Crypto Market Commentary
3 March 2019
Doc's Daily Commentary
Has bitcoin proven its role as a store of value?
In this article, I will explore whether Bitcoin, through its 10-year life, has shown characteristics of a store of value in reference to the current global reserve currency United States Dollar and the default historical store of value, Gold. I explore in brief, why gold has been the most effective store of value through history, and the important characteristics of a valid store of value. Finally, I present a study assessing the comparative performance of gold and Bitcoin as a hedge against USD inflation since 2013 to make an assessment as of Bitcoin’s role as a store of value.
This article is the first of two parts.
- Part 1 will discuss the basis of what makes a store of value and how Gold has fulfilled this role
- Part 2 will establish the fundamental basis for Bitcoin as a store of value and compare the relative performance of Bitcoin, Gold and the DOW index from 2010 to Jan 2019.
Bitcoin’s present use case
Ten years since the Bitcoin genesis block was mined and the dominant use case and ideology underpinning Bitcoin’s valuation today is the perception of it as store of value. The vast majority of owners of Bitcoin today entered the market for one of two reasons:
- Bitcoin’s ease of transport and transfer, un-censorable nature and/or price volatility are desirable characteristics in adverse political or monetary climates (as seen by adoption in Venezeula in response to hyperinflation of the bolivar and restrictive currency controls)
- Speculative or fundamental investment with expectations of future appreciation.
In both of these scenarios, the asset is seen to maintain its value over the short and long term relative to fiat currencies. It is important to note that the concept of a store of value is relative between assets. Given the majority of transactions involve money (usually fiat currency) as one side of the trade, the natural comparison is a store of value relative to these inflationary fiat currencies.
Longer term, Bitcoin has an uncertain future, both in terms of the risks and challenges it faces as well as the immense opportunities to become a vehicle for global settlement, payment or even act as the global reserve currency. However to reach this potential, Bitcoin and its layer stack must undergo both technological development, continued building on sentiment and trust and step through the evolutionary phases of money — Collectible, store of value, medium of exchange and finally unit of account. I believe we are somewhere in the early days of store of value.
Traditional stores of value
The inflationary model nature of money is a tried and “trusted” approach which has seen all historical forms of money devalued over the long term in relation to their purchasing power of commodities, goods and services.
Consumable goods and raw materials are generally one of the best measures of the relative purchasing power and value between different assets and currencies. This system is maintained by participants exploiting market arbitrage where goods become relatively cheap in one currency, demand and exchange via this route increases and drives prices up. Conversely, where goods become relatively expensive in one currency, the market drives consumers to seek cheaper alternatives and prices reduce.
However over the long term, any money which is inflationary by nature becomes increasingly devalued in its purchasing power. The dominant money today is government issued fiat currencies which are, under normal conditions, inflated at rates of a few percent per year. This system promotes holders of money investing in assets such as bonds, stocks, commodities and real estate which creates markets for these assets and growth in the economy.
In effect, these investments are a hedge against inflation where the expectation of appreciation in value (purchasing power) relative to inflationary fiat currencies is representative of a store of value, at least over the time horizon of the investment.
The prominent and default stores of value in the mind of the average investor are precious metals (gold as the primary candidate) and real-estate, the reasons which will be discussed in the next section.
Characteristics of a store of value
The concept of a store of value is well captured in book ‘The Bitcoin Standard’ through a study of the history, development and downfall of the numerous forms money has taken. For brevity, I will not repeat these historical lessons here but instead summarise the key characteristics a true store of value must have over the long term:
- Salability across space — The asset must be accepted widely enough as having value such that sufficient liquidity exists to dispose or purchase the asset without excessive slippage of price or difficulty transacting.
- Salability across scale — The asset must be sufficiently divisible that it can be bought, sold and used for purchasing both large and small transaction values without excessive friction or limitations on accessibility to the average person.
- Salability across time — The asset must not deteriorate over time nor carry significant risk of heavy future inflation or devaluation such that confidence in retention of purchasing power allows long term planning for financial decisions and inheritance.
