David and Goliath: The Institutional Argument For Crypto In a Post COVID World
This piece is a teaser from our “Institutional Argument for Crypto Post-COVID” series, a comprehensive examination of key macro trends influencing markets and crypto in the aftermath of COVID-19. Part I and Part II are out exclusively for Delphi Digital members at www.delphidigital.io. If you have any questions or comments, please reach out to Kevin Kelly or myself — we hope you enjoy!
The dollar as the world’s reserve currency has arguably become the US’s largest export. Fuelled by the eurodollar system which allowed for mass creation of dollar-based deposits outside the US, estimates pin the amount of dollar-denominated debt in the world at $60T. As a result, the world is always short dollars and Coronavirus has only accelerated this.
A dollar shortage is inherently deflationary. This hits EMs who hold most of the dollar-denominated debt and whose dollar-denominated cashflows are dependent on commodities and the US consumer. It also will then begin to spread to advanced economies and eventually the US. Already nearing the end of its long term debt cycle, reduced spending by consumers and businesses combined with a strong dollar that reduces competitiveness of exports will tilt the US definitively into deflation.
All cycles contain within them the seeds of their own demise and thus, like a wrecking ball, the same forces that drove the US into deflation will reverse into currency debasement.
A strong dollar weakens the US economy just as policymakers do “whatever it takes ” to prevent deflation and satisfy the insatiable global demand for dollars, spending unprecedented amounts through coordinated monetary and fiscal stimulus financed by issuing debt and minting currency to buy it (i.e. “Unlimited QE”). Gradually, then suddenly, the increasing debt burden, in combination with the ~$200T in off-balance sheet liabilities accelerates reduced foreign demand for treasuries, forcing the US to increasingly finance its own debt. Lacking the power to tax that it possessed in the 1930s, the US will be forced to mint ever more currency in order to continue financing itself. Following the playbook of all reserve currencies before it, the only logical end-point of this is currency debasement, threatening the US’s dominance as global reserve and opening up a gaping hole in the global financial system.
In this essay, we will outline the steps that lead us to this conclusion as well as the evidence that this is already beginning to take place. We will finish with some hearty speculation regarding what this may mean for the world and for investors. We argue that the process of disintegration of the dollar will be bullish for safe haven assets, with the main beneficiaries being Gold and cryptoassets, led by Bitcoin. We also argue that these cryptoassets may play an important role in helping to fill the hole left by the dollar, as their unique characteristics become ever more relevant in the world Coronavirus has accelerated us towards.
The Global Dollar Shortage And Deflation
The US Dollar is far and away the world’s most dominant currency, and arguably the most dominant in recorded history. Not only are the majority of international trade and capital flows denominated in it, 70% of world currencies are also anchored to the dollar in one way or another.
The dollar’s dominance has yielded great benefits to the world in the form of a stable, trusted, global currency that has allowed international trade to flourish. However, it has also come with costs.
The world’s dependency on the dollar gives rise to what economist Hélène Rey calls a “global financial cycle”, where shocks to the dollar reverberate across the world and can ricochet back to the United States. It also means the Fed is a monetary superpower, responsible for enacting monetary policy not just for the US but for the world. This is problematic as while the eurodollar system means anyone can create dollar-denominated liabilities, only the Fed can create the dollar-based assets necessary to satisfy them.
More worryingly, since currency is arguably the ultimate network effect product, the world faces constant self-reinforcing positive feedback loops that amplify its dependence on the dollar. The US is the main producer of global safe haven assets in the form of dollars and treasuries (promises of future dollars). During crises, demand for these safe haven assets grows. As a result: a) the dollar surges, inducing global financial stress as the real value of dollar debt rises and b) dollar financing costs increase relative to other currencies, further increasing the real value of dollar-denominated debt and reinforcing its chokehold on the global economy.
This is exactly what has happened since the 2008 crisis, as dollar-denominated debt in the world has doubled from $30T to a new all-time high of $60T.
