Author: Ben Ashby and Gerard Fox
Ben Ashby from the CFA UK Future of Money Working Group, and co-author Gerard Fox analyse the world of Bitcoin and its impact on the industry
There has been a rush by investors to draw up plans to either directly benefit, or even just survive, the rapid changes in the financial and technological landscape. They are right to be worried. There are profound changes afoot both from technology and also the unknown consequences of the large-scale monetary experiments by Central Banks.
A simple example of the consequences of this monetary policy can be seen in the European Union’s own accounts. This has seen its own pension liabilities balloon from an already deeply concerning €37.2bn deficit in 2009 to a simply stunning €97.6bn deficit[i] in 2019. Whilst many asset prices have done well, liabilities have exploded in present value terms due to collapsing nominal and real bond yields. A reading of various papers by the European Insurance and Occupational Pensions Authority (EIOPA) shows similar issues in large parts of the insurance sector with the problems delayed by a series of regulatory waivers that provide temporary relief. To use City parlance, the balance sheet is being put through the P&L.
Investors have reacted to these problems in a number of ways, with many taking on more risk or illiquidity and, in many cases, both. Capitalising on investors’ distress, a number of high-profile market commentators have talked about the role new digital currencies will play in this landscape. Some have claimed that these products offer salvation through superior potential returns as well as a variety of portfolio diversification benefits, such as a hedge against future risks. Indeed, some firms and investors have gone even further and started to introduce ‘digital assets' into their portfolios.
We at Good Governance Capital (GGC) strongly disagree. Whilst the problems related to negative yields may not be errors of entirely of investors own making, compounding it with unproven and questionable alternatives such as crypto - that introduce a whole new raft of potential risks – does not appear to be a prudent solution either. In this paper, we explore our concerns in more detail.
Enter the Technoking of Mars[ii]
Amidst a great deal of publicity, Tesla recently announced a significant portion of its cash balances had been placed into Bitcoin and, moreover, the company would start accepting the cryptocurrency as payment. In its SEC filing, Tesla stated this was done to achieve “more flexibility to further diversify and maximize returns on our cash”. Its CEO Elon Musk additionally stated that “Bitcoin is on the verge of getting broad acceptance by conventional finance people”.
Microstrategy, a US firm, invested an even larger percentage of their balance sheet in Bitcoin and went further in claiming that “Bitcoin offers additional opportunity for appreciation in value with increasing adoption due to its limited supply”[iii] despite the firm’s core business being software, not investment management or economic forecasting.
Tellingly Tesla - itself - does not describe its Bitcoin holdings as cash or even an investment but as “specified alternative reserve assets” - whatever that means. Microstrategy describes its Bitcoin holdings, more in line with current fashion, as “digital assets” in its accounts. Though, in both cases the accounting treatment is clear, they are booked under ‘intangibles-goodwill and other’[iv]. This implies that its value is hard to ascertain, and it most certainly isn’t cash for regulated accounting purposes.[v] Absent liabilities or accounts payable/receivable whose unit is measured in Bitcoins, Tesla has basically increased its balance sheet leverage by swapping out of US dollars and into cryptocurrency. As if its stock price was not already sufficiently volatile.[vi]
It is often overlooked, but companies are generally free to accept whatever they want for payment: airmiles, shares, crude oil or even tulip bulbs. Indeed, all of these items have been used in the past. However, just because individual companies are prepared to engage in barter it doesn’t mean these items of exchange are about to become mainstream monetary instruments either.
So what is money?
Classically, money has been identified to have at least three key features: a store of value; medium of exchange and a unit of account. In a broader sense, money is able to extinguish all private sector and government claims, be it past, present or in the future. Bitcoin struggles under all these criteria and in many ways is less adequate than old forms of commodity-based money such as gold. A more detailed analysis of this can be found here[vii] and for CFA members here[viii].
