December 2022
Nik says there should be more regulations and insurance mechanisms to help crypto investors safely store their assets. According to Nik, this is what FTX lacked. However, although their failure may have cast a negative light on cryptocurrency, Nik still believes bitcoin has considerable potential going forward because of its core innovation: decentralization. Its mining algorithm and military-grade security make intermediaries obsolete and pose a greater question to the world: can other systems be reformed in this way, like voting and the transfer of property title?
Chris and Nik also discuss the question of how “real” bitcoin is. Nik points to hash power, which refers to all the bitcoin mining hardware that is on and plugged into the mining network and fighting over the limited supply of bitcoin (a maximum of 21 million bitcoins can be issued and 19 million have already been mined). Nik says the competitive mining industry and infrastructure that have developed around hash power show him that bitcoin has real value. He thinks there may even be a time in the future when people will have bitcoin wallets before bank accounts, as digital currency and decentralization could become society’s new horizon.
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Check out past episodes of The Financial Commute here:
Ep. 13 Evaluating Opportunity in Fixed Income
Ep. 12 Key Items to Review When Year-End Planning
Hello, everybody, and thank you for joining us for another episode of The Financial Commute. I'm Chris Galeski, your host. Really excited. Joined today by Nik Bhatia. Nik Bhatia is the founder of The Bitcoin Layer. He's also a professor at USC in Finance. He's a CFA charter holder, has a background in fixed income securities, but you also wrote a book on layered money.
So you are a Bitcoin maximalist and pro of that cryptocurrency in general. Lots of really interesting things in the news going on with FTX and that debacle. Cryptocurrencies in general and as an investment firm, we get questions all the time from clients about cryptocurrencies and whether or not they should invest in them, and if so, how much or which ones.
And we're pretty agnostic and we feel like it's a very new investment choice. So we don't currently play in that space. But I'm excited to have you here to help educate us and our clients on crypto currencies in general. So thanks for joining us.
Of course. Thank you for having me.
So let's start with FTX.I think it's obviously the top of the line story with Sam Bankman-Fried now being arrested. Obviously a lot of fraud between FTX, the brokerage firm and Alameda, his research company and people are wondering what's the future of cryptocurrencies in general? I'd love to get your thoughts on what happened with FTX and then how you view crypto.
Sure. So if you'll let me start with the term Bitcoin Maximalist, because I think it's important. I do embrace that term. It's highly charged, but I do embrace it and everyone has their own definition. Mine is I'm a maximalist in terms of my personal allocation to Bitcoin within cryptocurrency for that asset class. And so for me, my allocation to cryptocurrency is 100% Bitcoin.
Mm hmm. And I. That is my approach to it. I think it's a highly conservative approach. People look at crypto as something that is so volatile, so it carries so much risk. And in a larger context, that's absolutely true. But within this new technological wave, a 100% allocation to Bitcoin is actually conservative from that narrow viewpoint. Yeah.
And as a fixed income guy myself, I tend to be that conservative investor. I traded treasuries. So, you know, the safe asset class with it, the safe asset within the safe asset class. And it's actually how I view Bitcoin, even though when you compare Bitcoin on a standard deviation basis to other asset classes, it's going to look much more volatile.
So in terms of what people should be thinking about, they should be thinking about looking at Bitcoin as a potential allocation within their whole portfolio. And if they do so, to even take that further step and explore Self-Custody, which is what would protect people in this situation. You can buy Bitcoin, but how do you store it? Right? And that question, how do you store it is a big challenge for, I think, the industry. Self-custody, it's easy for someone like me, but it would I would still have to teach somebody that's not used to it. And so no matter how quickly somebody can learn, it still presents that hurdle and that challenge. So I think that's important to understand that Bitcoin is a conservative investment within cryptocurrency because we don't really know what the rest of them are.
We know what Bitcoin is. We can get into that if we want to. And then the self-custody aspect to protect against what is now a known issue in cryptocurrency exchange, which is that they can be built on thin air or fraud or deception or a combination.
