A Hidden Threat to Bitcoin

In this day and age the advantage of an asset not carrying any intrinsic value is that everyone can just input their own reason for why they consider that asset valuable and they'd be correct. If with every passing minute someone else comes up with a new reason why that asset is valuable for them and buys the asset, that would not only vindicate everyone else's reason before them, but also would expand the amount of addressable newcomers. Bitcoin is the promise that keeps on delivering without actually delivering anything by itself, but if you hold an asset expecting it to perform in a certain way and it does, does it really matter the reasons why it did?

Bitcoin's original purpose, detailed by Nakamoto in 2008, was to become a decentralized asset outside of the range of the Federal Reserve and its inflation policies. The belief that through its monetary policy, the Federal Reserve has devalued the purchasing power of US Dollars sits at the core of the belief system of its proponents. Cameron Winklevoss lays out their main thesis in a recent tweet where he explains that the more dollars the Fed prints the less value your hard earned dollars carry and that Bitcoin is the ultimate hedge against those actions. It's rare to see a statement so utterly correct at the same time as being misleadingly wrong.

So how is Cameron right? If we observe the actions of the Federal Reserve in the last decade (measured by the assets on its balance sheet) and compare them with the price action of Bitcoin we will immediately see a relationship developing. As the balance sheet of the Federal Reserve has grown (particularly since the beginning of the coronavirus crisis), so has Bitcoin's price gained momentum. If anyone wants to make the case for Bitcoin they just need to show these two graphs to say "Told ya'!".

But why should anyone be interested in the level of assets held at the Federal Reserve in the first place?

The main risk households should be aware of is loosing purchasing power. The amount of dollars you earn each month should be able to buy you the same amount of products and services than las month's. If prices start to increase while your earning remain the same, well you'd have a problem. Cameron's assumption is that by increasing the number of dollars in circulation the Federal Reserve is decreasing their value following the simple supply/demand logic. If we were to test the assumption that expanding monetary policies (the printer going brr) causes inflation we could just plot the Consumer Price Index which tracks street level inflation against the balance sheet size of the Federal Reserve. We should expect that as the Fed's balance sheet has risen so should the year over year inflation measured by the CPI right? Seems like it does not. At all.

Seems like it does not. There is a strong correlation between periods of crisis (shadowed in grey and yellow) and the level of the assets held by the Fed. But notice how these spikes did nothing to the year-over-year change in the level of prices measured by the CPI. Yes, there are many goods and services that the CPI doesn't measure, and many areas of the economy have indeed observed inflation, but one could argue that those are because internal restrictions of the supply side, such as regulation and high barriers of entry, not because of the level of dollars the Fed has pumped.

This is where Cameron, rather by ignorance or malice, gets monetary policy wrong. The Fed does not print dollars. "Sorry, what?" Yeah, policies such as QE and the currency SWAPS, do not print a single dollar bill. What QE basically does is allowing commercial banks to loan more by freeing the reserve restrictions they have with the central bank. By having more assets on their balances, banks can loan more. But its not automatic. The Fed can do as much QE as they want but if banks do not want to loan because of the risk/return landscape in the economy then the Fed's actions will not transpire to main street.

And this is what's been happening. The Fed incentivizing commercial banks to loan more and more just for branch managers at your local Wells Fargo to stop that on their tracks by not granting more loans.

So, if monetary policies do not affect your purchasing power, why would you want to hold an asset that tightly follows the Fed's balance sheet?

The Hidden Risk to Bitcoin

So far, the fire of Bitcoin has been fed by the marginal allocation of savings from retail investors combined with the limited supply of BTC caused by HODL strategies. This limited supply has caused that the price sensitivity of BTC to that extra dollar being invested in it to be relatively high, that's why we commonly see gaps up and down as there are not enough BTC for sale for the amount of BTC demanded. But retail investors have limited amount of savings. That is why it is imperative to expand the TAM of BTC within this sector of market participants. But even if retail investors continue to jump into Bitcoin this only solves the problem in the short term. In order to continue delivering the promised returns Bitcoin will have to attract a different kind of investor, the institutional investor.

By institutional investor I don't mean Elon Musk or Microstrategy. I mean the large number of endowments, hedge funds, and money market funds. If we compare the bond market's AUM (250Trillion USDs) vs BTC's (1 Trillion USDs) we can see that this is where BTC's real potential growth lies. If with $1 Trillion USD the price of Bitcoin went from $0 to $50K imagine if it's able to capture even 10% of the bond market's attention. Problem is, institutional investors are real hedgers protecting wealth and liquidity by allocating to assets that have proven their reliability in previous periods of rampant inflation. If you have investment vehicles such as TIPS or commodities with a proven track record of being a hedge against inflation why would you as a Money Market Fund manager allocate into a seemingly riskier asset such as BTC?

This constitutes a real risk to Bitcoin. If institutional investors do not start adopting Bitcoin, the price of Bitcoin will remain dependent of the retail investor. As their marginal savings allocated to Bitcoin start to decrease the growth prospects for crypto will decrease as well and its price will stagnate. In this scenario if inflation finally happens Bitcoin will be unable to deliver its promise of being a hedge against the rise of prices as there will be no one else there to feed its fire. At the same time, commodities and inflation protected fixed income instruments would naturally increase in value potentially catching the attention of Bitcoin retailers, which would cause a "bank run" on Bitcoin bringing down its price but more importantly killing its narrative as inflation and devaluation hedge.