This massive increase in debt has not been accompanied by a corresponding increase in incomes, leading to higher global debt to GDP ratios and resulting in a $13T global dollar shortage estimated to increase to $20T by December.
Coronavirus — The Great Accelerant
In summary even before the Coronavirus, we were already facing the largest dollar shortage ever. Coronavirus, more than any financial crisis before it, exacerbates this structural shortage:
(1) It weakens the US consumer, which is especially problematic for countries that rely on US imports for their income
(2) It has coincided with the largest drop in oil and one of the largest drops in commodity prices generally that we’ve ever seen, further hampering dollar flow to economies dependent on selling commodities (i.e. Emerging Markets)
(3) It has caused a flight to safety/liquidity which, since the dollar is the world reserve currency, means increased demand for dollars and treasuries
(4) It has meant countries are having to issue more debt, much of it dollar-denominated, in order to enable their economies to weather the effects of Coronavirus lockdowns
(5) It has tightened the supply side of the dollar funding market, as banks and financial institutions withdraw liquidity at the time when it’s needed the most in an effort to reduce their risk exposure
Exporting inflation to Emerging Markets
Cumulatively, this means supply of dollars decreases while demand for it increases: leading to a rising dollar and initiating the global deflationary cycle. As the dollar rises, this hurts EM first as the real value of their debts rise just as they are earning less dollar-denominated income due to lower commodity prices and reduced US importing.
This was reflected in the strengthening of the trade weighted dollar index, which only began to weaken on May 25th after the US opened up repo lines with all major trade partners, injected multiple trillions of dollars of liquidity into the system and leaders of the IMF and World Bank agreed to suspend debt service payments from some of the poorest countries.
While the dollar initially weakened due to the size and speed of the US policy response, its spending levels relative to the rest of the world are poised to decline as other countries struggle to deal with the economic fallout from COVID-19.
Most importantly, these countries lack the luxury of a reserve currency that enables them to issue more debt to increase spending. As such, the rest of the world will continue to face a huge loss of dollar reserves while at the same time increasing their monetary base in local currency much faster than the Fed, without the benefit of being a reserve currency.
While the Fed may spend more in absolute terms, a dollar of spending by the US is very different from a dollar of spending by any other country due to its reserve currency status and the constant demand for dollars this creates. As Brent Johnson describes in his aptly named “Dollar Milkshake Theory”: no matter how much liquidity is added to the milkshake in the form of coordinated global stimulus, the dollar has the straw that sucks it all up.
EM’s are thus left with a difficult choice: a) painful austerity b) print currency and face potential devaluation, repeating the mistakes of Argentina, Zimbabwe and Venezuela c) default/restructuring
Austerity is impossible in the face of Coronavirus lockdowns as the economic and human pain would be unbearable. We are already seeing the beginnings of b) and c), with the former generally preceding the latter.
In early March Lebanon announced it will for the first time default on its dollar-denominated eurobond.
A recent report by the African Union expects a base case of 20 million job losses and 20–30% loss in fiscal revenues. Tumbling commodity prices will further disrupt the economies of big oil producing countries such as Algeria, Angola, Cameroon, Chad, Equatorial Guinea, Gabon, Ghana, Nigeria, and Congo Brazzaville.
Many emerging nations all around the world are in similar positions with Turkey, Brazil, Venezuela, Iran and India all showing currency weakness in anticipation of the pain to come. Defaults and restructurings contribute to the deflationary cycle, destroying credit and leading asset prices to decline further.
The IMF expects emergency financing demand to exceed $100 billion; the international organization has already received requests from more than 100 countries in need of economic relief.
Deflation in advanced economies — The beginning of the end of the long term debt cycle
While coronavirus will wreak havoc in the more sensitive EM economies first, it will also begin to poison advanced economies from within by accelerating the advent of their most feared and fearsome foe: deflation.
