Deribit insight: Bitcoin is an alternative asset with high liquidity


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Bitcoin is not only unrelated to traditional assets such as stocks, bonds, and commodities, but because of its unique risk-return factors that traditional markets do not have, Bitcoin can provide a true diversified investment.

Original title: “Bitcoin as an Asset Class”
Written by: Su Zhu and Matt Dibb, the former is the co-founder of Three Arrows Capital and the latter is Stackfunds’ crypto asset manager

Bitcoin is a decentralized digital asset that uses encryption to verify transactions. In 2008, Satoshi Nakamoto invented the underlying technology of Bitcoin-the blockchain, and since then opened a new era of financial innovation.

Since its inception, Bitcoin has performed well, attracting great attention from mainstream media and financial markets in the field of digital assets. In August 2010, the price of Bitcoin was only US$0.07. By February 2020, it had risen to more than US$10,000. This means that if you invested $1,000 in Bitcoin, its asset value will have reached $143 million (source). But for investors, it is not easy to stay in the market from beginning to end, because Bitcoin fluctuated greatly during this period, with multiple drops of more than 80%.

The cryptocurrency market is no longer what it used to be. With the help of futures, options, exchange-traded products (ETPs) and lending and other derivatives, the degree of financialization of cryptocurrencies is increasing, attracting more and more institutional investors and professional traders to further participate. As a result, Bitcoin’s volatility has been declining since it peaked in 2011, and institutional demand has also increased significantly. Since the launch of CME’s (CME) futures in December 2017, the nominal value of its total transaction volume has exceeded 100 billion Dollar.

Classifying digital assets is a big challenge

Although nearly 170 billion US dollars of assets are stored in Bitcoin, many investors have difficulty understanding whether Bitcoin is a currency, a commodity, a share of innovative technology, or a completely different asset. In addition, it is not easy to deal with the intricate regulatory procedures. In 2019, the U.S. Securities and Exchange Commission (SEC) issued a 13-page “Framework” to determine whether the issuance of digital assets is a securities issuance, so as to determine whether it needs to be registered with the SEC. According to this “Framework”, although some digital assets are recognized as securities, Bitcoin is not among them. Other government agencies such as the Commodity Futures Trading Commission (CFTC) treat Bitcoin as a commodity, while the U.S. Internal Revenue Service (IRS) classifies cryptocurrency as property instead of cash, resulting in all holders of digital assets being taxed .

Therefore, it is not surprising that there is a major confusion as to which asset class Bitcoin belongs to-even among professionals. A survey conducted by Bitwise shows that more than 40% of financial advisors in the United States will not allocate funds for digital assets from alternative asset investment plans, but will reduce cash or from allocations reserved for stocks, commodities or fixed income extract.

People often compare Bitcoin with traditional assets such as cash, stocks and bonds. However, this comparison only sees trees, not forests, because it is comparing different asset classes with different economic factors and risk-return characteristics.

Therefore, this article believes that digital assets such as Bitcoin should be regarded as an independent asset class. This article will study several characteristics to establish the definition of asset classes and the reasons why alternative assets are “alternative”. After that, an overview of the alternative asset market will be introduced, and the unique risk and return attributes of Bitcoin will be studied. In addition, it has been argued that with the rise of regulatory service providers for custody and insurance solutions and the rapid maturity of the market, the importance of Bitcoin in the eyes of investors is increasing. Several positive fundamental factors, such as increasing adoption and reduced supply, should help expand the price appreciation of this largest cryptocurrency. Due to its high liquidity and non-traditional risk factors, Bitcoin provides a unique diversified investment opportunity with high upside potential that every investor should consider.

What exactly is an asset class?

In the title “What is an asset class? “(“What is an Asset Class, Anyway?”) In his seminal paper, Robert Greer defined three super asset classes. These super categories have fundamental economic characteristics that make them unique. All traditional and alternative asset classes can be classified into these super classes.

