What’s in this newsletter?

• What are Cryptocurrencies and Blockchain
• How we think about Crypto at Main Street Research
• Recent developments in the space

What are Cryptocurrencies?

Over the past year, cryptocurrencies like Bitcoin have seen outsized gains and a massive interest from both retail and institutional investors. This has raised the question of whether cryptocurrencies belong in a modern portfolio strategy? So, what is Bitcoin? In 2008, an anonymous person named “Satoshi Nakamoto” published a whitepaper outlining Bitcoin’s technology. In the face of the great recession, confidence in our financial system had collapsed, and then quantitative easing spurred inflation concerns. The original purpose of the bitcoin whitepaper was to address these issues by creating a finite number of coins in a peer-to-peer electronic cash system. This system theoretically eliminates the need for financial intermediaries while also tackling the fears of printing money. Today, with record amounts of government stimulus entering our financial systems in response to the COVID19 crisis, the same inflation fears exist – hence the market and media’s recent attention towards bitcoin.

The maximum total amount of bitcoins that can ever exist is 21 million. Because this number is fixed and cannot be changed, many people compare bitcoin to gold, as they are both intended to be stores of value. A popular way to value gold or silver is a “stock to flow” model that measures the current amount of the commodity available against the flow of new production. When applied to Bitcoin, this model shows bitcoin as “fairly valued” and predicts price increases. However, it is unclear whether Bitcoin is more correlated to gold or to high-tech growth stocks – Bitcoin’s extreme volatility is more similar to technology stocks, but the store of value rhetoric is more similar to gold. Unfortunately, without earnings and cash flows, we can’t value bitcoin like we would a technology company. Nonetheless, institutional buying of Bitcoin is beginning to validate a small allocation (1-3%) to Bitcoin in modern portfolios.

What is Blockchain?

Blockchain is a new type of database technology that stores information in “blocks” that are “chained” together. New data is entered in new blocks that are chained to the previous blocks in chronological order. The most common application of blockchain is for a ledger of transactions. We believe that blockchain technology has already proved its potential to revamp financial services. A decentralized public ledger reduces transaction costs and speeds up settlement. However, Bitcoin is not blockchain. Bitcoin relies on blockchain technology, as do all other cryptocurrencies. It is possible that our society benefits from blockchain, but that bitcoin gets left behind. The sustainability of energy that is used to power the blockchain also remains a major risk. This scenario reminds us of the invention of the internet in 2001 – the technology benefitted society in the end, even though many companies related to the new technology did not survive. There is a plethora of different coins being invented and legacy Bitcoin may or may not survive with so many new entrants. Another coin enjoying institutional interest is Ethereum – which uses is transitioning to a “proof of stake” instead of “proof of work” system. While there are many benefits to Ethereum, we have witnessed many times in history that the system with the most features and complexities does not always prevail. These are the types of risks we are watching, especially since analysts are still learning how to value different types of cryptocurrencies.

The most valuable aspect of blockchain is that records cannot be manipulated. It allows information to be distributed but never copied. No central authority or bank owns or manages the blockchain – instead, it is validated by a wide community of users, which makes it extremely hard to demolish or alter past records. Each blockchain user has a copy of the data since the beginning of the ledger. To change a record, hackers would have to not only change one record, but change every block after it on the chain – which is extremely difficult. Some companies have already implemented new uses of blockchain technology. For example, pharma giants Eli Lilly and Pfizer have developed a blockchain-based system to track prescription drugs across the supply chain to better halt the flow of counterfeit medicines. We are carefully paying attention to the public companies implementing real use cases of this new technology.

Interestingly, the popular crypto trading platform Coinbase is a centralized exchange that charges high trading fees. We believe that maintaining the decentralized nature of the blockchain is imperative for cryptocurrencies to retain their value and that eventually Coinbase may turn into an “on and off ramp” into the crypto world. The irony of their business model, along with their frothy valuation, made us hesitant to buy into the recent Coinbase IPO. We believe the best way to gain exposure to cryptocurrency is to directly buy the coins to reduce the layering of fees, or to use a vehicle that can be traded in a traditional brokerage account, such as the Grayscale Bitcoin/Ethereum Trusts (GBTC or ETHE).

Recent developments in the Market

This past week, the crypto markets had a historic downturn that saw prices of Bitcoin drop as much as 40 percent on Wednesday. To the average investor, this may seem highly unusual, but for the crypto markets this kind of volatility is considered normal. Cryptocurrency markets are highly volatile, over-leveraged, and can experience lower liquidity – this combination means that price fluctuations can happen rapidly and violently. This past week’s volatility can be attributed to many things:  fear, uncertainty, and doubt surrounding environmental concerns and regulation in China, Elon Musk’s tweets, and more.  Overall, the “sell the news event” combined with over leveraged markets and low liquidity has created a cascading effect.  

How We Think About Crypto

Does the recent drop in crypto prices indicate a buying opportunity? While the asset class as a whole rapidly lost $1.3 trillion in market cap, Bitcoin is still up 20 percent year to date. The bearish case is that the asset is still very speculative, and that a 50% drawdown could signify the end of the bull cycle. Increasing environmental concerns could slow institutional interest. The stimulus packages that have been fueling inflation fears, and therefore bitcoin, are also likely to slow down.  On the other side of the (virtual) coin, wiping out leverage means that further liquidations are less likely, and this could indicate a good entry point.  Historically, these types of drawdowns in virtual assets have been viewed as healthy.  In fact, such rapid increases in any financial instrument make us wary, but bitcoin’s normal dips are simply larger than what most investors are used to seeing in blue chip stocks. Additionally, many legacy financial institutions have filed with the SEC to open crypto ETFs and have started to spend more money on researching blockchain technology. Whether the bull or the bear prevails in digital assets, we believe that cryptocurrencies will have a part in the future of finance and technology. Although the market is still highly speculative and it has a market capitalization of over $750 billion, it can sometimes trade primitively. This volatility and speculation should be kept in mind as the space develops. We are watching, listening, and learning about this new space regularly and keeping our clients informed is a part of our process.  

We hope this research update is helpful – if you have any questions or would like to discuss further, please do not hesitate to reach out.