Indeed, deflation in advanced economies had long been looming as they edged towards the end of their long-term debt cycles, with growth slowing, debt to GDP levels at or near all-time highs, interest rates near 0 and serious demographic problems exacerbating all of the above. While central banks struggled valiantly and did all they could to keep deflation at bay, Coronavirus tilts the balance definitively over the edge, marking the beginning of the end phase of the long-term debt cycle.
Demographics and debt
Before we get into the effects of Coronavirus, it’s important to briefly hover over the context of slowing growth that the US and advanced economies more generally already found themselves in before Coronavirus.
In terms of demographics, a combination of increased longevity and reduced fertility over time means there are an increasing number of people who aren’t part of the labor stock but lead longer lives while there aren’t enough births to replace the lost labor stock.
As a result, there is reduced labour stock supporting a greater number of retirees. In 1950, the number of working people per retiree in the US was 12. It is now 4.7, with the numbers being even lower in Japan, Italy and Germany. Most worryingly, these are continuing to trend strongly downwards, projected to reach 2.5 in the US by 2050 and <2 in South Korea, Italy, Germany and Japan. This already posed a huge growth headwind as a dwindling labour stock must support an ever larger number of retirees.
In addition, debt in advanced economies was already at unprecedented levels with corporate debt to GDP, national debt to GDP and central bank balance sheets all at or near all-time highs.
Similarly, consumers were vulnerable as auto loans, student loans were at all-time highs, with credit card delinquency rates also at 5 year highs.
Most shockingly, despite the Fed-fuelled asset boom of the last 11 years, 45% of Americans have 0 cash in their accounts, 38% of Americans could not come up with $500 without selling something or taking out a loan and 25% of Americans have no emergency savings at all. This reinforces the point that QE has truly been “Universal Basic Income for the rich”.
The Coronavirus accelerant
Coronavirus accelerates the deflationary consequences of both these trends. With bond nearing 0 and asset price returns expected to be significantly lower over the next decade, retirees must reduce their consumption significantly.
Similarly, with continuing jobless claims above 17M, the already highly indebted US consumer now faces reduced or uncertain cashflows. As a result, they will also reduce consumption, with many defaulting on debts, leading to impaired credit ratings and making banks, who are already hoarding cash, even more reluctant to lend.
Many highly levered corporates will also go bankrupt, with a strong dollar exacerbating their cashflow issues. While bankruptcies are normally a lagging indicator, April saw a 26% increase in Chapter 11 filings, with May seeing a 48% increase and June a 43% increase compared to 2019. Overall, US commercial bankruptcy filings are up 26% in the first half of 2020 compared to this time last year.
Governments have attempted to paper over the cracks with stimulus but this is unlikely to be enough as the velocity of money, which has been in steady decline for the last 10 years, is likely to drop further as people and businesses hoard cash in anticipation of reduced future cashflows.
This reduces the effects of each incremental dollar of stimulus and creates the deflationary doom loop in which:
households hoard money → corporates face reduced earnings and thus hoard money → banks see less credit-worthy lenders and also hoard money
The drop in commodity prices adds further fuel to the deflationary fire. Cumulatively, we are likely to see a drop in the CPI this year. Nominal yields could fall into negative territory barring a significant pick up in real rates, an occurrence last seen in the 1930s
Importantly, this drop in consumption may not happen immediately as the reopening will see a return to normal spending habits for many. However, many industries such as leisure, hospitality, energy and travel will not return to normal for at least 12–18 months and may be permanently impaired. Given the amount of debt in the system and razor thin margins of many, it only takes a small decrease in consumption at the margin to begin the deflationary cycle, as weakness in one industry spreads around the economy.
While this short-term deflation is in our view almost inevitable and arguably necessary, we will now argue that, given the setup of the current system, the next step will be large scale government spending and monetization of debt. As in all cases before it, we believe this will end with currency debasement and the threatening of the US as the global reserve, creating an opening for a new system.
