Thoughts: cryptocurrencies place in the constellation of institutional stores of value

Saket Kumar
Sep 6, 2018 · 9 min read

Bitcoin (BTC) has never existed in a moderate interest rate environment. With the Fed raising guidance to 1.75% to 2%¹, the second Bank of England interest hike in over a decade² and the likelihood that low rates guidance is finally about to be relaxed for the first time since the financial crisis, we are about to enter a unique chapter in Bitcoin’s lifecycle. While BTC is the cryptocurrency most associated with the ‘digital gold’ thesis, the questions and thoughts below extend to any cryptocurrency which hopes to drive at least part of their value through a Store of Value use case.

The initial question to ask is why does the interest rate environment matter? Because it introduces an opportunity cost for holding non-yielding assets (such as BTC & gold) as a store of value. You can lock in a return with a T-Bond, which typically also has liquid markets if an investors wants to exit early and does not want to hold the bond for its entire lifetime.

Viewing the opportunity cost of holding BTC in such an environment led me to realise that Bitcoin should not be benchmarked against gold. Framing Bitcoin as simply a substitute for gold is the wrong way to view the question at hand. The correct question for institutions will be: how do we optimise our store of value holdings across the plethora of options out there? This leads to a simple question for crypto investors and technologists believing they’re either investing in or building a future store of value: how does my token fit into that optimisation?

This essay will explore some of the questions that arise when you frame the store of value question from the perspective of a portfolio optimisation across all store of value options. Through the piece you may notice there is a paucity of convictions that I am married to and more exploratory thoughts. The reason for this is simple — this framing has only occurred me more recently and I am still building out my own convictions and theses around stores of value when viewing the questions through this prism.

Note that this essay is purposely focused on institutions storing values instead of end users in economies with unreliable fiat currencies, such as Venezuela³. However, similarly there a customer-first approach is an informative strategy for evaluating a given token as a store of value. While the core store of value concerns (i.e. purchase power retention) will be consistent, there are other concerns that the customer may put a premium on (e.g. portability). This may lead to a different optimisation, hence leading to a different basket of assets being held to store value.

Firstly, what is a store of value?

A store of value is an asset that retains its purchasing power into the future. Purchase power here should naturally be thought of in real terms; to put it more explicitly, an idealised store of value in any given future state, at minimum, has to return (in nominal terms) the inflation rate. This is why cash is not an ideal store of value; inflation diminishes its purchasing power over time.

Another issue to consider with a store of value is the asset’s market liquidity — illiquid markets may mean that the short-run available market price does not reflect the ‘true’ value of an asset. Consider how in the short-run, due to infrequent transaction volumes, one may not be able to sell off a given piece of art for its ‘true’ value. To tie this back more explicitly to the definition cited above, purchasing power ideally needs to be retained in all time states — t¹, t²,…,tn. Artworks, due to illiquid markets, typically do not provide this. Roughly speaking, liquidity is the cost of exchanging a given asset into cash.

What are some existing stores of value?

Gold is the store of value most often cited in the crypto community, but another prominent store of value are US treasuries — both long- and short-term bonds. They are both massive markets, total outstanding marketable treasury securities have a value of c. US$ 15 trillion⁴ and the global market for financial physical gold is c. US$ 3 trillion⁵. It is clear why technologists and investors are salivating at the opportunity to gain even a fraction of these markets.

Treasury bonds are US government bonds — i.e. debt issued by the US government. A bond is a debt obligation; typically, bonds pay a fixed rate of interest over their lifetime and then include a repayment of the initial principal. The rate of interest on an issued bond is the existing interest rate. Other types of bonds include floating rates bonds whose interest payments periodically adjust to the market interest rate and zero-coupon⁶ bonds, which offer no interest payments but a single repayment that is higher than the initial purchase price.

Using the store of value framing sketched out above purchase power for a fixed rate bond is retained through the interest payments. As long as the interest payments exceed inflation, nominal returns are such that real value is retained and hence value is stored.

This is a different mechanism through how gold retains value. Gold provides no yield — so if nominal prices stayed constant (i.e. it is US$ 500/oz today and US$ 500/oz in 10 years) real value is eroded as long as inflation was over 0%. Gold’s purchase power is retained through asset price appreciation. As long as the price of your gold holdings increases at a rate greater than or equal to the inflation rate, you’re retaining purchasing power going forward.

Why would you ever invest in gold?

Given the alternatives (e.g. locking in a return with a T-Bond) why would anyone store value with gold? Gold is a ‘currency alternative to the dollar to protect wealth in the event of inflation’⁷. Paulson’s quote succinctly sums up the rationale for investing in gold. In a low interest environment where you expect inflation and coupon rates on treasury bonds are low, such as the global economy post-financial crisis with low interest rates and huge quantitative easing programmes, it makes sense to look at gold. Gold more generally attracts investment when there is global uncertainty: whether economic, geopolitical or otherwise.

To put it more explicitly: it is important to think about why investors are investing in gold. They are looking to store wealth — storing that in gold is one choice among many, including treasuries. It is important to note that with low interest rates across ‘stable’ economies with low default risks, including the US, UK and the European Union, the opportunity cost for gold has been historically low. Increasing interest rates increases the competitiveness for these alternate solutions.

