You will see discourse against the idea of Bitcoin in certain social circles, but it’s evident that individuals with significant capital think otherwise. And who am I to disagree with those who have significant capital.”

Jason: “Vincent touched on it earlier, but I think the question of missing the opportunity comes down to the risk-reward profile of the investment. Obviously, if Bitcoin becomes the most widely used currency, those who own it will have struck gold. I don’t think any rational person thinks that there is a 100% certainty of that taking place, but some people might think it’s a 50/50 chance, others might think that there is a fraction of a percent chance. Those differences in opinion have a huge effect on the investment opportunity’s risk-reward profile, especially when you consider the fact that Bitcoin is at $57,000, with the possibility that the value could crash at any time. So whether or not you think this is an opportunity that you are willing to take a chance on, or not willing to take a chance on, that comes down to what you think the probability of Bitcoin’s adoption as a mainstream currency is and whether or not you are willing to tolerate the event of that not coming to fruition. So, some investors are okay to take the chance of sitting on the sideline and potentially missing a big opportunity because they can’t make sense of the risk-reward profile.”

Switching gears a little. Bitcoin isn’t the only crypto that is getting publicity, what are a few of the others that have seen a rise in investors?

Jason: “The two that have gotten the most publicity are Ethereum and Dogecoin. There’s a bunch more out there though.”

Vincent: “There’s also Litecoin, that’s a fairly well known one, and then there are a bunch of other coins that have been built on top of the Ethereum blockchain.”

What is dogecoin, why did it start, and is it a complete joke or does it have any viability as an investment opportunity?

Jason: “It was started as a joke by two software engineers in 2013. They were basically just being ironic and pointing out the ridiculous speculation that had been going on around crypto currencies. They jokingly created this coin and named it after a popular meme at the time, the doge meme. It works similarly to other crypto currencies in that it can perform peer to peer transactions. And yes, you could make money on it as an investment, but its unbelievably risky.”

Vincent: “Yeah it’s a joke, but I would venture to argue that if you compare Dogecoin and Bitcoin, Bitcoin is only superior on the margin and not really functionally superior. Regardless of it being a joke, you could have invested in Dogecoin on January 1st of this year at $.005 and a week ago it hit $.72, that would have been a pretty decent return.”

Many argue, that more so than any other crypto currency, Ethereum has the greatest potential to be a success, why are people so fascinated with Ethereum and what about the technology gives people this suspicion?

Jason: “It was created to be a better Bitcoin. Bitcoin was originally created to be a store of value and a way to transfer that value from peer to peer, but shortly after Bitcoin was launched, people realized that the blockchain technology that Bitcoin was based on had a lot more potential, so Ethereum is the result of people trying to build on that potential. The blockchain for Ethereum, in addition to having the same functionality as Bitcoin, also has other uses. One primary use is the function of supporting smart contracts through Ethereum’s virtual machine. Basically, with that technology, you can code the blockchain to run itself. Theoretically, you would be able to set up a blockchain to run a business, for example. It could make hiring decisions, balance the budget, figure out how to maximize profits, etc. all without any human intervention. Obviously, we aren’t there yet. I saw someone say that the point in the Ethereum lifecycle that we are in now is equivalent to where mobile phones were in the 90s, still pretty impressive but certainly a ton of room for improvement.”

Vincent: “The fundamental basis for Ethereum being a really high utility coin is its functionality with smart contracts. These contracts can be the foundation for many interesting decentralized financial applications that operate on the Ethereum blockchain. There are many examples of what the application of this technology could look like. One example would be lending platforms. This is the idea that you could lend out your coins and earn interest in return, but at a very high yield. Another application could be the technology’s us for prediction markets. You could write a smart contract that is to send 1 Ether to Jason, for example, if and only if he is able to beat the market today. If he does beat the market, the blockchain enforces this contract forcing me to send the Ether to Jason. To extrapolate the use case out, think about a hedge fund structuring their contracts in such a way. If a hedge fund is able to generate a specific return, the smart contract enacts the payment to compensate the hedge fund for the correct fee without any human intervention. This would eliminate any contract disputes that could arise. Again, we aren’t there yet, but it’s fun to speculate. One thing to note about the current status of Ethereum is that, Ethereum prices have gone up a lot. In conjunction with that, the cost of transacting on the Ethereum blockchain (the gas fee, if you will) has gone up a lot as well. This fee is extremely high at the moment due to both ETH prices rising, as well as many ancillary projects being created, driving up demand. This supply and demand imbalance is not helping the investment case for Ethereum, at least at the moment, so betting on quality ancillary projects based around Ethereum might be a better place to look than directly at Ethereum itself, again, at least for the time being.”

Fundamentally, how do Bitcoin and Ethereum differ?

Jason: “One of the most basic differences between the two is the supply. For Bitcoin, again, there is the limit of 21 million that could ever be mined, but Ethereum doesn’t have a limit, which affects Ethereum’s case for being a store of value. The other major difference between the two is what we discussed earlier, the utility that exists for Ethereum outside of just peer to peer transactions.”

Vincent: “I agree with Jason on that. The main difference between the two is that, though Ethereum and Bitcoin both operate on blockchain technology at their core, Ethereum has the additional layer of functionality that allows individuals to code on top of the platform. That functionality drives much of Ethereum’s utility, but it also allows Ethereum to operate as more of a living and vibrant ecosystem, verses Bitcoin’s more stable store of value structure. I would describe Bitcoin as the “boomer coin” and Ethereum as more of the younger tech start-up.”

In 5 years, what will be more valuable, Bitcoin or Ethereum?

Jason: “I would guess Bitcoin, but I think the price gap will be much closer than it is today.”

Vincent: “Why?”

Jason: “Gut.”

Vincent: “Fair. I really don’t have a thought. I would just say that Ethereum is more of a bet on the underlying technology’s success and Bitcoin is a bet on the adoption of crypto in transactions, so really whichever one of those ideas you think has a higher chance of playing out is the one that will be more valuable.”

John Grayson

Account Executive

John started at Narwhal as an investment intern in the summer of 2019 while working to complete his MBA at Auburn University. After finishing his schooling, John joined the Narwhal team in a full-time role as a client service associate in the summer of 2020. John has been tasked with servicing a portion of Narwhal’s younger client base as well as expanding the company’s management of outside 401k plans. Along with his MBA, John holds a bachelor’s degree in finance from Auburn.

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