Debasement
Deflation begins by destroying other countries, before seeping into the US economy and finally crippling its currency. How does this happen?
The strong dollar makes its exports become more expensive and weakens the US economy.
This lowers GDP, just as the US is forced to issue more debt to finance Coronavirus stimulus packages, stave off deflation and satisfy the global demand for dollars. It is estimated that by the end of this crisis, the US’s debt to GDP ratio will surpass the previous all-time high of 106% set at end of WWII. In addition, while at the end of WWII the US was still a creditor nation, it is now the world’s largest debtor nation, facing the worst net international investment position in its history at negative ~50% of GDP. For comparison, the US’s net international investment position in the 2008 crisis was “only” negative ~10% of GDP.
Crucially, this “official” debt doesn’t even account for the far larger off-balance sheet liabilities such as Medicare, Social Security and Pension which are estimated to amount to an additional~1000% of GDP.
While these may not be counted in the official figures, they are undoubtedly debt as for 40 years the US borrowed over $200T from its citizens in the form of Medicare, Social Security and pension deductions and it is now forced to deliver these benefits to its citizens.
Most shockingly, we find ourselves in this state of peak indebtedness with interest rates already at the zero lower bound, leaving no room for the 219–600 bp interest rate easing that happened in all previous crises.
How does the US deal with so much debt with interest rates already at 0? There are 3 options:
- Cut government spending or hike up taxes, both of which will likely trigger a long and painful period of austerity
- Debase the currency and wipe out the real value of the debt
- Grow its way out by carefully balancing the counterforces of inflation and deflation, reducing excessive leverage while issuing productive debt that jumpstarts economic activity and reigns in debt-to-GDP
(1) is unfeasible as the government can’t cut back on spending without risking a gut-wrenching downturn, plus the growing need for dollars requires the US to keep to its current course. In addition, increased capital mobility will likely hinder governments’ ability to raise taxes as they did in the 1930s.
(3) is ideal. It’s what we tried in the Great Financial Crisis, bringing us to the position we’re now in, with debt to GDP ratios even higher than in 2008 and interest rates far lower. While it’s true that inflation didn’t show up in the CPI, it certainly showed up in the stock market:
Just as it didn’t work in 2008, we believe it will not work now because:
a) structural headwinds to growth such as demographics, debt and de-globalisation mean that new debt issued is increasingly unproductive as shown by ever larger debt to GDP ratios
b) lowered velocity of money and increased savings rates mean each incremental dollar of spending is less effective at stimulating economic activity
c) no matter how much more productive debt is issued leading to GDP growth, the US is unable to reduce spending or increase taxation sufficiently to pay back its debt
To illustrate why, let us look at some numbers. Kotlikoff estimated in 2015 that funding this gap would require a permanent 58% increase in taxes or a 38% spending cut immediately. The numbers will be even larger now with the additional 5 years of continuous, growing deficit spending and Coronavirus stimulus.
Increases in taxation were successfully used in the 1930s where the top marginal tax rate was raised from 24% in 1929 to 94% by 1945 and would not go below 80% for the next 20 years. Even then however, it still took debasement in the 1930s and ~25% inflation from 1946–1948 to sufficiently reduce the debt burden to make it manageable.
However, the US cannot increase taxation like it did in the 1930s because it has far less leverage on its capital. With the hollowing out of its manufacturing base and the growth of digitisation, the US has far less ability to take over physical assets. Similarly, while in the 1930s the US could freeze bank accounts and enforce capital controls with relative ease, globalisation and the proliferation of off-shore bank accounts (and now cryptocurrencies) has vastly reduced government’s ability to confiscate its citizens’ wealth.
The US also cannot decrease spending due to the global shortage of dollars created by the eurodollar system. This system requires the US to continually run massive deficits in order to finance the world’s US denominated debt, or otherwise risk the US dollar rising, hurting the US economy. In addition, the allure of the unbridled spending that having a reserve currency permits has historically proven hard to resist, especially given the short-term incentives of most politicians.