Treasuries have remarkable safety (effectively a 0% default risk) and strong liquidity; as interest rates rise their attractiveness also rises and gold’s (relative) attractiveness decreases. Typically, you would not store all your wealth in one asset class, but your overall portfolio allocation may change.

What does this have to do with Bitcoin?

Firstly, to see the store of value argument for Bitcoin as a decision that is optimised against all global store of values. To put it another way, if Chinese government debt suddenly became the global de facto store of value then that would not just impact US treasuries but BTC too.

Secondly, tying together the above and my framing for store of values there are two things to look at when looking at Bitcoin’s place in a potential basket of assets in the future:

  • Market liquidity
  • Value appreciation

I believe that a robust store of value argument must show that Bitcoin offers value to investors in one of those two (ideally both) categories. In demonstrating this value BTC wins allocation in a given investor’s basket of safe assets. The value appreciation piece of the puzzle has been alluded to most consistently throughout this piece — rising interest rates increase the return of treasuries, making them more competitive (from a returns perspective) vs bitcoin. Also note that ideally purchase power is retained across all future time states. This means that the price volatility is a competitive disadvantage vs a fixed rate coupon with a good yield. Obviously, gold is a store of value and has price fluctuations — the point was simply to note this competitive reality.

The other way to win a % in a basket of store of value assets is by offering uncorrelated liquidity. Treasuries, in normal economic times, have strong liquidity. However, in times of crisis (e.g. the financial crisis) liquidity can and has cratered. If BTC market liquidity was uncorrelated with the liquidity of other stores of value, from treasuries to gold, then that may be a powerful reason to include BTC in a basket of assets.

What does this mean for Ethereum as it moves to Casper?

Similarly, one can look at Ethereum as a store of value across these two dimensions. However, these arguments are relevant for any potential store of value.

Before diving into value appreciation, it is important highlight a risk of holding treasuries — interest rate risk. This is important to understand when discussing how value accrues to proof of stake tokens later on. When purchasing a treasury in a low interest rate environment, investors are at risk of locking in returns and then seeing interest rates rise. A rise in interest rates means the selling price of a given fixed rate bond purchased in the lower rate environment has decreased. This effectively increases the cost of getting liquidity.

Why is this important?

Consider what a proof of stake token is: it is effectively an interest-bearing assets. I believe trivially so for institutions since custodians will almost certainly offer staking services. In the same way Bitcoin seems eerily similar to gold, staking tokens start to look eerily similar to treasuries (at least superficially). The main difference here is that a staking token’s ‘coupon payment’ is determined by network demand for transaction validation instead of central banks. However, here, unlike with treasuries, there is never a mis-alignment with the return on a given token and the potential staking returns from purchasing another staking token. ‘Interest’ is flexible, not fixed. Now consider it from a portfolio perspective, a flexible coupon driven by network demand. Imagine if there was little correlation between that demand (and hence interest payments) and the interest rates of major economies. This lack of correlation may be attractive for an institutional’s portfolio. It is unclear what returns will be for staking, but if they are ‘closer to five than to zero’⁸ as Vitalik claims then even in a moderate interest rate environment staking may produce superior absolute returns vs treasury bonds.

The liquidity benefits with respect to Ethereum or other proof of stake tokens are very similar to Bitcoin’s potential liquidity arguments. The only addendum to make is that Ethereum and other smart contracting tokens (ideally) will be utilised to purchase compute within their networks — they will be very ‘money’⁹. While unclear to me exactly how, I suspect this will be an important driver in impacting liquidity — particularly when one wants to make the argument that a given token will not suffer liquidity pressures at the same time (or to the same degree) as other assets held in a potential basket of assets for value storage.

Conclusion

The key takeaways from this piece are that the store of value argument is broader than just Bitcoin vs gold and it is certainly more nuanced than highlighting censorship resistance and portability (at least when viewing it from an institutional perspective). There is no singular global store of value, but there are a few options that financial institutions optimise across to provide both liquidity and real value to their clients. Through viewing cryptocurrencies as part of this equation we start to see where they fit into this portfolio. Moreover, we start to see how fundamental consensus algorithm choices and network usage will drive these features.

Entrepreneurs are always told to be customer-centric and investors similarly need to be customer-centric when building out a thesis as to why institutional money will store value in a given token.

Major thanks to Ely Sandler, who helped inspire this line of thinking. Further thanks go to both my colleagues Judith Dada & Dirk Sassmannshausen for their invaluable feedback.

Footnotes:

  1. https://www.ft.com/content/570e7290-6db3-11e8-92d3-6c13e5c92914
  2. https://money.cnn.com/2018/08/02/news/economy/boe-interest-rate-decision/index.html
  3. https://twitter.com/alegw/status/1024768885281710080
  4. https://www.treasurydirect.gov/govt/reports/pd/mspd/2018/opds062018.pdf
  5. https://www.gold.org/research/gold-investor/gold-investor-july-2018/key-gold-market-statistics
  6. A “coupon payment” is an interest payment and the “coupon rate” is the interest rate for a given bond
  7. John Paulson, https://www.youtube.com/watch?v=YD3wJyZx6ZI
  8. https://www.coindesk.com/the-economics-of-ethereums-coming-consensus-change-are-taking-shape/
  9. ‘Money’ here is used as an adjective; I first came across this framing from Multicoin here — https://epicenter.tv/episode/223/

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