Summary Cryptocurrencies like Bitcoin and Ether are a new asset class that deserves consideration as part of a diversified portfolio.

We compare Bitcoin and Ether with fiat money along nine factors. We find that there are real world advantages to crypto that will likely grow in time.

We examine the risk, return, correlation, and skewness profile of Bitcoin. We find that increased use has decreased volatility and improved the investment profile.

Crypto risks are numerous and include regulations, vested interests, price speculation, valuation challenges, and constantly evolving financial technologies.

“Experts” like Jamie Dimon, Aswath Damodaran @AswathDamodaran and the anonymous blogger Jesse Livermore @jesse_livermore have shared their views on Crypto. We summarize their views and where we disagree.

We summarize each in turn:

1. Scarcity is necessary for a currency to succeed. Crypto was created in the wake of the Federal Reserve’s first quantitative easing (QE) program. Since 2009, over$13 Trillion in new money has been printed by the world’s largest central banks. In contrast, Bitcoin (but notably not Ether) offer a predetermined rate of money creation that decreases over time. Expert cryptographers largely agree that it would take a quantum computer, or something equally unlikely to occur in the near future, to crack Bitcoin. Moreover, as Bitcoin’s creators point out, even if someone did build a supercomputer fast enough to crack Bitcoin they would have more incentive to contribute and earn “mining” fees than to steal or make fake Bitcoins in a manner that would undermine their legitimacy.

2. Intrinsic value is not necessary for a currency to succeed, but it does help. Currencies made of precious metals like Gold require less trust in the issuer. This is why gold backed most of the world’s currencies for hundreds of years before Nixon left the gold standard. Bitcoin has no intrinsic value, but Ether, the second largest crypto by market cap does. Ether is used as “fuel” to run smart contracts on the Ethereum network. The more valuable the network the more valuable Ether will become. The Enterprise Ethereum Alliance (EEA) has 86 firms including big names like JP Morgan, State Street, Toyota, Merck, ING, Broadridge and Rabobank. Real world applications are everywhere you might use a traditional contract, such as the Monetary Authority of Singapore’s decision to use Ethereum to create a crypto version of their own national currency.

3. Convenience means a lot of different things when it comes to currencies. Transaction costs make a currency less convenient. In this respect, fiat money is not particularly convenient. Most everyday transactions in fiat are actually done by credit card for which credit card companies typically charge 1-3%. Checks and credit cards also come with a risk of fraud. Additionally, banks stand between all of these transactions to confirm their legitimacy. All of these factors result in higher prices. Perhaps the single most obvious benefit of crypto is for international wire transfers which can cost as much as $50! The downside of crypto is that it is more complex and has less connection to the real economy than fiat currencies. Also, in 2017 the rise in demand on Bitcoin has put pressure on the cost of transctions.

4. Anonymity is another key reason why acceptance of crypto has grown. The ability to buy most anything without big brother knowing is clearly valuable to some people, and not just criminals. The ability to own money without needing a social security number, address, or other proof of identity means that crypto is readily available to many without access to banks. This predominantly includes the poor and people who live in countries without a strong financial infrastructure or property rights. All you need to buy crypto is an internet connection. However, this anonymity has brought a lot of unwanted attention, such as from recent wannacry and copycat hacks demanding payment in Bitcoin, and the illegal marketplace known as Silkroad.

5. Governance in this context means how changes are made in the way a currency is circulated. For most fiat currencies, any change is decided by the central bank. Most governments have given central banks this authority because politicians might be tempted to use the power of the currency for their own benefit (think short term economic boom via government spending paid for with printed money…followed by collapse of currency). Centralized control of money has not worked out well for everyone. If you don’t believe us…go ask a former Bank of Cyprus depositor or citizen of Zimbabwe.

Those with the power to print money need to have steady hands and think long term. This would seem to favor having a governance structure that makes change very hard. Bitcoin has such a governance structure, but the fast pace of technological innovation in this area can sometimes make change necessary. Ethereum is more centralized in its governance structure. Much of the decision making authority lies with Vitalik Buterin, the 23 year old prodigy developer of Ethereum. This has allowed Ethereum to quickly overcome several technological challenges in recent months, but such power in the hands of so few can make some investors nervous.

We will address factors 6 through 9 in the next section.

