Lina Smith

There comes a point in every investor’s journey when he must admit he is wrong about something. In my case, I was wrong about bitcoin and whether it would ever be considered a legitimate asset class. This realization dawned on me in the last month when the price of bitcoin passed its December 2017 highs of $20,000.  My prior belief was that bitcoin wouldn’t surpass these highs for many years, if at all. I didn’t think that bitcoin was “going to zero,” but I also didn’t think it would eclipse its December 2017 peak anytime soon.

Now that it has surpassed that peak by over 50%, I have come to realize that bitcoin isn’t the one-trick pony I thought it was. As Paulo Coelho wrote in “The Alchemist“:

Well, here we are again. Bitcoin is on another spectacular bull run and investors are taking notice. Now that bitcoin has survived (and thrived) beyond its 2017 peak, many investors who used to see it as a joke are now realizing it isn’t one. I am one of them. 

I have changed my tune on bitcoin, but not because of many of the arguments put forth by bitcoin bulls. For example, bitcoin bulls have claimed that bitcoin would be used as a currency, that the U.S. dollar would plummet in value and that the halving in May 2020 would increase bitcoin’s price. They were wrong on all counts, yet bitcoin’s price has still gone up.  

What the bitcoin bulls were right about was increased adoption and the ability of many bitcoin owners to hold (“HODL”) even as prices rose dramatically. These two effects (more demand from buyers and reduced supply from sellers) have helped to boost bitcoin’s price and cement it as a legitimate asset class within the investment community. As a result, bitcoin has become a form of digital gold. You may not agree with this assessment, but if you still think bitcoin is “going to zero” you should reconsider your assumptions.

The problem with arguing that bitcoin is “going to zero” is there are too many investors who are willing to buy it at a price far above $0. I remember speaking to many non-crypto investors before the recent run-up in price who said they wouldn’t buy bitcoin at $10,000, but if it dropped to $1,000-$2,000 they would surely jump in. 

Well, guess what? Now that the current price is above $30,000, some of those investors have likely increased the limit at which they would consider buying bitcoin. Instead of buying at $1,000 these same investors may be happy to jump in closer to $10,000. And every time the price goes up in the future, these “mental buy limits” go up as well, increasing the likelihood of bitcoin’s future survival.

“But Nick, bitcoin doesn’t have any intrinsic value!” Well, guess what? Neither does gold, which has a $10 trillion market capitalization! So if you want to argue against bitcoin on intrinsic value terms, then you have to argue against gold, too. Because both the price of gold and the price of bitcoin are based around one thing and one thing alone – belief, the belief that these assets will have value in the future.  

See also: Pondering Durian – Why >15% of My Net Worth Is in Bitcoin

And right now the collective belief in bitcoin is increasing. The cult is becoming a religion. Don’t just take my word for it though. There are plenty of articles (see here, here and here) that discuss this increased adoption within the investment community. And if this trend continues (as it probably will), then we are even less likely to see a future without bitcoin. 

Now that bitcoin is here to stay, you might be wondering how it will behave in the future. Will increased adoption lead to higher prices? I have no idea! What I do know is bitcoin is a speculative asset class. Therefore, we should look at other speculative asset classes as a guide for how bitcoin might behave. And I believe there is no better speculative asset to use for this comparison than the early years of gold as an investment.  

While gold has been around for millennia as a form of money, it wasn’t until August 1974 in the U.S. that it was an investable asset class. And in the six years following its reintroduction to the investment community (1974-1980), gold tripled in value in real terms (i.e., the yellow line below): 

But since that tripling, it hasn’t performed all that well. Though bitcoin is unlikely to follow a similar path to gold, it is likely to exhibit similar behavior. This means bitcoin will continue to have huge run-ups in price followed by violent crashes that may last years (and possibly decades) in the future. We have already seen this kind of behavior from bitcoin before and I am quite confident we will see it again. 

However, there are still some reasons to be bearish. The main one is that bitcoin is associated with some of the most speculative investment activity out there. This is most apparent when comparing its price movement to the price movement of another speculative cryptocurrency – dogecoin. Though you may not have heard of dogecoin, it is an alternative crypto currency (altcoin) that is kind of an inside joke on the internet. 