The first big issue that Bitcoin runs into is that it is far too volatile to serve as a medium of exchange and though ‘mined’ its supply has an arbitrary hard cap of 21 million units. This suggests – if nothing else - that issues around fragmentation will be a continuing issue. It also means that any financial system based on it would almost certainly be extremely deflationary, which presents its own issues.[ix] Though it may be accepted for transaction by some private sector entities, it is not an official unit of account, which crucially means you cannot directly pay your taxes with it. As we wrote in our previous article, we cannot see any advanced country willingly giving up its monetary monopoly.[x] [xi]
Behaviourism & Financial Innovation
That is not to say there may be some highly subjective value in Bitcoin or indeed all crypto currencies; beauty is in the eye of the beholder. The famous economist, Lord Keynes famously called gold “a barbarous relic” but it was reported that he had latterly said he had overlooked ‘it was also a human fetish’. In essence, Keynes may not have seen much value in gold, but other humans did. Perhaps this is where Bitcoin’s redemption lies?
The value of gold certainly has certain behavioural qualities in light of its reduced monetary benefits and limited industrial properties. In a historical context, gold was money because it met all the above set criteria but crucially and often overlooked because many states officially backed gold as money. These are qualities and a pedigree that crypto lacks. We suspect most investors will continue to have faith in the tax raising and legislative powers of advanced sovereign states, even under the perception that these are being squandered or misdirected.
Many crypto enthusiasts claim faith in a widely distributed ledger and ‘in the math’ of crypto but conceptually it’s no different to ‘the math’ used in any other software program. Additionally, as Lord Keynes observed that “human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectations, since the basis for making such calculations does not exist”. This issue of false precision is one we will return to later, but we remind readers of an observation we made in our previous paper. Which is the knowledge gap between those with backgrounds in technology, making sweeping statements, and the long evolutionary history of modern financial markets into which they are venturing.
Some of the alleged intrinsic value claimed for Bitcoin is due to its exorbitant energy consumption or the arbitrary cap on units. But these seem to be well known cognitive fallacies rather than anything to do with true value. Hence the recent behaviour of crypto, especially given the exceedingly loose financial conditions and the rapid price increases, could well be driven by “the madness of crowds”[xii] and the ‘bandwagon effect’; which is essentially a fear of missing out or FOMO.[xiii] This is a common feature of bull markets. As Charles Mackay said, “Men it has been said, think in herds; it will be seen that they go mad in herds, while they only recover their sense slowly, and one by one”. Crowd behaviour could well rapidly change with evolving circumstances and incentives.
That said, to some of its more vocal advocates, Bitcoin does seem to have a strange sort of utility at an individual level. Some describe a world where the existing financial order has or will be broken down. Like modern goldbugs, the other tribe of ‘financial survivalists’ the question has to be asked: Taken to its logical conclusion what kind of world exists where the international monetary order and the tax raising power of major states have broken down. Under that scenario, are you still going to be able to rely on your software to pay for things? We like Mad Max movies too, but we didn’t see too many internet cafes in the apocalyptic wastelands. So, it appears to be ideological or psychological rather than logical.
Assuming these advocates are correct, before we even get to such dystopian conditions, it is far more probable the State would have confiscated your crypto as the US did in the 1930s with gold.[xiv] We note that the modern US State has already started imposing its tax raising powers into the crypto world.[xv]
Specific problems of Bitcoin and first-generation crypto
Unfortunately, crypto’s problems do not end there. There is an old joke in the crypto community that Bitcoin has a lot of new and good ideas. Unfortunately, the new ideas are not good, and the good ideas are not new.
As we highlighted in a previous piece there are serious issues around Bitcoin’s ESG credentials. It is our belief that due to these an unpleasant rendezvous with various governments remains highly probable. Tesla itself appears to recognise this and broader legal risks in their SEC filling “we expect to begin accepting Bitcoin as a form of payment for our products in the near future, subject to applicable laws” (emphasis is ours). Microstrategy mentions the risk that Bitcoin could cause increased regulatory scrutiny. Indeed!