Money Printer go brrrrr
The US must and will therefore continue to print. We are nearing the point at which annual US debt burdens will exceed tax revenues, and the US must begin issuing additional debt just to pay off the debt it already has. Gromen previously estimated this would happen as soon as 2021.
While this can go on for a while, at some point, the world begins to question whether it makes sense to continue funding the US’s increasingly large deficits while being paid 0 nominal rates for the privilege. There is evidence the world is already tiring of doing this, with China and Russia especially reducing US treasury holdings and increasing Gold reserves, as well as seeking to denominate commodities trade in Gold.
In the short-term, this contributes to the dollar shortage as central banks have less dollar-denominated income/reserves and US domestic bond purchases crowd out consumption/imports, further reducing dollar flows. In the long-term however, like Japan since 1990, the US is increasingly forced to finance its own debt by issuing more debt and printing currency to buy it, further feeding the vicious cycle of spending and debt.
The only end-point of this is currency debasement, either via excessive spending (i.e. increasing supply of money) or large scale debt jubilees (i.e. reducing future demand for money).
The former is what happened in Japan since 1990. After a debt-fuelled asset bubble popped in 1990, the government attempted both monetary and fiscal stimulus, financed by money printing. This has led to currency devaluation, stock market stagnation and low inflation.
This also happened in the Great Depression in which the popping of the 1929 bubble led to stock market declines, low or negative inflation and currency devaluation vs Gold. This was only resolved after significant, repeated dollar debasement in the 1930s, 25% inflation in the post-WW2 years combined with increased taxation helped deleverage and propel the economy forward. Importantly, both these cases, while serious, involved creditor nations.
It’s also what happened in Ancient Rome, where despite an ever-expanding empire, excessive spending by emperors beginning with Augustus birthed a burdennsome bureaucracy fuelled by low interest rates and massive amounts of debt. This led to consistent crises followed by taxation, asset seizure and currency debasement, with the silver content of the denarius at 0.02% by 268AD vs 99.5% in 27BC. Estimates pin the inflation rate at 1,500,000% over the third century, precipitating the end of the Roman empire in 450AD.
In every case, when debts get too high, the only way out is through significant currency devaluation. In the case of modern reserve currencies, this devaluation rarely if ever ends up in hyperinflation and historically only has when it coincides with the end of an empire (Roman Empire / Tsang Dynasty).
However, it will certainly affect the US’s status as world reserve currency, as devaluation reduces the value of dollar reserves and thus its relative dominance vs other currencies. Additionally, expectations of further devaluation break confidence in the dollar, which at the end of the day is most of what really sustains any currency, especially the world reserve currency.
Reserve currency — Blessing or Burden?
People often highlight the advantages of minting the global reserve currency in that a country is able to spend as much as it wants knowing there will always be demand for its currency and thus for its capital (promises to deliver future currency). However, there is a darker side to this.
Like The One Ring in Lord of the Rings, having the reserve currency grants one the power to spend as much as one wants; a temptation difficult to resist. This is the trap that all world currencies have historically fallen into: their powerful network effects makes their issuer act as if demand for them is truly unlimited. As a result, they continuously spend more than they take in.
Like Gollum however, the results of becoming addicted to this power can be ugly. As the ability to issue debt appears infinite, the need to ensure that debt is invested productively diminishes. This is an extreme case of what the Austrians call “malinvestment”. We see it in action in the swelling Roman bureaucracy of the 400s, in the Japanese public work schemes since 1990, and in the US deficit spending since 1968 which has led to consistently higher debt to GDP ratios, not to mention off balance sheet liabilities totalling 1000% of GDP.
Short-term incentives by politicians exacerbate all of this with debt issuance being seen as an easy fix with consequences to be passed on to the next generation, like an inter-generational game of monetary musical chairs.