So just to summarize right, first of all, most fixed income analysts that I've met, there's not too many optimists there because you're looking at balance sheets and a lot of negative things. So you mentioned that you tend to be on the conservative end of things. And when you're talking about 100% allocation of Bitcoin, you're not talking about all of your investments.
You're just talking about when you invest in cryptocurrencies, you're only choosing Bitcoin versus other ones.
That's correct.
And when you talked about self-storage, what came to mind, it’s not too different than if somebody was to buy gold. You can buy it through an exchange traded fund or an index fund that's supposed to be backed by those assets in reserve. Or you can go buy physical gold and store it in a safe or at a bank. You're talking about owning cryptocurrency or owning Bitcoin and having it on the self-storage that you custody at home.
Yes. And think about three types of ways to store Bitcoin. Number one, you buy it on an exchange and withdraw to your own self-custody. You have full responsibility in that scenario of the custody of the Bitcoin. If you lose your device or however you're choosing to store it, you're in jeopardy of losing it forever. There's no 1-800-Bitcoin.
You got to remember the username password.
You have to take measures. Basically, you have to take measures. So number two, you can buy something like GBTC, which is in this pseudo regulated environment. And look, it's trading at half of the net asset value and is facing a lot of challenges as an investment vehicle because there's not a lot of regulatory clarity around exchange traded funds that hold Bitcoin itself in the United States today.
And the third would be just buying it on an FTX, for example, and leaving it there or what maybe more of your clients have is a Coinbase account and that they bought it on Coinbase and it's just in their Coinbase account. Right. So you have these three situations, they all have different risks to them and we don't,
Bitcoin is extremely young like we were talking about relative to other asset classes. So you're really only in, I would say, year six or so of any sort of custody industry. Right. And that includes iPhone wallets, hardware wallets, which are devices or collaborative custody, which are companies that will share the keys with you and hold a back up for you, basically, and you can hold a couple of keys.
They'll hold a backup key and you only need two of three. So there are a bunch of ways to hold it. And everybody needs to take their own approach. And because we're early in the industry, there is no consensus way, there is no regulatory approved way. Yeah. And that presents a lot of challenges. And that's really what I'm trying to do with The Bitcoin Layer, is build a base knowledge set for this asset class, which is lacking.
Right. So when you think about owning Bitcoin and some of the lack of regulation that caused FTX, a brokerage firm where it's supposed to be safe to store your cryptocurrency, going under, you're choosing the route of self-storage to best protect yourself and remove that medium.
Well, I do recommend self-storage. I think people should learn that process if they're going to get involved in Bitcoin. But again, I mentioned that there are other sort of collaborative custody situations that could be advantageous to people, but we also need a regulated way for people to hand over the keys to somebody else with the proper insurance mechanisms.
And that's what something like an FTX, to get back to FTX, that's what FTX lacked completely. At least Coinbase is now traded on an American stock exchange and they have to file quarterly and disclose a lot of information to investors that will hopefully protect Coinbase clients from an FTX situation. But I can't say that with certainty. Yeah. And that again, that presents a challenge.
We don't have FDIC insurance. Right. We don't have a 2a-7. You know, the money market complex regulations. We don't have the mutual fund set of regulations and all these securities acts, the 33 Act. The 40 Act. All these and you know, 40, that's 82 years ago, right?
Right.
Right. So again, youth of the asset class is at the core of a lot of the problem. And when you see spectacular volatility, like 75% drawdowns, it helps to know that this has happened 3 to 4times in the past. But on such a short time horizon, each and every time that it's almost so noisy for the average investor, that's not paying attention.
Now, you were just on CNBC and they were asking you because of the fall of FTX and some of the fears around crypto, whether or not blockchain or cryptocurrencies are going to exist in the future. What are your thoughts there?
It comes back to what is the innovation? The innovation is a network, a monetary network that doesn't require a central party. And the way it achieves that is with computing power. And so Bitcoin, the inventor of Bitcoin, figured out a way to design a network that could that had the ability to evolve into a decentralized and scarce monetary network at the same time.
Hmm. And what was figured out, was really earth breaking, earth shattering in terms of how you could transfer value on the Internet? It was never possible to do it without a central server of some sort. Right. And because the Bitcoin mining algorithm and the security that went along with it, the Bitcoin network uses U.S. military grade security, a hash algorithm called SHA-2, which is an NSA technology.