But the issues go deeper than this as Bitcoin and Ethereum are also plagued with engineering issues of their own design. Aside from the profligate energy usage, there is the so-called trilemma: scalability; security & decentralisation. Where you can achieve two but not all three and therefore give up significant functionality as a payment medium. This lack of scalability has caused some people to describe early cryptocurrencies as a ‘toy town payments system’.[xvi] But a payment system is not a currency. This also seems to very much run against the claims of some of Bitcoin’s proponents who claim it now has positive network effects when the system has such obvious limitations. It also leaves Bitcoin very vulnerable to being superseded by another superior product both as an asset but also payments system.
The problems of liquidity and ‘near cash substitutes’
As Keynes identified, money partly derives its “importance from having a greater liquidity premium than any other article”[xvii]. Often these alternative ‘near cash instruments’ are shorthand for short-dated pieces of credit in one form or another. Historically, certain commodities such as metals played the role of near cash but only because the state accepted it as so. In a debt based financial system, all assets accepted as collateral by central banks act as ‘near cash’. This impacts the price of all assets that match this criterion, a fact not often understood outside the world of bank treasuries.
In considering crypto as part of a cash substitute in a portfolio, the recent problems for investors in the speciality financing company Greensill highlight the perils in less transparent or liquid ‘near cash’ substitutes that sit outside a Central Bank’s purview. Again, Tesla appears to recognise this risk with regard to its Bitcoin holding and describes it as “maximise returns on…cash that is not required to maintain adequate operating liquidity” (emphasis ours), so it sits outside the corporate liquidity pool.
Microstrategy goes further in its 10k stating that their Bitcoin strategy exposes them “to various risks associated with Bitcoin” which includes: “regulatory scrutiny”; “they may not be able to serve as a source of liquidity” and “security breach or cyberattack” at their third-party custodians; a key reason why getting insurance for this is so difficult.[xviii] A series of new risks appear to have been accepted in return for some very uncertain benefits.
The illusion of false precision
But what about some of the other claims made by crypto enthusiasts of its benefits? Such as Bitcoin is “untethered to sovereign monetary policy and can therefore serve as a hedge against inflation” as Microstrategy puts it. For those investors keen to acquire “specified alternative reserve assets” as a means of diversification or an inflation hedge, can this be tested?
Before digging down to the issue of modelling crypto itself it's perhaps worth taking a wider view of the entire issue of financial modelling. Whilst finance draws heavily on maths and statistics it is not a ‘natural science’. Even if it was a ‘true’ science, many people forget that science itself is a continuing process[xix], where theories hold until more data and evidence disprove them. [xx] Even then, this process of scientific change is often hard as Thomas Kuhn described[xxi] or as Max Planck more bluntly put it ‘science progresses one funeral at a time’.
Finance, therefore, encompasses a huge field stretching from essentially modelling human behaviour based on past - often flawed - data whilst assessing how the global economy will behave, which itself is a huge complex adaptive system.[xxii] Hard learned lessons are often forgotten as market cycles and participants change. As the famous US market commentator Jim Grant put it “progress is cumulative in science and engineering, but cyclical in finance.”
From this, we move to the subject of modelling essentially what is the ‘behaviour’ of Bitcoin. First, even if we assume that Bitcoin has some sort of objective value, any serious analysis of crypto’s merits has to be set against a track record of just over a decade’s worth of observations during a period of quite extraordinarily loose financial conditions. We do not believe these could be described as ‘normal’ conditions from which to derive data and form a thesis, let alone make predictions. Secondly, the data itself is also very ‘noisy’ and deriving any true signal from the noise is extremely tricky.
Despite these already weak foundations, we see a spectrum of claims from various markets and even academic sources that range from simple apophenia – or pattern recognition - at the more basic end through to complicated statistical analysis at the more sophisticated. Even where more sophisticated analysis has been used there often seems to be additional deficiencies of method such as simple data mining and overfitting models to produce ‘HARKing’[xxiii] through to what appears to be ‘p-hacking’ [xxiv]. We question the entire merit of such endeavours.
