In this CoinDesk 2016 in Review special feature, Burniske and White discuss their recently published white paper, "Bitcoin, a New Asset Class", unpacking what they see as the tech's investment potential.
While much of the traditional financial world was focused on "blockchain" in 2016, few gave bitcoin as much attention.
When brought up, bitcoin was referenced in the context of macroeconomic dislocations like the depreciation of the Chinese yuan, India's banknote ban, or Trump's surprise election win. While these events often provided great examples of its use as a "disaster hedge" in the face of capital market turmoil, we believe the bigger story of bitcoin's evolution as a unique asset class was left mostly untouched.
Recently, however, we have witnessed institutional investors awaking to bitcoin's maturation and long-term value proposition in the context of Modern Portfolio Theory (MPT).
MPT emphasizes that investors should not consider single investments in isolation, but rather in the context of an overall portfolio.
Using MPT, investors can intelligently construct portfolios by including uncorrelated assets to maximize returns for a given level of risk. Alternative assets such as gold and oil have become a popular means to add diversification to traditional portfolios of equities and bonds.
In our paper, we show that bitcoin's attributes could make it a valuable addition as part of a diversified investment portfolio.
Making the case
Using six years of data, we investigated aspects of bitcoin's market behavior, such as its use cases, volatility, risk-reward profile and price independence.
The results show bitcoin is gaining traction as a disruptive peer-to-peer currency, a development that bodes well for its long-term potential.
As one of the three core pillars of a currency, we think bitcoin's use as a means of exchange is critical for its long term viability. Coinbase has unique insight into how bitcoin is being used as a means of exchange for goods and services, with around 45,000 merchants using its payment processing tools.
In 2016, both the number of transactions and monthly processing volume that merchants accepted using bitcoin, doubled from the previous year.
Some of this volume is being driven by new bitcoin users. For example, the number of Coinbase daily new user signups has also doubled since January 2016. In the broader bitcoin ecosystem, transactional volumes grew 118% year-over-year, with bitcoin's blockchain now processing over $115,000 per minute.
As bitcoin continues to grow, Coinbase and ARK are seeing increased interest and enthusiasm from capital market investors.
We believe many institutional investors are realizing bitcoin may be one of the best ways to get "blockchain" exposure in their portfolios.
Bitcoin’s absolute returns have outpaced most other assets over the last five years, but few realize that its volatility has been dropping too. When measured by the trailing year standard deviation of daily percent price changes, bitcoin's volatility dropped 28% in 2016.
Many people mistakenly equate a rising price with increased volatility. Bitcoin’s 2016 market behavior, however, provided a great counterexample to that misconception.
While bitcoin’s price more than doubled last year, it did so in a gradual manner when compared with the more severe spikes and drops of years past.
An instance of controlled volatility was during the August 2016 compromise of the popular bitcoin exchange Bitfinex, when bitcoin's price dropped sharply only to quickly regain its footing.
We believe this to be a sign of mature investors taking up slack from weak holders, quickly balancing out the order books of bitcoin markets. In prior years, bitcoin’s recovery may not have been so graceful.
To give some context on how much bitcoin’s volatility has decreased, it was 30% less volatile than Twitter’s stock in 2016, and just as volatile as USO, one of the more popular oil ETFs on the market.
Reward versus risk
Dividing absolute returns (minus the risk-free rate) by standard deviation yields an investment calculation called the Sharpe Ratio, which calibrates each unit of return for the risk taken.
Despite its perception as a "high risk" asset, in 2016 bitcoin compensated investors twice as much for the risk they took than the S&P 500 did.
Moreover, 2016 provided bitcoin’s best year of risk-adjusted returns ever, as shown in the graph below from our white paper.
Over the years, bitcoin has behaved in a relatively independent manner from the broader capital markets. We believe price independence is a valuable characteristic in a world where the cadence of macroeconomic dislocations seems to be accelerating.
As we saw in 2008, world markets tend to be highly correlated in times of crisis.
Bitcoin, however, has shaken that trend and consistently demonstrated low correlation with other capital market assets, shown below.
Bitcoin demonstrated its differentiation as an emerging asset class within the capital markets in 2016. That said, if more institutional investors begin to incorporate bitcoin into their portfolios, bitcoin may intensify in its correlation with other capital market assets.
For example, when investigating bitcoin's correlation with gold, it was interesting to us that in 2016 its correlation reversed, climbing back into positive territory.
Certainly, correlation does not imply causation, but the narrative of bitcoin as gold 2.0 appears to be gaining steam in the capital markets.
If bitcoin shows increased correlation with other capital market assets in 2017, then 2016 may mark the beginning of convergence between the Street, the Valley, and Satoshi’s currency.
Mixed paint image via Shutterstock
Disclaimer: CoinDesk is a subsidiary of Digital Currency Group, which has an ownership stake in Coinbase.