- Generally have a high stock-to-flow ratio — that is the inflation of new supply is relatively small in comparison to the existing supply such that value is not heavily diluted. The longer this trend is demonstrated and the greater the confidence supply will not greatly increase in the future, the better the store of value.
With this in mind, it is obvious why in today’s world neither apples, livestock or vehicles are seen as stores of value whilst durable and widely available assets like gold have adopted the role of stores of value across numerous civilisations. The majority of people would see real estate as a store of value given the proven long term appreciation and reliable demand. However the major limitation with real estate is the cost of entry which is increasingly precluding participation by a large cross section of society.
Precious metals as a store of value
Gold and silver have been used as money throughout history and in the context of stores of value, the reasoning behind their adoption as money is sound:
- Widely available and historically accepted as having relative value across the world. Liquidity for these metals has been created through history by authorities utilising them as the basis for money and today, the free market perception as a “risk off” hedge continues to support supply and demand (salability across space).
- Relatively divisible either by way of physical separation (coins or bars) or via proxy ownership such as ETFs, digitised ownership or gold backed currencies prior to the abandonment of the gold standard (Salability across scale).
- Durable materials which do not deteriorate or tarnish over time which results in the ability to hold the asset indefinitely and pass value on as inheritance (salability across time).
- Natural limit on overall supply coupled with a high difficulty and cost associated with production leading to a relatively low inflation rate and thus a high stock-to flow ratio.
Gold in particular is seen as the de-facto store of value and historically, has shown relatively constant purchasing power throughout the 20th and 21st centuries. Of note is the transition in 1973–74 at the end of the Brenton Woods System “gold standard” at which point the USD underwent a rapid and substantial devaluation relative to gold and the gold price became subject to the forces of a free market rather than a government defined valuation.
Figure 1 – Purchasing power of gold in relative value (green) and in 2018 terms (yellow). Note how the purchasing power of gold has never fallen below $250 (yellow) and has been in constant increase in relative terms (green). This shows that over the long term gold is indeed a store of value relative to the USD and the USD has lost purchasing power over time whilst gold maintains it. (Chart Source)
Gold as a store of value
Given the durability of gold, almost all above ground gold throughout history remains available in one form or another today. The dominant location for above ground gold is jewelry, accounting for 47.6% of the 2018 total supply. The other primary use cases are investment either by countries (17.02%) and increasingly as a private investment (21.3%) with the rest associated to industrial applications or unaccounted for outcomes.
Fun fact – If you were to collect the global above ground supply of gold and smelt into a cube, it would have dimensions of ~21.6m for each side – an interesting correlation to the 21million supply of Bitcoin. Furthermore, the gold available for Investment purposes only (excluding jewelry and industrial) amounts to cube with 17.4m sides – similar to the widely estimated final circulating supply of 16 to 17 million bitcoin after accounting for lost coins.
1M bitcoin may be reasonably compared to 1m on each side of the above ground gold cube. Another Satoshi special?
Figure 2 – Use cases and total supply levels for above ground gold (Data source)
Now with an average and relatively constant inflation rate over the past decade – gold has shown to have one of the highest stock-to-flow ratio of any asset on earth, for 2018 sitting at 56.8 when accounting for Jewelry and 84.5 if we only consider official holdings and private investment. This means that the amount of new gold entering the investment market is 84.5 times less that that which is already owned. This creates the scarcity of the metal and instills market confidence that no significant increase in supply is expected in the future and thus assuming demand remains, price stability to appreciation are the most likely long term outcomes. Note also that stock-to-flow ratio is the inverse of inflation rate (stock-to-flow = 1/inflation rate).
The inflation rate of gold is expected to decrease when the concept of “peak gold” comes into play. This is the tipping point where the maximum global gold production is realised and thus a reduction in inflation is expected to occur into the future. Peak gold is estimated to occur in the near team, between 2022 to 2025 which will act to reduce the flow (inflation) and thus increase the stock-to-flow ratio. This will improve the fundamentals of gold as a store of value (similar to the halving of Bitcoin although on a significantly smaller scale).
Be sure to check back for Part 2 tomorrow! Email email@example.com with your questions or suggestions for future topics!