The House always wins? – Central Bank Digital Currency
Whilst we remain deeply sceptical on Bitcoin and its first-generation peers. We think it’s likely that this vast amount of innovation and capital expenditure will leave some residue on the financial sector, thereby laying the foundation for change. Perhaps the real beneficiaries will be the central banks? They have certainly shown an interest in digital money with a rash of papers and proposals on the subject of Central Bank Digital Currency (CBDC).[xxv], [xxvi] This is an issue that we intend to explore in more depth later.
Buy in haste, repent at leisure
In summary, change is coming. The world’s financial system is likely to see huge changes over the coming years as both the economic policies of the last few years collide with technological advances.
Many well-known firms are likely to fall by the wayside, replaced by more agile and evolved competitors as incumbents fail to adapt. We see many areas for this in finance. For example, whilst we have focused on crypto the wider wealth management industry seems particularly ripe for disruption as both generational and technological changes occurs. As Max Planck put it “innovation rarely makes its way by gradually winning over and converting its opponents.” “What does happen is…that the growing generation is familiarized with the ideas from the beginning: another instance of the fact that the future lies with the youth.”
That is not to say there won’t be many false starts, wrong moves and unenforced errors. We wonder if Bitcoin may fall, ultimately, under one of these?
It fits no recognised definition of cash nor does it seem to offer any intrinsic value. Given its engineering limitations its general utility even as just an alternative payments system appears to be very questionable. Therefore, its value largely seems to rest on the treacherous grounds of the opinion of ‘the crowd’. Further, given these uncertain foundations - and the limited data that covers its entire existence – we question how it can be effectively modelled? It may well appreciate and offer protection against inflation or it may crash in tighter or even more inflationary financial conditions. It could also be regulated into a stranded asset or worse become useless due to wider evolutionary changes in the financial system such as CBDC. For its believers, Bitcoin appears to be more an article of faith than objective fact.
Which makes Tesla’s Bitcoin holdings even more remarkable. The company’s board may well be happy to accept Bitcoins on the balance sheet, but not all firms have a CEO that has visions of living on Mars either. It seems to serve, at best, a very limited corporate purpose for the firm since it does not appear to be required for working capital or other operational needs. Whilst it doesn’t have credit risk – in the conventional sense - it offers no yield though it does inject material amounts of market risk onto the balance sheet. It also suffers from serious issues of liquidity, especially when compared to more conventional money. It also introduces new and hard to quantify risk such as cybersecurity or regulatory. For us, it raises more questions about Tesla than anything else.
None of us can accurately predict the future and it's possible Elon Musk gets his dream of ‘Life on Mars’ but we suspect with regards to Bitcoin itself the odds are stacked against it. Our view is it will - at best - remain a ‘god-awful small affair’[xxvii] but for more terrestrially focused investors we worry it’s more likely to leave an impact crater.
Gerard Fox is a Consultant at Good Governance Capital. He is a Director of the Regulatory Policy Institute. He Chairs the East Sussex Pension Fund Committee and has steered major changes to the Fund seeking to better align it with the challenges and opportunities associated with the Energy Transition. A member of the Corporate Programme Advisory Group for the Institutional Investors Group on Climate Change (IIGCC), he is a Chapter Zero member. He is a former Managing Director of Credit Suisse. Gerard@GoodGovCap.com
Good Governance Capital is a strategic consultancy helping clients bridge the gap between innovative and traditional finance through the use of our expert network, applied data science and technology. See LinkedIn page.
[v] IFRS also requires cryptocurrency to be recorded under IAS 38-Intangible assets as an identifiable non-monetary asset without physical substance. Additionally, Microstrategy’s auditors also clarifies, under critical accounting matters, that auditor judgement was required in “assessing the existence of the digital assets and whether the Company controls the digital assets”.
[xii] Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay.
[xvi] Libra Shrugged: How Facebook tried to take over money by David Gerard
[xvii] General Theory of Employment, Money and Interest by John. M. Keynes