Capital assets

  • Provide continuous value stream
  • Provide a series of monetary rewards, which can be discounted to determine the net present value
  • Example: stocks / bonds / real estate

Consumable/convertible assets

  • Has economic value, can be consumed directly or converted into other assets
  • Does not generate a continuous flow of value
  • Example: oil / corn / cattle / copper / gold

Value-preserved assets

  • Can’t consume
  • Unable to use discounted cash flow model valuation
  • Example: Artwork / Collectibles / Gold

Traditional assets such as stocks, bonds, and income-generating real estate are classified as capital assets because they represent the cash flow requirements of underlying assets. However, not every asset can be uniquely classified into a superclass. Some assets belong to multiple superclasses. For example, as a store of value, gold is in high demand during market turmoil and is “consumed” in the production of electronic products or jewelry. At the same time, it also presents the characteristics of capital assets because it can be rented out. Generate rental income.

Traditional assets provide limited risk diversification

Most traditional assets are subject to three general factors: risk-free interest rates, corporate returns that represent the level of economic activity, and market risk premiums. Due to fewer risk factors, traditional investors have limited risk diversification. In times of economic instability, this situation will become more serious. Many investors complained incessantly at the end of 2008 and have a deep understanding. During the global financial crisis, the correlation of many asset classes that previously exhibited low correlations suddenly soared. To make matters worse, these assets not only dragged their feet during the bull market, but also failed to provide sufficient diversification benefits when needed.

Bitcoin-the new type of “digital gold”

From the above classification, it can be seen that Bitcoin has different fundamental economic characteristics from traditional assets such as stocks and bonds. However, due to the limited supply of gold and other assets, Bitcoin and precious metals have many of the same attributes. Due to this fact, the argument that Bitcoin is becoming a value-preserving asset has gained considerable popularity in the investment community.

When it comes to gold, no one knows how much gold is left on the earth. The current gold stock has been accumulated over thousands of years and is several orders of magnitude larger than the annual output. In fact, gold production in the past few decades has been hovering around 1.6%. In other words, the annual inflation rate of gold is about 1.6%, that is, the stock-to-flow ratio is 62, which is much higher than the stock-to-flow ratio of 22 for silver. (Source: “Bitcoin standards”, author: Saifedean Ammous, 2018 published)

The stock-to-flow ratio of a commodity is essentially a measure of scarcity, and refers to the ratio of the current reserve of the asset divided by the annual production volume. As a store of value, the reason why gold is so attractive to investors is that its stock-to-flow ratio is very high: even if the annual output increases substantially, the price will not be affected too much, because the additional production capacity is only A small part of the current reserve. This feature enables gold to play an important currency role in human history and play a role as a store of value.

In the case of personal consumer goods, the opposite is true: for example, if the price of zinc or copper rises, its output will increase significantly relative to the current supply, thereby lowering the price. Although the supply plan for gold in the past was relatively stable, it is not ruled out that if new mineral deposits are discovered in the future, or if technology makes space mining feasible-there are currently several projects underway by companies-the current situation may occur. Variety.

As we all know, the upper limit of the number of hard-coded bitcoins in the system is 21 million. Therefore, bitcoins will never be subject to the aforementioned supply shocks. By the halving in May 2020, the mining reward for each block will be reduced from 12.5 BTC to 6.25 BTC. It is estimated that 18.375 million or 88% of the bitcoins will be mined by then (source). By then, the stock-to-flow ratio of Bitcoin will double from the current 25 to 50, becoming the asset with the highest stock-to-flow ratio after gold. Even if Bitcoin can only obtain a small part of the market value of gold, its price will appreciate tremendously. Some analysts predict that by the halving in 2020, the market value of Bitcoin will reach 1 trillion U.S. dollars, or the price of Bitcoin will rise to 55,000 U.S. dollars, which will be only a small part of the overall market value of gold (source) (see Table 1 below).

In summary, Bitcoin is different from stocks and bonds in fundamental economic characteristics, and is incomparable with personal consumer goods, because once all 21 million Bitcoins are mined, miners can no longer produce more coins, so its supply There is almost no flexibility. Therefore, it is wiser to compare Bitcoin with other alternative assets.

What is “alternative” in “alternative assets”?

