The Looming Financial Crisis: What Will Happen To Bitcoin?

So… What will happen to Bitcoin?

Scenario 1

During a ‘euphoric market’, retail and institutions are more risk-seeking, investing in assets that have a higher yield potential. As shown in Figure A, high(er) risk assets, such as the VanGuard FTSE Emerging Markets ETF and the Australian Dollar, saw great returns. You may have also noticed that gold, also had similar returns, and this was partly due to the ‘Commodities Supercycle’.

However, there’s no doubt that the investments to first get liquidated are the ones that carry the highest risk; institutions and retail both require cash-flow during a financial crisis and the most logical investments to get sold are the highest risk ones. Alternatively, they might seek to minimize risk by investing into ‘safer’ investments, such as, the iShares 20+ Year Treasury Bond ETF, Gold, etc.

In Figure B & C, you can clearly see that the assets that got hit hardest during the economic turmoil, were the riskier ones. The VanGuard FTSE Emerging Markets ETF and Australian Dollar taking a ~80% hit (from their all-time-high between 2006 and March 2009). In comparison, ‘safer assets’ took a hit of ~30%.

Now that’s out of the way, it would come as no surprise that Bitcoin could get into trouble during a financial crisis, as it can be considered a high risk investment, due to:

  • Market Risk — Bitcoin has only been around for nearly 10 years and still remains a highly speculative asset that is purely driven by supply and demand. The only reason why Bitcoin holds value today, is because of the growth expectation and possible future real use cases.
  • Regulatory Risk — As Bitcoin is a step away from the ‘traditional financial system’ and has the ability to be (more efficiently) used for nefarious purposes, governments agencies have been trying to find a way to regulate it. However, due to the nature of Bitcoin, this has proved to be extremely hard and the ‘the lack of uniform regulations about bitcoins (and other virtual currency) raises questions over their longevity, liquidity and universality.’
  • Security Risk — Given the nature of the blockchain, where all transactions are final and irreversible, security is a great risk. Once Bitcoins have been transferred from Party A to Party B, the only way for have them returned back, is for Party B to explicitly refund them. Since Bitcoin-related activities (wallets, exchanges, etc.) live in the digital world, they are open to hackers, malware and operational errors. For example, once a malicious actor gains necessary access on an exchange to illegally transfer Bitcoins from the exchange to his own wallet, there’s no way to reverse such action. There have been number of exchange hacks, most notably, the Mt. Gox hack in 2014, which led to losses in excess of $450 million at the time.
  • Insurance Risk — Depending on jurisdiction, some traditional investments are insured through a number of schemes, such as the Securities Investor Protection Corporation (US), the Federal Deposit Insurance Corporation (US) or the Financial Services Compensation Scheme (UK). Most exchanges (and accounts) do not have such federal/government protection and are mostly self-insured.
  • Fraud Risk — Since Bitcoin is pseudonymous and has a low entry barrier, it carries a larger risk of being used fraudulently. Scammers and fraudsters have a much easier time selling ‘false’ Bitcoins, in comparison to, a bond or a stock.

Scenario 2

Gold has long been considered a ‘safer asset’ during times of economic turmoil and this can be proven by the charts above. Gold took a hit of ‘just’ 30% during The Great Recession, in comparison with other assets that took losses of over 80%.

Bitcoin has been long-called ‘digital gold’, for a number of reasons. Although Bitcoin set out to become a ‘digital currency’, it also performs exceptionally well as a store of value. It shares a number of characteristics with gold, such as:

  • Scarcity —It’s quite hard to gauge how much gold is in circulation and what the total supply could be, but there’s no denying that gold is scarce. Similarly, there can ever be 21M Bitcoins minted (as of today, we’ve minted ~17.5M Bitcoins).
  • Durability — Although gold can wear slightly if not handled properly, both gold and Bitcoin are extremely durable. Gold doesn’t rust nor corrode and Bitcoin can’t be destroyed nor altered, even if the internet was to disappear. They can both stand the test of time with no impact to their composition.
  • Fungibility — The property of a good or a commodity whose individual units are essentially interchangeable. One ounce of Gold will always be equal to another ounce of gold (given the same purity) and similarly one bitcoin is always equal to another bitcoin.

In addition, Bitcoin has (even better) properties, that gold doesn’t. These include:

  • Storage — Bitcoin is digital, gold is physical. Storing Bitcoin is extremely easy, whereas, storing gold isn’t as straight forward (nor safe). Many gold investors use third-party vaults, bringing cost and risk. In addition, carrying gold along is quite inconvenient as it has some fixed allowance limits and also creates high possibilities of theft. On the contrary, Bitcoin is stored in a digital wallet and has no physical space requirement. Digital wallets can easily be restored using a seed phrase, in the event they are no longer accessible (i.e. new phone).
  • Security —This comes down to how securely an individual stores his gold (physically) or Bitcoin (digitally). Obviously, it’s much easier to securely store Bitcoin than gold and that’s why third-parties are often involved in gold storage, which brings greater risk.
  • Portable — Bitcoin can be ‘carried around’ much easier than gold. Gold is inconvenient to carry around (fixed allowance limits) but also comes with a greater risk of theft. On the other hand, Bitcoin can be carried around with just your phone. Portability brings a host of other benefits, which I will discuss below.
  • Divisible —Although gold can be divided, it can’t be divided easily nor in a highly precise manner. On the other hand, Bitcoin can easily be divided down to 8 decimal places (with possibility for more).
  • Method of Payment —As noted above, Bitcoin set out to be a ‘digital currency’ and can still perform pretty well as such (despite a few technical limitations which are being worked on). Although gold can be traded electronically (exchanges, etc.) it can’t really be considered a currency as you can’t just rock up to a grocery shop and pay with gold, whereas, you could easily do that with Bitcoin (given necessary framework is in place).
  • Finite Supply— Although, in theory, gold is scarce, there is a possibility, that more gold can be mined (undiscovered gold deposits, meteor mining, etc.). On the other hand, Bitcoin will only ever have 21M coins minted, period.

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