It combined that with this little game theory and, you know, rules set to how a scarce digital commodity could come into existence. And with a decentralized computing network, you know, and that itself was ascribed value in the early days. And by early days, I mean about 2011, when Bitcoin first got up above $1 from nothing. Right. And the first cryptocurrency exchanges popped up and people started trading dollars for Bitcoin in a real way.
Everything else since that time when people realized that Bitcoin had value. Ever since that time, people have tried to copy Bitcoin and they've also tried to use the Bitcoin decentralized way of transfer to argue that other things should be done in this way. For example, voting, for example, property title. Yeah, and many other things. So there's nothing wrong with pursuing decentralized voting.
And there's nothing wrong with trying to come up with a new digital currency, but none of them have achieved the long term value that Bitcoin has, all the early coins that popped up failed because there wasn't a need for a currency that didn't have the same network effect that Bitcoin did. And then other things like Ethereum have come about and have gained a lot of market value, but in my opinion have yet to prove that their network is lasting and material.
Compared to Bitcoin.
Compared to Bitcoin.
Because I think the the transfer of payment without an intermediary is so fascinating, especially in this world of technology. It's so, you know, a lot of us use Venmo or other types of payment transfer systems, but the ability for some people to transfer money across the world through that blockchain technology and how it's going to change industries, you think about property or title or trust companies.
I'm always worried about the viability of their future. When you can transfer dollars for an asset through a secure way and remove that intermediary. It's fascinating. Blockchain. How do you separate blockchain versus bitcoin itself? Yeah, well.
The word blockchain comes from a chain of blocks, and blocks are data sets of Bitcoin transactions, and chain is the word that's used to describe the mining process where the computers are generating, you know, trillions of numbers a second to try to basically win each Bitcoin reward. So the word blockchain really has to do with the Bitcoin mining process.
And I think that the words distributed ledger technology better describe what people really fancy about Bitcoin's architecture, which is that you can do things in a way where we can all see the ledger. Hmm. And that technology is important, but it doesn't have any of the same demand components or the speculative components that Bitcoin has because of Bitcoin's scarce supply.
And Bitcoin's scarce supply, which is backed by its mining network, gives people the ability to own something in digital format that can't be taken away from them and can't be devalued. So the gold thesis and the gold thesis is an old one and the current monetary system is really only 50 years young in terms of when we went off the gold standard.
And, you know, my book, Layered Money argues that since about the 1930s, the U.S. has been trying to remove the world's monetary system from the gold standard and was pretty effective in doing that from the thirties to the seventies. So we've been without gold for a long time, but gold has stuck around as a monetary asset and has grown in nominal terms steadily over the years because of that fact and Bitcoin is designed to be a digital gold.
If you read the early writings of Satoshi Nakamoto, the anonymous creator of Bitcoin.
Yeah, the whole fear of, look, we've been in a global stimulus of money printing worldwide, $30 trillion worth of debt. I mean, it wasn't long ago that you couldn't fathom what$1,000,000,000,000 really meant. Now we've got $30 trillion in debt. So the feeling that gold or Bitcoin can help preserve its value better over time than this debasement of currencies that countries are going to have to face because of how much debt they've consumed. That's the theory?
Of course. And we look at the price volatility in dollar terms. But if you go to Turkey or Venezuela or Argentina or now Nigeria, one of the growing countries that have growing userbase of Bitcoiners, you look at the price in local currency terms and it looks like a phenomenal investment and a wonderful hedge against their governments and whatever either corruption or profligacy or combination of the two that we don't have in the United States.
We have we have fiscal profligacy. And we have this blessing in disguise to being the world's reserve currency that allows the US dollar to preserve value versus assets and trade all across the world and actually dominate that sphere. So it's obscure to us as Americans the value that Bitcoin brings to a vast swath of the global population.
Yeah, it's hard because, you know, even though the U.S. has 400 million people, the world's got 8 billion. And most of us Americans tend to just think in our own little bubble. But we have to understand the impact that something like Bitcoin can do globally. I think that's a good point.