And since dogecoin’s price is a clear indicator of speculative behavior, if we look at the correlation between dogecoin and bitcoin we can get a better feel for how much speculation might be occurring in bitcoin at any point in time:

As you can see, over the last three years the correlation between dogecoin and bitcoin has been quite high, with the most recent correlation reading around 0.8.

But if we compare dogecoin to gold, we see that the correlation between their prices tends to center around 0:

This is just more evidence that bitcoin is associated with speculative activity and will continue to behave like a speculative asset in the future.

Though I have changed my mind on bitcoin, I haven’t necessarily changed my view on how one should invest in it.  I believe the only prudent way to invest in this asset class without any long-term negative repercussions is to hold no more than 2% of your portfolio in it. I wouldn’t recommend this approach for everyone, but it may work for some people. By limiting your exposure to 2% of your portfolio you’re unlikely to get rich, but you’re unlikely to go bankrupt either.

Why 2%? This was the allocation I got when I worked out the optimal portfolio back in October 2017. Anything more than 2% adds too much risk (per unit return) to your portfolio and anything less than 2% reduces your returns (per unit risk) too much. Of course, the optimal portfolio is the best solution for the past, not the future. Either way, I don’t see the harm in a 2% allocation, but please do your own research first.

See also: Ajit Tripathi – Why I’m Long Crypto, Short DLT

The biggest risk I see to owning bitcoin going forward isn’t a price crash (which is inevitable), but the possibility of a government ban on ownership. This might seem outlandish but in April 1933 the U.S. government banned the ownership of gold bullion/coinage for all U.S. citizens. The reasons for that ban are very different from a bitcoin ban that could happen today, but with the recent Securities and Exchange Commission complaint against Ripple I wouldn’t rule it out completely.

Lastly, I might be wrong on many of the things I have stated today or in the past. But I don’t blog so that I can be “right.” I do it so I can learn more about investing and get closer to the truth. As economist John Maynard Keynes (or Paul Samuelson) supposedly said:  

Despite the excitement and enthusiasm in the Ethereum community, many people don’t yet fully understand the significance – and the opportunity – of the second-largest blockchain for large institutions and enterprises. 

The nature of network participation is changing dramatically as well as the incentive mechanisms for securing open permissionless protocols, demonstrated by Ethereum’s shift to a radically new consensus mechanism.

Anyone holding ether (ETH) as an asset can participate in securing the network and earn rewards. Given the increased growth and utilization of the protocol, now is the time for large enterprises to take a look at the Eth 2.0 opportunity. 

Ethereum, currently the second-highest market cap network with over $40 billion in value, aims to be a globally distributed computer for executing peer-to-peer contracts. In other words, it’s “a world computer you can’t shut down.” More important, Ethereum has become the most utilized blockchain protocol in the world, settling over $6 billion per day. 

Eth 2.0, the next iteration of this distributed system, represents years of research and coordinated effort from teams across the world. A primary goal of Eth 2.0 is to enable the protocol to continue to grow with our industry and scale to support trillions of dollars in value transfer in a decentralized manner. 

See also: The Risks and Rewards of Staking on Eth 2.0

Before the launch of its skeletal system on Dec. 1, more than 835,520 ETH was staked to the Eth 2.0 deposit contract, far exceeding the minimum of ETH required to trigger the new network’s “genesis.” 

Not only is this launch a huge milestone for the crypto community, the transition also represents a significant change in how the protocol will be secured, as the network moves from mining (proof-of-work, or PoW) to staking (proof-of-stake, or PoS). 

In decentralized protocols, mining and staking seek to accomplish the same goal, determining network consensus. Coming to agreement on the “state of the chain” ensures the monetary balances the blockchain stores are accurate. But networks based on mining and those based on staking operate very differently in the real world to achieve this consensus. 

In PoS, mining to secure the network is a separate activity from holding tokens. Many bitcoin miners are sophisticated actors, with large balance sheets. They optimize for access to cheap hardware and electricity but don’t always meet the necessary margins to stay profitable. PoW miners face the significant risks of price swings of the native protocol assets they hold and depreciation of their assets – a risk greater than some investor appetites. 

A large portion of this PoW mining happens in China and is controlled by a few large mining companies. These large mining companies are not known for operational transparency and, as such, are not an attractive option for well-established enterprises or institutions with fiduciary responsibilities. 

