A highlight of 2017 financial markets has been the explosion of interest in cryptocurrencies. The price performance of Bitcoin and its crypto brethren has been nothing short of spectacular. Recently, Bitcoin vaulted 445 percent from its March 25 close of $960 to an intraday high of $5,234 on Oct. 12. During the same span, the market capitalization of the digital currency universe increased more than 600 percent, from $23 billion to $162 billion. By comparison, the coincident performance of gold bullion has been entirely pedestrian, rising some 4.0 percent. Needless to say, these widely divergent performances have fostered speculation that Bitcoin has usurped gold’s role as a “store of value.”
It seems reasonable that much interest in cryptocurrencies arises from concerns similar to those motivating gold investors. In short, resentment is mounting over the financially repressive policies of global central banks. Beyond this similarity, however, the investment merits of gold and Bitcoin appear to be substantially different. In recent periods, gold has continued to function as a reliable store of value and productive portfolio-diversifying asset. In contrast, Bitcoin’s current investment merits appear best categorized as potent speculation. Bitcoin can play a productive role in many portfolios, but that contribution will be entirely different from that offered by gold.
Bitcoin is the market leader in the emerging asset class of digital currencies. Importantly, Bitcoin is based on blockchain technology, which is essentially a distributed database used to maintain a constantly growing list of records, called blocks. By all accounts, the blockchain is potentially the most disruptive technology since the advent of the Internet. Its applications are virtually limitless. However, it is important to differentiate between the blockchain and Bitcoin. They are not one and the same. Bitcoin is simply the leading brand in the blockchain’s first emerging application (digital currency). While Bitcoin’s lead in cryptocurrency is currently substantial, there is no guarantee Bitcoin will ultimately prove to be widely adopted.
It is ironic that Mark Andreessen, one of the most powerful voices for the blockchain and cryptocurrencies, was also a cofounder of Netscape. Just as Netscape was once the undisputed market-leading browser in an emerging technology called the Internet, Bitcoin is now the undisputed market-leading crypto in an emerging technology called the blockchain. It is far too early for definitive evaluation of Bitcoin’s long-term prospects, much less to compare Bitcoin to gold as a store of value.
Quite simply, gold is gold. For more than 5,000 years, an ounce of gold has been exactly the same: an ounce of gold. There are no variations or imitations. Central banks hold gold because of its extraordinary density, rarity and immutability. Gold is virtually indestructible.
Bitcoin, by comparison, is a string of code generated by software protocols and cryptographic algorithms. While a sophisticated programmer might take comfort in the technological impregnability of the blockchain, this type of intellectual security eludes many investors. Further, since operation of the Bitcoin network is increasingly concentrated in the massive computer farms of a limited number of programmers, a human element is being introduced. Because humans eventually do what is best for themselves, network concentration may lead to unforeseen protocol changes sooner than many recognize.
An intellectually attractive aspect of Bitcoin’s design is its strictly limited supply. Bitcoin’s total circulation is hard-capped at 21 million units. As of Oct. 12, Bitcoin in circulation totaled roughly 16.619 million units. Strict limits on the amount of potentially issued Bitcoin lend a discipline and scarcity-value to Bitcoin notably absent from global fiat regimes. However, while the ultimate number of Bitcoins may be limited in supply, there is absolutely no limit to competing cryptocurrencies. Bitcoin’s meteoric price appreciation has spawned one of the fastest growing “industries” of competing products ever witnessed. As of Oct. 12, crypto-monitoring website coinmarketcap.com reports the total number of cryptocurrencies had ballooned to 1,159.
Because gold investment decisions are often fueled by emotion, precious metals have earned a reputation for volatility. Gold’s commodity characteristics expose the metal to the trading patterns of limits, stop losses and aggressive trading tactics popular on the COMEX. Additionally, over long spans, gold can post high-percentage moves reflecting changing economic and monetary conditions. Despite these price variations, gold has remained throughout the years an effective store of value as measured by a myriad of divisors, from the cost of a man’s suit, to barrels of oil and everything in between.
In contrast, volatility of digital currencies is off the charts. Bitcoin’s history to date has been characterized by upward price shocks, followed by equally rapid downward corrections. By way of example, Bitcoin exploded 446 percent in less than a month in November 2013, before falling 53 percent by mid-December. Amid the current Bitcoin advance, two-day 15 percent corrections occurred during the weekends of July 14 and Sept. 1. In one particularly rough stretch of 2017, the top-50 digital currencies posted declines between 25 percent and 70 percent in the three weeks ended July 16. No asset class with broad-based declines averaging 50 percent in a three-week span should logically be confused with a store of value.
For thousands of years, gold has been an alluring target for plunder and theft. Just this past March, thieves used a ladder, a rope and a wheelbarrow to cart away 220 pounds of 24-karat gold coin worth $4.2 million from a Berlin museum. To most, however, there exist a full range of bulletproof options for bullion safekeeping. By contrast, Bitcoin still presents nettlesome hurdles for safekeeping. As infallible as blockchain code may be, Bitcoin storage still involves a wide range of Internet-type vulnerabilities.
Marc Andreessen suggests that the truly disruptive breakthrough of Bitcoin is that its technology enables a “distributed network of trust” in which the blockchain allows “one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure.” In essence, the blockchain empowers trust in substitute for knowledge of counterparties. This trust element is the key in enabling decentralized commerce, eliminating legacy needs for traditional trust providers such as banks and credit card companies (which charge high fees and are increasingly hacked). While the level of trust provided by the blockchain may be sufficient for speculative transactions such as flipping Bitcoins for a profit, for Bitcoin (and the blockchain) to reach full potential, an element of institutional trust and oversight will eventually be required.
Gold, on the other hand, is an investment asset with a strong legacy of trust and oversight. Gold coins and gold bars are minted and refined to precise parameters for size, weight and purity. Institutional volumes of bullion are generally stored in the literal epitome of trustworthiness: impenetrable vaults. Similarly, individual investors generally store their gold bullion at repositories which have earned their utmost confidence, such as local banks or established bullion custodians. It will be difficult for the blockchain to inspire widespread investor trust until some form of institutional oversight is introduced.
While Bitcoin may represent an attractive portfolio diversifier for individual investors, its relatively tiny market capitalization is unlikely ever to compete with the depth and liquidity of gold markets. Bitcoin’s market capitalization on Oct. 12 measured roughly $86 billion. While this is an impressive jump from Bitcoin’s March 25 market cap of $15 billion, there are several global entrepreneurs whose individual net-worth exceeds the entire Bitcoin universe. In contrast, the above-ground gold stock measures more than $7.8 trillion. Subtracting always-fungible jewelry and central bank bars, the readily investible gold stock approaches $3 trillion at current prices.
In short, Bitcoin and cryptocurrencies are a fascinating development with far-reaching implications for the global payment system. Digital currencies offer freedom from traditional payment systems such as banks and credit cards, which charge high fees and are increasingly hacked. And, of course, cryptocurrencies have generated tens-of-billions of dollars of trading profits, in a very short period, for a growing list of speculators. It is still far too early, however, to assess survival probabilities for any cryptocurrencies, much less compare them to gold as a store of value. Only time will tell.
Trey Reik is senior portfolio manager at Sprott Asset Management USA.