Investing fundamentals

In the previous section we addressed the first five factors that give crypto value. These included more qualitative aspects of crypto that serve as a rationale for why they have grown in acceptance. Here we address factors six through nine; which include risk, risk adjusted return, correlation with other assets, and skewness. These are the fundamentals that drive ubiquitous investing models like the Capital Asset Pricing Model (CAPM).

Bitcoin historical prices are notoriously unstable. This is important to keep in mind as we present historical measures of risk, return, correlation, and skewness. The price run up to the Mt Gox scandal in late 2013 is a perfect example. Volatility was high but steadily falling during 2012. This trend abruptly reversed in 2013 and early 2014 as annual returns exceeded 4,000% before plummeting. Anyone who was using historical prices during 2012 to inform their investment strategy was surprised to put it lightly.

6. Risk, as measured by price volatility, has been steadily falling and more stable since the Mt Gox scandal. This is to be expected in a market growing in size and diversity of participants. This is true for both a traditional measure of volatility (i.e. standard deviation) and a measure we like to use called negative volatility. Negative volatility only includes negative falls in price. We like this alternative because people don’t tend to think of large upswings in price as a “risk”.

By comparison, the dollar has exceptionally low volatility. For example, after the US election on November 8 th, 2016 the dollar surged 5% in just two weeks relative to a basket of other major currencies. That is considered to be a big move for the dollar, but that same size more happened to Bitcoin on over 7% of trading days between June 2015 and December 2016. That said, the dollar is considered to be the most stable fiat currency in the world. Pretty much all other fiat currencies are more volatile than the dollar. Venezuela, which experienced hyperinflation of 1600%, provides a useful case study for why some might prefer to hold their cash in Bitcoin rather than their national currency. Depositors at Cyprus bank, as we have mentioned, provide another. Today, anyone in the world with an internet connection has a crypto alternative, and the more people join the less volatile (and more valuable) the crypto alternative becomes.

7. Risk adjusted return (Sharpe) has also been rising from the trough in early 2015 of -1 to around 5 today. Before the run up in price this year our YoY (year-over-year) Sharpe measures came in around 2. For comparison, this is twice that of the S&P 500 at 0.94 (higher is better). Compared to fiat currencies this is even better. Return on fiat currency is generally negative due to inflation. This makes cash a poor investment, but historically low volatility for most fiats still made it a good short term store of value. Ether has had its Sharpe ratio rise from zero to as high as 45 depending on how you measure it. However, Ether is so new that we are focusing our historical price analysis on Bitcoin.

Of course, improved Sharpe ratios mean nothing if the price plummets to zero tomorrow, so it’s important to consider why this is happening. Several facts suggest the days of 90% price plummets are probably over (except for the occasional flash crash). For one, there are more and better regulated exchanges today. The Mt Gox scandal broadened awareness of risk management practices and other controls to prevent fraud and hacks. Investors and users are also more familiar with crypto and so are less likely to panic when prices fall (Google #HODL). Lastly, crypto is used by many thousands of businesses and more are signing up every day. This connection to the real economy is what ultimately makes a currency more stable, and with acceptance comes lasting value. This is one reason we hold Ether instead of Bitcoin as explained here.

8. Correlation with other assets is either zero or close to it for Bitcoin. The same is also true for other crypto which tends to be correlated with Bitcoin. This is good for investors because it improves diversification and therefore improves risk adjusted return for the portfolio. This is not true for fiat currencies. Cash flows from stocks and bonds are denominated in fiat currency. If the fiat falls in value, so does the stock/bond. This makes crypto comparatively better. However, we expect that in the event of a major drawdown in global equities or bonds that some of this selling may flow over to crypto as investors liquidate anything that has value to meet margin calls. This is a key reason why gold prices fell during the financial crisis. Gold seems like an apt comparison because many investors in crypto consider it to be a safe haven in the event of a major currency collapse. A similar rationale has been used by some (but not us) to justify investing in gold.

Thanks to Chris Burniske @ARKblockchain for the above chart!

9. Skewness is the last factor we consider, but it may be the most important. Skew is the shape of the return distribution. We like positive skew which offers a better chance of huge upside than downside. Stocks and bonds tend to have negative skew because all it takes is one economic shock to send PE ratios tumbling or inflation rising. However, some investments have positive skew either naturally (such as Swiss Franks) or by design (like options).