Investors allocate alternative assets for many different reasons: they seek high absolute returns and risk-adjusted returns in private equity (PE) and venture capital (VC), and use real estate and infrastructure assets to diversify investment and income Purpose, and because hedge funds and natural resources have low correlation with other asset classes, part of the funds are invested in it.

Alternative assets generally refer to assets that are less relevant to other asset classes. Although this is true for most alternative assets, this is not a sufficient standard. Correlation fluctuates over time and may be broken when investment diversification is most needed. Going back to the original definition of asset classes, what distinguishes alternative assets from traditional long-only stocks, bonds, and cash is its unique risk factor.

Nevertheless, lower liquidity, looser regulation and lower transparency are aspects that need to be considered when investing in alternative assets. Since current market prices may not be available, and liquidity risk premiums need to be considered, it is difficult to value assets. Historical risk and return data are limited and sometimes even problematic, because the volatility of alternative assets will be underestimated compared with traditional assets and will be affected by survivorship and backfill biases. For retail investors, it is difficult to access certain alternative assets, because many hedge funds require investors to be certified.

Alternative asset market

Over the past decade, the alternative asset market has achieved tremendous growth. At the end of 2013, the global alternative asset management scale was US$6.43 trillion, and by mid-2019, it had exceeded US$10 trillion. Market research company Preqin predicts that this trend will continue and that by 2023, the total amount of alternative assets held by investment managers will further grow to US$14 trillion.

Due to excessive asset valuations, weak economic growth and increased protectionism, the next decade will be full of challenges. In order to better diversify investment risks, investors who pursue returns have turned their attention to alternative assets. More than 80% of investors plan to increase the ratio of alternative assets in the next five years. In addition, the participation of alternative investments, that is, the number of investors in alternative assets, is also expected to increase. The total amount of dry powder—or funds to be allocated—that fund managers have accumulated reached a record high and exceeded US$2 trillion in 2018 (see Figure 1).

Figure 1: Global private capital dry powder

Although the economic environment is full of challenges, people’s pursuit of income never stops. Once investors realize that digital assets have unique risk-return characteristics that other alternative assets do not have, the investment ratio of Bitcoin is expected to increase. As Stack stated in a report, the diversified investment income brought by Bitcoin allocation is considerable and can significantly increase the Sharpe ratio of the investment portfolio (Source: Stack AM: “Bitcoin Analysis” (“The Case for Bitcoin”)). If the market value of Bitcoin is compared with other alternative asset classes, it is obvious that Bitcoin has not yet become the main product of the investment portfolio, and most investors have not yet taken advantage of this advantage.

The market value of Bitcoin is about 2% of the total value of gold, or about 21% of the total venture capital. From another perspective: As long as 8% of the available capital in the private market flows into Bitcoin, its market value will nearly double.

Deribit insight: Bitcoin is an alternative asset with high liquidityTable 1: Market value of specific alternative assets (unit: US$1 billion)

Digital assets as a separate asset class

Although the history of Bitcoin is relatively short, and how its price reacts during an economic crisis or a long-term risk closure period remains to be seen, the risk-return characteristics of digital assets are different from traditional asset classes. Research has found that Bitcoin’s trend is almost independent of stocks, currencies, macroeconomic factors and precious metal commodities. However, Bitcoin is affected by specific factors related to the digital asset market, namely momentum and investor attention. These factors are the characteristics that help explain the long-term risk and return performance of Bitcoin. (Source: Yukun Liu & Aleh Tsyvinski (2018): “The risks and rewards of cryptocurrency”, National Institute of Economic Research (NBER) working paper)).

How do traditional market factors affect Bitcoin?

From the perspective of the linkage between stocks and Bitcoin, traditional models such as the Fama-French three-factor model, the capital asset pricing model (CAPM), and the Carhart four-factor model cannot explain Bitcoin’s return law. Scale, market, and value premiums can largely explain the changes in stock returns, but they have no explanatory power for Bitcoin, because Bitcoin produces a significant alpha coefficient (alpha) in all these models. The alpha coefficient is used to describe the surplus return that cannot be explained statistically by risk factors. In this case, the alpha coefficients of the various models mentioned above are between 16% and 19%.