At a certain point, the music stops and the power becomes a burden. Rather than enabling the US to spend as much as it wants, the reserve currency begins to force the US to spend as much as it can, even if there are no productive investment opportunities available, in order to keep the dollar from appreciating and harming US competitiveness. Effectively, external demand for the country’s currency begins to guide national spending decisions rather than the universe of investable opportunities available.
It is no coincidence that historically every reserve currency, from the Roman Denari to the Huizi of the Song Dynasty have ended in extreme indebtedness and devaluation.
Does a great America require a weak dollar?
Despite all its spending, the perpetually strong dollar has still hollowed out US manufacturing and hampered its competitiveness worldwide. A McKinsey study estimates that “exporters and manufacturers that compete with imports lose out by up to $100B because of the strength of the dollar, reducing employment in these sectors by between 400,000 and 900,000”.
In addition to the economic benefits, the US had already begun to realise that supply chains, especially for ICT, represent a natural security risk. This has only come into sharper focus post Coronavirus as the PPE shortage highlighted the US dependence on China. While early policies were seen as xenophobic, there is now bipartisan support for the US to address this dependency.
Moving manufacturing nationally is naturally inflationary, driving input costs, domestic wages and consequently prices higher. In addition, it pushes the need for a weak dollar to make exports competitive.
Even President Trump understands this, having repeatedly called for a weaker dollar:
What’s next?
Whether deflation amplifies a global dollar shortage and leads us to question our dependence on the mighty greenback, or currency devaluation simply reducing our faith in it, it is likely that Coronavirus will accelerate the historically inevitable demise of the dollar as the world’s reserve currency. This will open up a massive crater in the global financial system.
We argue there are three main candidates to fill this hole:
(1) Another sovereign currency
(2) A basket of central bank digital currencies
(3) Some form of hard money
We will go through these in turn.
Another sovereign currency
We argue the dollar cannot be replaced by another sovereign currency. The only real candidates are the EUR, GBP, JPY, or the CNY.
The eurozone faces perpetual low growth as well as political and fiscal problems that threaten its dissolution.
Britain is increasingly isolationist and is in any case facing a difficult transition out of the EU which is likely to further reduce its importance as centre of global commerce.
Japan and China face their own debt problems and in any case have no interest in becoming a reserve currency as they have benefited hugely from continual devaluation of their currencies that has helped make them the manufacturing heart of the world.
While China undoubtedly wants to overthrow the US as world reserve currency, their words and actions show they are not seeking to replace this with the Yuan but rather with some non-sovereign currency, whether the IMF SDR’s or some form of hard money.
A basket of CBDCs
Central banks around the world have announced they’re looking into CBDCS, with the Bank of International Settlements recently creating a group with the central banks of Canada, the UK, Japan, EU, Sweden and Switzerland to jointly research the subject.
A particularly vocal proponent is Governor of the Bank of England Mark Carney, who argues “a synthetic hegemonic currency… provided perhaps through a network of central bank digital currencies” is necessary to “dampen the domineering influence of the US Dollar on global trade”.
Despite its seeming promise, we believe there are many technological and political barriers to its implementation, especially after Coronavirus which has only served to accelerate the unwinding of globalisation and international cooperation.
It’s important to realise that a digital currency is a technology product with a large (and increasing) competitive set. Government institutions, particularly in the West, are known neither for their technical prowess or their agile product development skills and it’s difficult to imagine them winning here.
This is particularly the case when we realise how many areas of society would be affected by a digital currency. Are commercial banks still necessary as middlemen if the central bank can send money directly to citizens? How many government bureaucrats would lose their jobs if state spending was digitised, transparent and automated?