Given the historical volatility of Bitcoin we decided to keep our initial investment in Ether rather small. Three months later the price was up 3,000% so it still had a big impact on our portfolio. Even if the price drops to zero our losses would be small because we kept our exposure small. This kind of success can only happen when you have positive skew. We discuss this aspect of crypto in detail here. However, over very short time periods of an hour or a day, crypto tends to have negative skew. What that means is that on any given day you could wake up and be down 20% or more. It happens a lot in the crypto space and if you can’t stomach those moves you are better off staying out of crypto completely.

Risks

Crypto risks are numerous. Investors would be wise to only invest an amount they could lose. A key reason why Charlie probably doesn’t like Bitcoin is that crypto has historically had an unstable return distribution. However, there is a very real possibility of losing everything on some of the more esoteric cryptos (“Mooncoin” comes to mind). We think the chance of losing everything on Bitcoin or Ether is very unlikely, but a 50% sustained drop in price is certainly possible. Anyone who thinks they might be tempted to sell during such an event would probably be better off steering clear of crypto. It is not for the faint of heart.

Here are four key risks that deserve consideration before investing in crypto.

1. Regulations and vested interests could greatly limit the acceptance of crypto. Governments and central banks like the ability to control money supply and enforce capital controls. The most obvious example was China’s crackdown on Bitcoin as a means of circumventing capital controls. For a while this made for a unique trading opportunity; which we discussed on Twitter. However, it also serves to highlight how governments and other vested interests may see crypto as a threat. Vietnam, Iceland, Bolivia, Ecuador, Kyrgyzstan, and Bangladesh have all banned Bitcoin. Most major economies have left Bitcoin alone (US) or embraced it (Japan, Singapore).

If a major economy were to try to stop crypto, or make it impractical, the price of crypto could fall drastically within moments. While the network itself would likely be difficult if not impossible to shut down, higher valuations can only be justified if acceptance and use continue to grow. Governments may not know who owns crypto, but they can (and have) targeted exchanges because they are the entry and exit points. No one knows when/if a push to stop crypto may occur, but there are plenty of incentives.

2. Crypto is generally considered to be a risky financial asset, not a currency. This necessarily limits its current value. As we argue here, this is because it is still too volatile to be a good store of value, and not yet widely accepted by businesses, at least compared to most fiat currencies. That is fine so long as volatility continues to decline and the rate of acceptance continues to grow. However, the fact that crypto like Bitcoin and Ether are viewed as risky financial assets means there is a limit to how large the market capitalization can grow relative to other financial assets. If the value gets too large relative to other assets, investors will have an incentive to reduce their exposure.

3. Crypto is extremely hard to value. Assets with cash flows can be valued by discounting future cash flows (ex. Stocks and bonds). Assets without cash flows can still generally valued by replacement cost or cost to produce (ex. Commodities). Money is different. There are no cash flows and the cost to produce is near zero. This reality makes valuing crypto (or money more generally) very complex. Crypto is even harder than traditional money because it has no country! We have no economy of Cryptoville to analyze as we would for dollars and Euros. Traditional analysis of exchange rates rely on comparisons of economic growth, debt sustainability, capital flows, and other metrics specific to a country. This approach doesn’t work for crypto because crypto is global.

As we argue here, valuations need to be justified by how much it is accepted, and by extension used. This truism makes it possible to make relative valuations (compare one crypto price with another), but not absolute valuations (determine if a crypto price is too high or low). Even if our valuations are right, the market (or more precisely the people in them) ultimately determine the price, and as Keynes once said, “the market can stay irrational longer than you can stay solvent”.

4. Fintech is constantly evolving and changing crypto and fiat money. Even if crypto in some form is inevitable, this doesn’t tell us which crypto will dominate. Not all crypto is anonymous and there are technological and governance issues that have made it harder for crypto to grow. However, limitations with existing crypto will undoubtedly be addressed in subsequent generations of financial technology (Fintech). Fiat money is evolving as well. Zelle now allows people to send fiat money instantly through participating banks using a smartphone, encroaching in an advantage normally associated with crypto. This change can make picking a crypto hard. We have commentedon several cryptos out there via Twitter, but nothing beats doing your own homework.

Addressing the “Experts”

We have read just about every article written on cryptocurrencies and the debate over classification. Here we point out a few of our favorite “experts” and address their views.

