George Athanassakos is a professor of finance at the University of Western Ontario’s Ivey Business School, where he holds the Ben Graham Chair in Value Investing.
Investors are looking to alternative investments to preserve their wealth from degradation if inflation is not “transitory,” but “permanent,” as it has been for the past 30 years. Digital coinage, such as BTC, has become a popular alternative in recent years and has achieved some currency.
Bitcoin (BTC) arose in the aftermath of the 2008 financial crisis, which resulted in a massive increase in central bank liabilities. At the same period, private and public debt issuance increased dramatically.
This brought to light the fact that global economies have been living beyond their means for some time. It was feared that inflation and devaluation of fiat currencies would happen.
Because BTC provides a way to sidestep governments and central banks, the reduction in faith in the financial system has increased demand for cryptocurrencies like Bitcoin.
Is this, then, what distinguishes Bitcoin from other cryptocurrencies?
Bitcoin embodies two innovations: blockchain technology, which is a public ledger that contains all transaction data dating back to the creation of the cryptocurrency, and decentralized governance. It is managed by “miners,” who are paid to keep the supply of Bitcoin very steady.
Bitcoin’s theoretical roots can be traced in Austrian School economics teachings and Friedrich von Hayek’s works, who argued that private banks should be able to issue their own money.
Central banks, like Gold, are unable to print Bitcoin. And, like gold, the quantity of Bitcoin is limited to 21 million coins, which is calculated by an algorithm. After performing computationally hard operations that are required for the Bitcoin system to function, new Bitcoins are made. Every year, however, only a small number of Bitcoins are “mined.”
Due to the increased demand for Bitcoins as a result of the hype, media reports of increasing prices, fear of missing out, and ignorant speculators, as well as the feedback loop that follows, a serious demand-supply imbalance has developed. As a result, Bitcoin prices have soared.
Having said that, Bitcoin investors will eventually need to ask themselves questions like:
First, how much is BTC worth?
Is Bitcoin a form of currency?
Is Bitcoin a type of asset?
Finally, what rights does Bitcoin give you?
When I teach valuation at Ivey Business School, I refer to value as an economic or fundamental value, which refers to an asset’s ability to provide a stream of after-tax cash flows.
What are bitcoin cash flows, and how do they work? None!
What is Bitcoin’s current market value? Or, to put it another way, what makes it valuable? Is it because a large number of persons believe it is valuable? Is it valuable because it’s cool, and we expect others, particularly those in the online community, to think so? Do investor demand dynamics matter as much as fundamentals?
“Prices move because people do things regardless of fundamentals,” said Xavier Gabaix and Ralph Koijen in a recent paper. They explain in their work, In Search of the Origins of Financial Fluctuations, that the amount of money going into the markets, regardless of fundamentals, can have a significant impact on share prices. They do, however, conclude that prices will return to fundamentals in the long run. However, how long is a lengthy run?
Is Bitcoin a form of currency? It isn’t, because it fails to perform the three essential tasks of money: store of value, unit of account, and medium of exchange. Bitcoin is very volatile, illiquid, and incapable of processing massive volumes of transactions.
Bitcoin is neither a real estate nor stock asset because it does not generate or expect to generate cash flows at all, and it is also not a bond for the same reason. It also doesn’t have the same inherent worth as gold. Gold is considered precious due to its unique traits and attributes, such as being the best conductor, being more malleable, being able to be used to manufacture tools and jewelry, and being able to be worn, among other things – something we cannot accomplish with bitcoins.
Other markets, such as the stock market, have no association with Bitcoin. The correlation coefficients between Bitcoin returns and those of the S&P 500, Nasdaq, Russell 2000, and S&P/TSX, for example, are 2%, 3%, 5%, and 4%, respectively, none of which are statistically different from zero. As a result, Bitcoin cannot be utilized as a hedging tool. Despite the bull market of 2018 and 2019, the value of bitcoin has plummeted.
Furthermore, government regulation erodes Bitcoin’s value proposition. Several central banks have stated their intention to establish their cryptocurrency. Government measures that are unfriendly to Bitcoin (for example, in China) make bitcoin more vulnerable and less appealing.
Every generation has to learn the hard way how to do things. Now it’s the turn of millennials, who are obsessed with all things digital. It’s time to educate yourself on the dangers of fads, whether digital or analog.