Internationally, a CBDC basket as reserve currency would require a robust governance framework backed by the collaboration, trust and agreement of all major powers. This is difficult to imagine given the two most powerful nations in the world are currently waging economic war against each other. In addition, the US, whose commitment would be critical to the success of any such alternative, is increasingly retreating from world affairs and in any case has little incentive to push adoption of an alternative currency. In the immortal worlds of ex-Citibank CEO Chuck Prince: “As long as the music is playing, you’ve got to get up and dance”.
Hard money
Historically, as the long-term debt cycle draws to a close and the world reserve currency suffers its inevitable devaluation, the next step is to reset with some form of hard money to rebuild people’s trust in government and its currency.
Gold will undoubtedly play an increasingly important role as it always does during times of increased economic instability.
This will especially be the case this time as we believe the diversification benefits of bonds on portfolios will be drastically reduced since:
(1) As bond rates hit 0 worldwide, their upside is far lower and heavily tethered to price appreciation, which is only possible if yields go negative. For instance, to get the same linear benefit from a bond portfolio as investors received in 2008, rates would have to drop to ~-2%
(2) Consistent fed intervention means correlations between bonds and stocks have been converging over time
However, we also believe Bitcoin will continue to become an increasingly large part of this conversation. Like Gold, Bitcoin has increasingly shown low correlation to stocks and other asset classes over longer periods. While Bitcoin lacks Gold’s 6000 year brand, its characteristics as a safe haven are in every other way superior to Gold.
We believe these benefits will become increasingly important in the world COVID19 is accelerating us towards, driving Bitcoin to gain increasing market share as a safe haven asset.
The Bitcoin Advantage
Evading capital controls & taxation
While the world was already trending in this direction, we are seeing Coronavirus accelerate the unwinding of globalisation, accentuating geopolitical tensions and fuel isolationist sentiment. Driven by increasing indebtedness and inequality, we believe that just like in the 1930s governments will respond with strict capital controls and increased taxation.
While Gold was traditionally the asset of choice to evade oppressive governments, it is both more difficult for citizens to acquire and easier for governments to seize. This is evident both by the ease with which FDR banned private ownership of Gold (and enforced this through multiple persecutions and Gold seizures) and more recently in the many stories of Venezuelan immigrants having their Gold confiscated at the border. We’ve already seen digital assets successfully be used to evade capital controls in Asia, Venezuela and other countries and we expect demand for non-sovereign money to increase as sovereign currencies’ vulnerability to seizure becomes apparent.
Financial intermediaries
It is said that Gold is the only financial asset that isn’t someone else’s liability. While this is true of physical Gold, the difficulties associated with acquiring, holding and verifying the purity of physical gold mean a large percentage of individuals’ Gold exposure comes through synthetic financial instruments such as ETF’s and futures.
This is problematic as Gold is meant to provide tail risk insurance and yet these ETF’s are custodied by banks which often have sub-custodying agreements with other banks, exposing investors to significant counterparty risk with the very institutions that would be negatively affected by the tail risks investors are seeking to insure against. Similar problems apply to futures in which the counterparty is almost always a financial institution.
As awareness of these risks grows or we see instances of these risks playing out, we expect to see Bitcoin gain market share vs Gold.
Demographics and trust in institutions
As a result of the above, Gold fundamentally requires individuals to trust institutions, specifically financial institutions, on which trust is at all-time lows. This is particularly true for millenials. A Facebook research paper showed 92% of millennials do not trust their banks while a Fundstrat study shows that trust in the US government is now at a 60 year low.
At the same time, a Charles Schwab report shows that within their 401ks, bitcoin is already the fifth biggest holding amongst US millennials. The true number including those who self-custody or invest through exchanges is likely to be considerably higher. The trust over time curve is completely different for Millenials as they understand these technologies much more intuitively having grown up on the internet.
