The Biggest Existential Risks To Bitcoin In 2021

Bitcoin has had an interesting year under the backdrop of regulation and gaining institutional acceptance. However, it’s not all been smooth-sailing.

In July, the US’ OCC (Office of the Comptroller of the Currency) passed a law that allowed banks to offer custody services for digital assets. This was a massive milestone in the goal of broad cryptocurrency adoption, finally providing some regulatory certainty in Bitcoin banking.

Not too far after in September, the state of Wyoming awarded the well-known exchange Kraken a license to create the first cryptocurrency bank in the US — Kraken Financial. Expected around Q1 2021, customers of Kraken could pay bills or receive salaries in cryptocurrency and hold cryptocurrencies with the bank. Future services could include crypto debit cards and staking.

Kraken won’t be the only cryptocurrency bank in the US — they will have competition from Avanti who was granted the same bank charter a month later. By all accounts, it seems like cryptocurrencies are here to stay and that American citizens will be able to hold their digital assets in the same way they hold their dollars.

Overall, I see three main existential threats, or at the very least, risks on Bitcoin’s horizon:

Custody

Compared to that of traditional assets like stocks and bonds, the safekeeping of bitcoin is different. Bitcoin adds a new dimension to custody and the ownership of assets. Cryptography enforces bitcoin’s ownership: the possession of digital private keys equates to ownership. The highly technical management of private keys requires solutions that do not exist in traditional asset custody.

In the last ten years, the mismanagement of private keys has cost investors hundreds of millions of dollars, without legal recourse. Even the largest bitcoin players have suffered from security breaches in the last two years, several retail exchanges losing $800 million collectively in client funds. While self-managed custody provides individuals with the optimal protection for their bitcoin, fiduciary responsibilities preclude institutional investors from the custody of bitcoin.

Under the Securities and Exchange Commission’s (SEC) Custody Rule, for example, US institutions must adopt full-service third-party solutions to custody bitcoin. Fortunately, an ecosystem is evolving that should enable access to bitcoin with custodial services on par with traditional asset management services.

Regulation

One of bitcoin’s primary value propositions is its ability to exchange and store value “permissionlessly”. In other words, I believe it will not succumb to the arbitrary imposition of financial regulations. As a result, regulators are questioning how bitcoin can and should be regulated. As a borderless, internet-native asset, bitcoin operates without regard to jurisdiction, though nation-states can and do treat it differently. Some countries like Bolivia have banned it, while others like Malta have created national strategies promoting it.

In the US, bitcoin falls in the regulatory cracks between stocks and commodities. Potentially due to concern that they would become obsolete in a fast-changing environment, the SEC has not pioneered bitcoin-specific policies. Without FDIC insurance and formal depositor rights, bitcoin’s infrastructure also is unregulated. I believe investors have an opportunity to capitalize on the vacuum created by this regulatory uncertainty. Like the Internet, because the Bitcoin blockchain and the bitcoin cryptocurrency are here to stay, governments are likely to discover ways to deploy them to their advantage.

“Over-Institutionalization”

Ironically, institutional adoption could present an existential risk to bitcoin’s value proposition.

Specifically, bitcoin users and investors could fall prey to the custody of assets by third parties, limiting the satisfaction of the first two economic assurances explained in Part 1: 1) Value should be exchanged globally and freely, and 2) Wealth should be owned wholly and protected.

In my view, institutional adoption and Bitcoin’s core principles may be mutually exclusive.

Because institutions must custody bitcoin with third party services, a custodial “banking” layer could result in just a few trusted parties dominating transactions. Users drawn to the most cost-efficient solutions also could transact with IOUs, saving on transaction costs and further diminishing Bitcoin’s ability to satisfy the first two economic assurances.

As noted in a recently published article by Deribit Insights Why Bitcoin Might Not Survive A Bitcoin Standard, bitcoin could succumb to the fate of gold in 1933 and 1970, when the US government cancelled redemptions and abandoned the gold standard, eliminating its core value proposition.23 Today, more than 4 million BTC – 22% of bitcoin’s circulating supply – is in held in centralized custodial solutions.

Final Remarks

Bitcoin is an emerging monetary asset. I believe its rapid growth has positioned bitcoin to earn an allocation in well-diversified investment portfolios.

Bitcoin offers one of the most compelling risk-reward profiles among assets, as my analysis suggests it should scale from roughly $200 billion today to $1-5 trillion network capitalization during the next five to
ten years. In my view, capital allocators must consider the opportunity cost that will be associated with ignoring bitcoin as a new asset class.

What’s been clear is that opportunity cost has skewed one certain direction for nearly the entirety of Bitcoin’s existance.