Adam Ludwin

In our view, the best article ever written about the meaning of crypto was composed by Adam Ludwin, owner of the company Chain. He wrote a response to Jamie Dimon after his barage of criticisms (see below). Jamie Dimon is one of the greatest bankers of all time, but he doesn’t understand cryptocurrencies.

Adam argues that “cryptocurrencies” should really be called “crypto assets”. His reasoning is that their value fundamentally come from the networks upon which they are built. For example, ether is used as a fuel to run smart contracts on the ethereum network…therefore ether is more like gasoline than a currency. He also points out that the use of “miners” to ensure the integrity of the crypto networks provide another parallel to commodities.

We agree with most everything that Adam wrote in his rebuttal to Jamie, but disagree on his pure classification of crypto as a commodity type asset. The fact that folks can and do use crypto like a currency, its acceptance by many thousands of businesses, and official designation as a currency by countries like Japan, are proof that it is also a currency.

Aswath Damodaran

We follow @AswathDamodaran and enjoy his musings, but crypto and currencies more generally are not his strong suite. He published a third piece on crypto today wherein he made several errors. It was his piece today that inspired us to finally get our own piece published because it was obvious to us that there is very little in the way of good information for investors on crypto as an asset class. Here are his comments and why we disagree:

Aswath argues that “currencies have no cash flows and cannot be valued, but they can be priced against other currencies”. This just simply isn’t true. Currencies are valued all the time, but just not in the same way as stocks and bonds which are his speciality. Central banks, hendge funds, and other financial institutions regularly used supply demand models to value currencies. Key inputs into these models include yields on debt denominated in those currencies and inflation rates. Ultimately, what drives the fundamental value of a currency is the size of the economy where the currency is used and the amount of units created by the central banks. These components untimatly drive the supply and demand of the currency and hence its value.

Crypto posses problems for traditional currency valuation models in large part because there is no “Cryptoville” economy that we can measure the size of as we discussed in our piece on crypto market valuation. But this doesn’t change the fact that there is a crypto economy. Some considerable portion of that economy may consist of people that do not want their transactions followed, making it even harder to tract, but the crypto economy exists just the same as evidenced by the chart below and the growing number of companies accepting crypto for payment.

Aswath also argues that one cannot invest in crypto because it cannot be priced. He states, “To invest in something, you need to assess its value, compare to the price, and then act on that comparison, buying if the price is less than value and selling if it is greater.” That is precisely what we did when we invested in Ether on March 5th. The Ethereum network was priced at $1 Billion. We determined for the reasons outlined that the first fully functional smart contract platform had to be worth more than $1B given the many places in the world without reliable governments and institutions to support traditional contracts. Now the Ethereum Network is priced at $30 Billion. Is the true value more or less? We don’t have a view, but if it ever goes back to $1 Billion, we will be investing, not trading, in Ether again.

Aswath goes on to say that, “Bitcoin is not an asset , since it does not generate cash flows standing alone for those who hold it (until you sell it).” This is simply wrong. For thousands of years, before the invention of stocks and before the widespread use of debt markets, peoples assets consisted of land, precious metals, slaves (immoral assets, but assets non-the-less), shells, and other things people considered valuable. Many of these assets are still used today (thankfully, not slaves)!

Aswath also points to just three possible scenarios for crypto: Either it becomes a globally acepted digital currency, a gold like haven for those afraid of central banks, or a 21st century tulip bulb bubble. Wrong again Aswath! The most likely scenario, as Adam Ludwin points out (you really do need to read his article), is that crypto is most useful for those who value security over everything else. There are many parts of the world where fiat currencies have abruptly lost value such as Ukraine in 2014 and early 2015. The Hryvnia list 2/3 of its value in less than two years! And it never recovered!

Bitcoin is a highly volatile currency, but so are the fiat currencies of many countries. Here we picked four for comparison which recently went through an abrupt devluation inclduing Ukraine, Argentine, Brazil, or Kazakhstan. What you see below is average volatility from day-to-day over the course of years 2014 through 2017. Bitcoin was generally more volatile, BUT that volatility was pretty constant throughout the year. The countries in our sample all look like Ukraine. One day everything is fine…then a few months later you lose half your savings, often wthout the ability to exchange money into dollars because of capital controls like those imposed on the Chinese. If you lived in one of these countries would you think about buying some Bitcoin? We think so, and these evidence of this is supported by Google trends.