At present, there is no consistent evidence that digital assets will be affected by traditional currency fluctuations. Judging from the performance of the world’s five major currencies (Australian dollar, Canadian dollar, Euro, Singapore dollar and British pound), no statistical impact has been found, and the alpha coefficient is still large (about 24%) and the impact is significant.

Analyzing the impact of commodities such as gold, platinum, and crude oil, there is no exposure between the returns of these commodities and Bitcoin. In addition, macroeconomic factors such as non-durables consumption growth, durables consumption growth, industrial production growth, and personal income growth are not important risk factors that explain Bitcoin’s earnings.

Factors driving the growth of the digital asset market

Because these traditional factors cannot explain Bitcoin’s price behavior, analysts have to find another answer. They found that the digital asset market exhibits unique risk-return characteristics, which are different from those of traditional markets.

It was found that momentum is an important predictor of Bitcoin’s earnings. Momentum describes an asset’s tendency to perform well in the future if it has performed well in the past. Similarly, if an asset has shown negative returns in the past, it is expected that its recent performance will be worse. The momentum factor is classified as a continuous factor because it is related to market trends. In certain future daily periods and within one to four weeks in the future, Bitcoin’s daily rate of return is positively correlated with its future rate of return. Therefore, the current rate of return significantly positively predicts the future rate of return during these periods.

There are many Google searches that investors pay attention to. Among them, the search record with the keyword “Bitcoin” is particularly prominent. This concept has a strong explanatory power for the return rate in the next one or two weeks. However, negative investor sentiment is also reflected in Bitcoin’s rate of return. The higher the search frequency of negative phrases such as “Bitcoin hacker” on Google, the stronger the negative returns of Bitcoin in the short term.

In summary, the variables that drive Bitcoin’s growth stem from people’s attention and curiosity towards Bitcoin, and the resulting demand for digital assets. In addition, it can be said that the difference in attention has led to the importance of momentum, and therefore also led to a strong trend in the short term. Interestingly, possible important variables such as gold and oil prices, volatility and on-chain metrics such as transaction volume and wallet addresses seem to have no significant impact on the rate of return (source). However, due to the dynamic nature of Bitcoin, its price fluctuations and the evolving ecosystem, these factors will change over time.

Bitcoin-an alternative asset with high liquidity

Unlike many other alternative assets, Bitcoin has high liquidity due to its fungibility and high degree of financialization. Over the past few years, the volume of transactions in the futures and options market has increased substantially, confirming the continued increase in interest from institutional investors.

Deribit insight: Bitcoin is an alternative asset with high liquidity

Deribit insight: Bitcoin is an alternative asset with high liquidityFigure 2: Total holdings of Bitcoin futures and options

Compared with the low transparency and low availability of other alternative assets, Bitcoin provides a simple way to access non-traditional risk-return factors and to diversify investment returns. In addition, other alternative assets such as hedge funds or real estate funds have high management costs and may result in high transaction fees, while the investment cost of Bitcoin is not high.

The legal and tax issues involved in Bitcoin and various other digital assets are still changing rapidly, and the regulations in different jurisdictions are also different. However, with traditional financial institutions showing increasing interest in providing custody services for digital assets and the launch of insurance solutions that provide comprehensive coverage of customer assets, it is expected that the regulatory system will become clear in the near future.

in conclusion

Usually, whenever the price of Bitcoin drops, people describe its value store function as a failure. This is a special criterion for holding any asset, not to mention a rapidly growing new asset. In fact, we should not abuse language, but insist on the original meaning of value store, that is, it is an alternative asset that is durable, non-consumable, zero cash flow, and has low correlation with traditional assets.

From this perspective, Bitcoin provides an attractive asymmetric investment opportunity. Not only is it not related to traditional assets such as stocks, bonds, and commodities, but because of its unique risk-return factors that traditional markets do not have, Bitcoin can provide a truly diversified investment. Digital assets form an asset class by themselves due to their economic characteristics. Driven by advanced custody and insurance solutions, more and more institutions are adopting digital assets, and there is still a large amount of dry powder waiting to be deployed. Investment managers are expected to deploy more and more digital assets to harvest these alternative risk premiums .