Utility
While Bitcoin is often derided for its lack of utility, its natively digital nature makes its utility innately superior to that of Gold. Bitcoin can not only be used for payments and transfers (15,174 businesses accept Bitcoin worldwide), there is also an entire emergent financial system being built on top of Bitcoin. Ultimately, this will provide an alternative to the existing financial system , recreating foundational financial applications such as credit, insurance, capital formation, exchange and more with a decentralised, open, peer-to-peer and non-custodial architecture. Crucially, this makes Bitcoin the only financial asset that can actually be used as part of a broader financial system without becoming someone else’s liability.
As the ecosystem and technology develop, we expect the utility of Bitcoin to rise exponentially, increasing its liquidity and network effect.
Bottom-up vs top-down
As a result of the aforementioned difficulties with using Gold directly, its adoption as a basis for a new financial system must be always be mediated and implemented top-down by existing institutions. As in all previous iterations of the Gold standard, individuals inevitably end up trading some form of Gold IOUs issued by institutions. Not only do these institutions have a history of ceasing to honour these IOUs when it suits them, they also heavily regulate the use of these IOUs, slowing innovation.
Bitcoin does not require top-down planning but rather can emerge (and arguably is already emerging) bottom-up via the individuals themselves. There is evidence this social movement is already extremely strong, with the majority of BTC holders (or “hodlers” as they’re often known) continuing to hold, or even add to, their positions even amidst serious selling pressure.
In addition, developers from all around the world are building completely open, borderless and permissionless financial applications on the blockchain. As the technology matures, this will give more people a way to partially or completely opt-out of the fiat financial system by voting with their money, further facilitating the bottom-up revolution.
Supply chain vulnerabilities
Gold supply chains have already shown vulnerabilities due to Coronavirus, with disruptions in physical delivery creating large differences between physical and spot prices. We believe these problems will only be exacerbated during currency crises, especially considering rising geopolitical tensions and capital controls which will see countries seeking to keep control of as much of their Gold reserves as possible.
Bitcoin’s supply chain is digital and decentralised, meaning it is far less exposed to logistics issues. In addition, custodying physical BTC is far simpler than custodying Gold and getting easier by the day, making demand for financial BTC products unlikely in the long-term.
Conclusion
We began by showing how Coronavirus accentuates the global dollar shortage, wreaking havoc in EM countries with large dollar-denominated debt burdens. We then talked through the deflationary effects on advanced economies, and the necessity for the US to continue running ever larger deficits funded by debt monetisation in order to avoid dollar appreciation which is bad for the entire world. As the US continues to finance more of its own debt, debt productivity will continue decreasing, initiating a vicious cycle which will be deflationary but also eventually lead to currency devaluation as in Japan since 1990. This process will weaken the dollar, eventually threatening its status as world reserve currency.
While we aren’t saying Bitcoin will take its place, we do believe that firstly demand for safe haven assets will go up considerably in the world Coronavirus accelerates us towards, and secondly that Bitcoin’s superior safe haven characteristics also become far more important. As governments leave this crisis with the highest indebtedness levels in modern history and interest rates at 0, there will be increasing demand for assets that can act as a hedge to an ever more fragile financial system. As these same governments scramble to finance themselves by any means necessary, there will be increased demand for seizure-resistant assets. As globalisation unwinds and trust in institutions hits all-time lows, people will naturally gravitate towards bottom-up solutions that bypass institutions altogether.
Bitcoin is not the only asset that facilitates this. Both Gold and cash can arguably fulfil some of these roles. However, neither of them do it as well or as easily as Bitcoin. Most importantly, neither of them can facilitate an alternative, global, open, non-custodial financial system to operate on top of them. Given the potential magnitude of this outcome (and its lack of correlation with almost all other bets one can make), the probability just doesn’t need to be that high to make a small portfolio allocation a no-brainer. Many well-known traditional investors are now seeing this, and we believe many more will too in the coming years. We hope our work at Delphi can play a small role in making this happen.
Thanks to Kevin Kelly for his knowledge and feedback in writing this post. If you want to read the full series, sign up as an institutional member at www.delphidigital.io