Yeah. And if you look at the adoption of Bitcoin, it should support the value of the network in terms of the overall number of users. And as that grows around the world, it should support the value and there are other use cases to Bitcoin besides hedging against a dictatorship in an emerging market, for example, like the instant transfer of money and the usage of money on the internet without a central party is something that is very exciting to the online, you know, the developers that are working with Bitcoin as well.
Thank you for sharing that. You know, I feel like I could talk to you for hours about this because I'm learning so much in terms of your viewpoint. A client asked me the other day, what do I think of cryptocurrencies in general? Do I think that they're real? Are they fake or are they all a fraud? Obviously, this comes about because the FTX thing, what's your main thesis between Bitcoin versus other crypto?
Yes. If you start to understand the word hash power, hash power refers to all the Bitcoin mining hardware that is on and plugged into the Bitcoin mining network and fighting over the supply of Bitcoin that comes every 10 minutes on average. That war over new Bitcoin, the mining war.
Because it maxes out at 21 million.
The supply maxes out at 21 million. We're currently at 19 million Bitcoin that have already been mined. So, you know, there aren't that many that are left. And the economics are that you have to pay for the hardware, obviously, the rent and the electricity. And then you factor in the current mining difficulty on the network, which is, you know, how many machines you have to have on at a time on average to win one of those awards, you take all those factors and you get an input price to Bitcoin, just as you would for gold miners that have equipment, that have employees, that have the lease of the land from the government for 99 years, and all the energy costs that the coal, the oil that they have to burn to operate the mining machines. So we have an input cost to Bitcoin and it's highly industrialized now. We have many publicly traded Bitcoin miners. A lot of the mare going bankrupt right now, but it doesn't change the overall war for those Bitcoin, just these few companies are going bankrupt because they were overleveraged but other people are stepping in and trying to win those awards just the same.
Another issue is a zero interest rate policy for 15 years. That's right. You could take on a lot of leverage in that context.
That's right. So when we talk about is crypto real? If you see these machines and you know, I've seen some of these warehouses that are trying to win these awards and the infrastructure that's developing on the Bitcoin mining side, you can see that people with computers are interested in investing in a cloud computing network that is only focused on securing the Bitcoin network and trying to earn money along the way.
And that industry itself shows me that this has serious value. This is something that people want to protect in a real way.
And so even though the price has come down 75%, give or take, since the all time highs, you mentioned to me earlier that you're still seeing Bitcoin grow in terms of number of users or interest in purchasing and that might be irrelevant to price. I mean, we'll just kind of finish it up. Wrap your thoughts up with that.
Yeah. I mean, every year or so, studies are published that are tracking the number of Bitcoin users around the world and it's growing every year. It's not a high frequency data set that we get, we also have the data that we get from Bitcoin's blockchain itself, which if you strip away some of the if you look at some of the data internals, we can see that the number of small users is growing in terms of participation on the Bitcoin network.
So there are different ways to see that adoption is slow and steady, but price again, price is so headline grabbing that it's sometimes hard to see that this is a technology, much like the Internet, which is getting slow and steady adoption. It's just something that people are using more and more. And I do believe there's a certain age of child today that will definitely have a Bitcoin wallet before they ever have a bank account.
And that's an important consideration as we think about, you know, the long term viability of this asset class. And crypto doesn't have anything besides Bitcoin with the global recognition and the lasting power because of this network that I'm describing, it's something that people want to protect, hence the mining industry dedicated to it. And Ethereum has just fired mining as a security mechanism recently this year.
It's a big risk. And so it doesn't use mining anymore, which I find confusing, but it's not my area of expertize. I focused on Bitcoin. Yeah.
Nik, thank you so much for joining us. Please tune in to The Bitcoin Layer to learn more about cryptocurrencies, what's going on with Bitcoin and how to best protect yourself. Nik, thanks, I look forward to having you on in the future again.
Thank you so much. Appreciate it.
Disclosures:
Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and do not represent the views and opinions held by Morton Wealth. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your attorney, finance professional or accountant before implementing any transactions and/or strategies concerning your finances.