Finally, Aswath says he won’t buy Bitcoin at $6,000 …not because he thinks its overvalued, but “because I am not and never have been a good trader”. See chart below. No “trading” was required to make good on an investment in Bitcoin at any point in the past nine years. Some people saw this coming. Here we need to introduce Aswath to the term HODL, a term used by those who saw the value of Bitcoin early and realized they could profit if they resisted the urge to sell every time prices tank. Its also called “buy-and-hold”. Apologies to Aswath for being at least a bit provacative (not that he has ever heard of our little blog), but it really is a bit dissopointing to see one of our favorite commentators on investing make such illinformed claims.

Jesse Livermore

The anonymous blogger @jesse_livermore is exceptionally good at thinking through finance concepts like the meaning of money and value. We highly recommend his blog. In 2014 he wrote a piece on Bitcoin and why he concluded that it would never become a dominant form of money. Essentially, he argues (correctly) that central banks and governments can prevent this by simply making it illegal for loans to be denominated in Bitcoin. This would prevent Bitcoin from expanding in use beyond just a “giftcard” for tech geeks.

But Jesse seems to have missed the point; which is easy for us to say because we missed it to until March of this year. As already mentioned, its less about taking over as a currency and more about smart contracts and it’s usefullness as a currency for parts of the world that don’t have stable alternatives like the Dollar.

As Adam put it, there is a subset of the population that values “censorship resistence” over other factors that give currency value like speed, cost, scale and user experience.

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There have been many pieces written about the value of cryptocurrencies. We have probably read the vaste majority. Almost all of them are very articulate and inaccurateas we tried to illustrate here. It is quite possible that we are missing some important considerations. All we can do is keep reading and remaining open minded. We suggest you do the same.

Conclusion

For crypto to be a sound investment it needs to provide some benefit over existing currencies. We find that cryptos like Bitcoin and Ether offer several advantages over traditional fiat currencies such as the inability of any government to print more of it, positive intrinsic value in the case of Ether, extremely low transaction cost, almost immediate settlement times, no need for banks intermediaries, no need to trust in a central authority, and ability to transact anonymously. Many individuals lack access to stable national currencies and reliable banks. Many others would prefer not to hold all their money in a form that a central bank can print at will or track. These individuals are only just beginning to recognize crypto as an alterantive. This is why we expect the rise in crypto acceptance and use amoung individuals and businesses to continue.

We argue that these real world advantages make crypto a sound investment, even for value investors like Charlie Munger. These advantages are helping the market to grow and mature. This has in turn improved the crypto investment profile. Bitcoin volatility is many times higher than that of stocks, but has generally been falling as more diverse and educated investors and users transact on more plentiful and robust exchanges. Finally, investment fundamentals such as risk adjusted return, no persistent correlation with other assets, and positive skew suggest that crypto can be a profitable investment for the right kind of investor.

Crypto risks are numerous. Regulations and vested interests could greatly limit acceptance. A move by a major economy to slow or stop crypto could greatly diminish its acceptance; which is needed to justify higher prices. Most owners of crypto think of it as a risky financial asset, not a currency. This means they will not let it become too large a part of their portfolio, limiting how large the crypto market can get relative to other financial assets. Additionally, crypto is extremely hard to value. We have tried several approaches, but all require the market to be rational and educated about fundamentals like acceptance rates and use in the real economy. Finally, fintech is constantly evolving and changing crypto and fiat money. These changes can drastically impact valuations. We enjoy writing and tweeting about how Fintech is changing the way we use money, but there is no substitute for doing your own homework.

In conclusion, we are treating cryptocurrencies like Bitcoin and Ether as their own asset class. They provide many real world benefits that will likely grow in value as FinTech improves. They are fundamentally distinct from fiat currencies in that they are global and require no third parties. They lack cash flows which makes them nothing like stocks and bonds. They are distinct from gold and other commodities which do not have a fixed supply. Historical correlations with other asset classes are near zero or unstable because they have their own risk and return factors. In other words, they are a class unto themselves. In a world with sky high stock prices, rock bottom yields, and growing geopolitical risks…we decided it was prudent to add crypto, the newest asset class, to our diversified portfolio.

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Feel free to share your own thoughts on crypto. There is no better compliment you can give us than your thoughtful criticism. You can reach us at intuitecon@gmail.com, or follow us on Twitter @intuitecon

Sincerely,

IntuitEcon Team

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Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.