At a minimum, all you need to participate in Eth 2.0 is 32 ETH and an active validator. For enterprises and large-scale token holders, active PoS network participants may also consider running in-house infrastructure, as well as the time investment and opportunity cost of capital. 

In the five years since Ethereum’s debut, a number of new PoS protocols have launched including Polkadot, Celo, NEAR and Flow. There has also been a proportional rise in “infrastructure as a service” companies. These companies make it safe and easy for token holders and institutions to earn rewards as network validators. 

These enterprise-grade, cloud-based blockchain infrastructure providers can strengthen the network by geographically distributing the network’s nodes, without introducing the costs associated with proof-of-work mining. 

Further, we’re seeing a trend towards professionalization of the staking industry as new products are brought to market that provide liquidity for staked tokens and additionally provide insurance protections around slashing penalties – a major concern for institutions.

As Ethereum’s utilization continues its hockey stick-like growth, staking represents an opportunity to own a small part of the growing Web 3.0 ecosystem. A distributed web built on blockchain technology is a drastic shift from the internet we are familiar with today, where there is no way to own or monetize your usage. 

Policymakers understand this is a clear movement towards enabling users to own a small part of the next generation internet. As Ethereum grows to power trillions of dollars in daily settlements, owning a portion of this next-gen web will become a once in a generation opportunity.

Lastly, taxation of assets is an important consideration for institutions. There is promising work being done to advance the idea that staking rewards should be treated as “created property” so that rewards are taxed when they are sold, not when they are first created. These “capital assets” would give token holders the opportunity to hold their staking rewards for longer than one year and then receive long-term capital gains treatment under current tax rules. 

Clarity here would provide even more assurance that participating in PoS networks won’t come at the cost of an excessive tax burden. 

See also: US Lawmakers Don’t Want Proof-of-Stake Networks to Get Overtaxed

Eth 2.0 represents a fundamentally new kind of business opportunity. It offers a chance for non-technical market actors to own a piece of the Ethereum protocol and the fees that come with its utilization. While still in the earliest stages of its rollout, there’s already a well-established ecosystem of professional companies to support institutional investors with cloud-based infrastructure. 

It’s experimental, but the rewards are there for the brave new adopters. 

In the run-up to the 2017 market peak, stories abounded of traders who bought bitcoin in the spot market just a few months before only to cash out to the tune of hundreds of thousands, if not millions, of dollars.

The days of tripling or quadrupling your money in just a week or two just by buying bitcoin may be behind us. But since those heady days of three years ago, the crypto derivatives market has taken up the mantle of being the place where astonishing returns can occasionally be had by taking huge risks. 

Indeed, some traders with bullish outlooks have recently generated significant profits by taking long positions using the cheap out-of-the-money call options. That has given them the same reward as holding multiple bitcoins in the spot market but at a significantly less cost, albeit with more risk.

That’s what a bullish call options trade executed five weeks ago on the world’s largest crypto options exchange, Deribit, has achieved.

On Oct. 30, someone (a single trader or small group) bought 16,000 January expiry call options at the $36,000 strike for 0.003 bitcoin per contract, according to data shared by Deribit. The total cost was 48 bitcoin – the number of contracts (16,000) multiplied by the per-contract premium of 0.003 bitcoin.

In dollar terms, the per-contract premium at the time was around $39.90, and the entire trade required an initial outlay of approximately $638,400.

As bitcoin rallied from $13,400 to over $19,000, the premium drawn by the $36,000-strike January expiry call rose from 0.003 bitcoin to 0.0145 bitcoin, generating a paper profit of more than $4 million. 

Here is how the net return is calculated:

If the position were to be liquidated now, and assuming dumping on the market 16,000 far-out-of-the-money calls wouldn’t drop the price, the net return ignoring the fees charged by the exchange would be seven times the initial outlay. 

A call option gives the holder the right but not the obligation to buy the underlying asset at a predetermined price on or before a particular date. A put option represents a right to sell. Options on Deribit are also cash-settled, which means when they are exercised it is only the profits that are paid. One options contract represents the right to buy or sell one bitcoin. 

As of now, the $36,000 call is an out-of-the-money call option – one which has no intrinsic value due to the spot price hovering below the strike price. 

Theoretically, the purchase of the $36,000 call expiring on Jan. 29 is a bet that prices will rise above $36,000 before the end of January, making the option “in-the-money.”